All the Fuss over Accrued Accounting

I am not going to enter any fights about cash accounting versus accrued accounting. As I note in my latest book, there is not a small business owner that does not keep in her head how much she is owed or how much she owes. It is just a question of if she records it in her book of records.

I am not going to argue about if DCAA or GAAP requires accrued accounting. Thirty years ago one could raise the specter of cash accounting as an alternative ‘comprehensive’ form of accounting and there are still some specific industries where cash or modified accrued are even required.  Unless you are one of those specific industries (some form of insurance companies for example) DCAA is going to expect accrued accounting and GAAP assumes it.

I am going to argue that an understanding of accrued accounting takes a bit of work and is poorly understood by many DCAA auditors and many small business contractors. The Department of Defense actually placed their misunderstanding of accrued accounting into regulation with DFARS 252.242-7006 “Accounting System Administration”. I will explain why I believe this in a few moments.

I am also going to argue that the introduction of powerful inexpensive personal computer accounting software designed and marketed for use by non-accountants and non-bookkeepers further blurred the lines between cash accounting and accrued accounting and brushed aside the basic need to understand the very nature of accounting.

I feel I offer a bit of unique insight into this issue due to my background. I started out in operations with government contracting, frustrated because I did not understand what the accountants were muttering about.  I developed into a full charge bookkeeper in addition to my operational responsibilities and moved on to jobs as a controller, Finance Director, and CFO. Eventually I passed the CPA exam in one sitting, began my practice, and taught accounting both at the undergraduate and graduate level.

Let’s Make One Thing Perfectly Clear

I believe most of the confusion on accruals and government contracting compliance arise out of one simple misunderstanding of GAAP. It is this simple FACT – All of GAAP applies to the Accounting Period and for most entities the Accounting Period is one YEAR.  The accounting period is not the month, not the quarter, not the day. It is the YEAR!

One hundred years ago, without the help of computers, businesses kept their ledgers on a cash basis. At the end of the accounting period, the balances were transferred to a working trial balance where adjusting journal entries were made to correct any identified errors and to make the necessary accruals. After the creation of the necessary financial documents (Balance Sheet and Income Statement) the closing entries were made to close out the temporary accounts to retained earnings, most of the adjusting journal entries were reversed, and the business began the accounting for new accounting period (year). This is what is referred to as the Accounting Cycle.

Without the help of computers, it was almost impossible to track accruals easily. Even with computers it is amazing how much trouble small businesses get into. The art of the reversing journal entry seems to be lost as accountants attempt to ‘true up’ entries when the actual amounts are known instead of reversing the original accrual and entering the actual cost.

Compounding this is the lack of documentation to support accruals and journal entries. When I taught intermediate accounting, I displayed a section of the original accounting records maintained by the US Army. Perhaps you heard of the bookkeeper – George Washington. Almost 250 years after he started keeping track of the Army’s revolutionary war expenses you can follow his entries perfectly; “To Cash for recovering of my pistol which had been stolen and for repairing then afterwards – 1.10”. I bet he kept the receipt.  I told my students that I expected to see their journal entries as clearly stated 250 years after the fact. I cannot express my frustration with journal entries that, if I am lucky, say – “To credit cash and debit repairs”. If you cannot articulate why you are doing the entry how sure can you, or anyone else, be that it is correct?

I worked with one of the largest government contractors in the country in the 90’s and they still preserved this historical proven Accounting Cycle, although due to SEC and DCAA positions they applied most accruals on a monthly basis. They did this even with the resources available with today’s accounting software. Payroll was weekly and this made the Wages Payable accrual pretty easy. It was set up to automatically reverse at the start of the new month allowing the actual amount to post. Accounts Payable (AP) were cleared every Thursday and any unpaid AP at the end of the month was put into a file, added up, and accrued as a reversing journal entry. Unearned revenue was accrued on a reversing entry and so on.

Again, modern accounting software makes it easy for most contractors to keep a fully accrued set of books if they are just careful about any journal entries or adjusting journal entries they make. Of course, I find that most small business contractors, knowingly or not, do not keep fully accrued books each month. I believe I have successfully demonstrated that GAAP does not require them to do so as their accounting period is one year. One of many example areas is depreciation. Many small business contractors do not make depreciation entries until they close their year and finish their tax returns. Again, GAAP states this is fine.

Everyone happy? Apparently the Department of Defense was not. For years DCAA auditors time and time again would argue that GAAP applied as they wished, normally on a monthly basis. A few years ago, DOD adopted the aforementioned regulations that requires contractor accounting systems to record costs on a monthly basis. Sigh…

There is a definition of ‘costs’ that confines them to a cash basis but there is also a definition that defines costs as the total to include multiple expenses ($1,000 in costs divided between an expense of $750 dollars and an asset of $250 for example). Guess which definition DCAA will rely on?