Accrual Accounting

Part of the problem that worker cooperatives face is an accounting system that is built for modern finance. Under Generally Accepted Accounting Principles (GAAP) there are two methods that are used for reporting, cash basis and accrual accounting. The use of cash basis accounting is limited to small businesses who can choose which method to use.

The use of accrual accounting is problematic for worker cooperative because it under reports the losses during the startup period, effectively hiding the losses founding members face. These losses are in addition to the losses hidden in the negative equity account or collective reserve account.

The second and perhaps broader problem with accrual accounting is that is does not give an accurate picture of the current state of a cooperative, which is needed to conduct various transactions. Unlike a conventional business, a worker cooperative will routinely conduct transactions like patronage distributions (whether through cash or written notice or allocation) or payouts from member departure, that are based on the current earnings or assets of the cooperative. In its estimation of the “current state” of a business, accrual accounting relies on assumptions about future events that have not occurred. While these events may be probable, they may or may not actually happen. Accrual accounting assumes the business will continue as a going concern, that accounts receivable will results in future payments, future revenue will offset certain past expenses, etc.

Accrual accounting is designed to match income and expenses to the period they are incurred, whether or not the payments are made or received at that time. The matching principle will cause expenses to be reported in the period that revenue resulting from those expenses was generated. For example in a retail operation the cost of goods will not be recognized until revenue is produced from their sale. This tends to shift the reporting of expenses forward in time.

While accrual accounting might make sense for a conventional business where the current owners have all the future profit rights, it is problematic for worker cooperatives where the current members at any give time have claim to the profits. In a worker cooperative losses are transmitted to the current members immediately, even if it is not reflected in the accounting.

This leads to a variety of potentially unfair situations. For example, take a hypothetical four person worker cooperative where each member puts in $30k ($120k total). The coop spends $60k on leasehold improvements. Then one of the members leaves. If the leasehold improvement created an asset on the balance sheet then the members is paid out $30k, because the expense resulted in a fictitious asset.  Assume the coop ceased operations immediately after the member left. The leasehold improvement would be essentially worthless (you can’t sell improvements to a building you don’t own) and the remaining members would each get $10k back [=($120k initial – $30k payout – $60k improvement) / 3 members] . Basically the loss from the inclusion of a fictitious asset was transferred to the remaining members when the first member was paid out. The point is that the payout of $30k for one member and $10k for the rest is unfair. Fundamentally the state of the cooperative (aside from the payout) didn’t changed after the first member left so there is no reason the other three members should receive less for leaving later.

The same thing can occur with a prepaid expense that is not recognized in the current period. Say a worker coop pays a consultant to develop a strategic five year plan. The consultant is paid immediately but the expense will show up on the income statement in equal amounts over the five years. Assume a similar situation where one member leaves and is paid out right after the strategic plan is completed. If the cooperative ceases operations before five years, the remaining members will be stuck with the loss. Note that the loss was transferred immediately when the first member left, and was fully realized by the other members when the cooperative ceased to be a going concern.

The phenomena of expenses getting pushed forward in time with accrual accounting leads to earnings and assets being recorded as higher than they are at present. The problem is that payments are made in the present based on an inflated value. And it becomes a problem when thing don’t turn out as expected. It could be the business stops operating, a counterparty fails, or other adverse economic events occur. Since it is hard in practice to claw back payments already made a better solution would be to reduce the initial payments to accurately reflect the current state of the cooperative.