An accounting method refers to a set of rules that a company adheres to when keeping its financial records and reporting financial transactions. The transactions are recorded in a manner that accurately reflects true income. The two basic methods of accounting are cash accounting and accrual accounting.
Under the cash method, income and expenses are reported and deducted in the tax year they are received and paid, respectively. On the other hand, under the accrual method, both income and expenses are generally reported in the tax year when they are realized, regardless of when they are received.
An accounting method refers to a set of rules and guidelines that determines how a company reports its income and expenses.
The two main accounting methods are cash and accrual. Under the cash method of accounting, income is recorded as received, and expenses are recorded after payment, while under the accrual method, transactions are recorded when realized.
The cash accounting method is simple, easy to implement, and appropriate for smaller businesses, while the accrual accounting method is generally complex and expensive.
Types of Accounting Methods
1. Cash accounting method
Cash basis accounting is relatively easy to implement; hence, it is commonly used by small businesses. The cash method does not conform to the conventions of Generally Accepted Accounting Principles (GAAP). Under the cash method, financial transactions are not recorded until they are actually realized.
For example, income is recorded when payment is received, while expenses are entered in books of accounts when a bill is settled. Financial statements prepared under the cash accounting basis contain information about the sources of cash during the tax period, how the cash was used, as well as the cash balances at the date of reporting. Additional information about liabilities may be contained in the notes to the financial statements.
Although the cash accounting method is most appropriate for sole proprietorships and small businesses, it also used to manage personal finances up to a specific limit. For example, if annual sales that a business realizes are more than $5 million, the Internal Revenue Service (IRS) dictates that it must use the accrual method of accounting.
One notable flaw with the method is that it can offer a misleading picture of an entity’s financial health, especially when transactions, such as unpaid expenses, cash receipts, or outstanding receivables, are not represented in the financial statements.
2. Accrual accounting method
The accrual method of accounting is founded on the matching principle, whose aim is to match income and expenses in the correct year. The criterion is further based on a cause-and-effect relationship between reported revenues and expenses, making it a prerequisite for the matching principle.
Matching revenues and expenses helps the accrual method to achieve a more accurate measurement of periodic net income of business since transactions are recorded together in the same period.
Under accrual accounting, profits are only recorded after they are earned, and expenses are recorded after they are incurred. It implies that an invoice can be recognized as revenue, even though funds are not yet received.
Similarly, expenses are recorded even though payment can be deferred. It is important to note that when receiving an advance payment under the accrual method, the recognition of advance payment is postponed until the following period when the revenue is earned. It is, however, impossible to postpone beyond the next tax year. As a result, the advance payment must be included in the income in the relevant financial reports and gross receipts for tax purposes.
Selecting an Accounting Method
The accrual accounting method becomes valuable in large and complex business entities, given the accurate picture it gives about a company’s true financial position. A typical example is a construction firm, which may win a long-term construction project without full cash payment until the completion of the project.
Under the cash accounting guidelines, the company would accrue many expenses, and until the entire revenue payment is received, it would not realize revenue. It means that the company’s book of accounts would look weak until the cash is recorded. A lender, for example, would consider the company as not creditworthy because of its large expenses and is in a large loss position.
Comparatively, under the accrual accounting method, the construction firm would realize a portion of revenue and expenses that correspond to the proportion of the work completed. It can present either a gain or loss in each financial year in which the project is still active. The method is called the percentage of completion method.
Nevertheless, it is the cash flow statement that would give a true picture of the actual cash coming in. Such an approach would show the prospective lender the true depiction of the company’s entire revenue stream.
Accounting Method and Taxation
Taxpayers are required by the IRS to consistently use the method of accounting that accurately captures the true income. Consistency is essential since the swapping of accounting methods can potentially create loopholes that a company can use to manipulate its revenue and eventually supplant tax burdens.
Regardless, provided the specified requirements are met, companies are given the discretion to use a hybrid of cash and accrual accounting methods under the IRS.
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