What is an Accounting Method?
An accounting method is defined as the rules, circumstances, and methodologies used by a company to report its financial data. Companies will often choose to use one accounting method over another based on their overall goal of keeping accurate records of their operations. Accounting methods are also important because they dictate how money is tracked throughout the life of an organization.
There are two basic accounting methods: Cash basis and Accrual basis. Each method, when used alone, provides a straightforward summary of what the company does each year, but it can lead to confusion when combined with other financial information.
Understanding an Accounting Method
Accounting methods are used to track financial transactions of any entity, whether legal or not. Understanding how it all works and how important it is to track financial data is essential to a successful business. Accounting methods help accountants create, update and maintain detailed records of every transaction taken out or generated within an organization. Understanding how each part of an accounting process works helps minimize errors and increase accuracy throughout the organization.
Understanding the various accounting methods and principles involved in taxes is important. Understanding these principles assists both the auditor and the taxpayer provide correct information to the government during an audit. It also helps prepare people for any potential problems that may come up during later years when filing their return or during an audit.
Accounting methods are the methods used to determine the status of transactions on a company’s books. Every business has its way of handling accounting, so understanding the different methods can help your business stay organized and effective.
1. Cash Accounting
A cash basis accounting method is a popular method of accounting for small and mid-sized businesses. At its core, cash accounting records all of your transactions as if they were payments made with your traditional accounting method, but the cash is held in a separate account and is not added to your total income. As the name suggests, this accounting method records transactions like purchases or sales, using only the cash deposit made by the vendor/buyer on the sale or purchase.
Cash basis accounting is not only used by small businesses. Large enterprises must also use cash accounting methods to keep their books in order and comply with various government regulations.
The cash basis is the basis for cash management. As such, it deals with the time in which the last transaction is made. It generally includes bills like rent, insurance, credit card bills, taxes, and so on. It deals with these transactions immediately, and cash is also kept in reserve as an emergency fund for these purposes.
2. Accrual Accounting
The concept of Accrual Accounting is relatively simple. An expense is recognized when it is incurred, whether or not it is paid by revenue. For example, if you sell one thousand products and receive one hundred dollars of revenue per product sale, you have incurred one thousand dollars of costs in product development. Similarly, if you receive ten cents of revenue for each sale of one thousand products, then there would be ten cents worth of costs for products sold.
It involves following up on minimal/ repeat sales with subsequent sales that also meet this criterion. The closer you can get to matching revenue with expenses, the easier it will be to recognize revenue from repeat sales. This can help companies significantly improve their cash generation and overall profitability.
Example of an Accounting Method
Accounting methods can differ depending on whether it’s for an individual or a business. A business may often choose to use accrual accounting, which recognizes revenues when they are earned and expenses when they are incurred. With accrual accounting, the construction of a building, for example, might generate revenue as it’s being constructed, whether or not the company has collected any payments from the building’s tenants yet.
Under the cash method of accounting, expenses are recorded as they are incurred, but no revenue is recorded until the cash is received from customers. So, the income statement and balance sheet will show zero income (because revenue is not recognized until cash is received) and high expenses (because all expenses are immediately charged to expense). If this company were looking for debt financing from a bank, it would likely be rejected because it has weak financials with little or no revenue.
Under accrual accounting, construction companies recognize revenue and expenses corresponding to the complete project portion. Companies can use either the percentage-of-completion method or a completed-contract method. The former requires estimates of costs and revenues that may be revised as the project progresses; the latter applies only when specific contracts are completed. In each case, cash flow is also reflected in a company’s cash flow statement.
Accounting Method and Taxation
The IRS requires taxpayers to use a consistent accounting method that will accurately report income. Fluctuating between methods too often creates loopholes that companies can use to manipulate their revenue, shifting a greater tax burden onto other taxpayers. Doing so ensures that a company cannot manipulate revenue to escape taxation.
Although the IRS allows small businesses to use a hybrid of cash and accrual accounting methods, they must meet certain requirements.
Accrual Accounting vs. Cash Basis Accounting – Key Differences
Accrual basis accounting is used for net operating income recognized in the income statement for the current year. This is the method most commonly used when recognizing cash flows from operations. Cash basis accounting is used when estimating an entity’s future income and expense based on knowledge of the owner, including specific patterns of purchases and sales. A distinction can be drawn between these two methods. Both result in recognizing temporary differences between the current and previous periods while recognizing the permanent nature of enduring relationships between assets and liabilities.
Cash basis accounting is the traditional method of accounting for small business owners and owners of other independent businesses. It’s the traditional method of accounting for cash flow generation, which means it gives you an accurate picture of a company’s cash position at any given time. Recording all liability in the current year and accruing receivables from customers over time shows you how much money your company is spending but doesn’t show you what you’re earning. Accrual accounting can be challenging for large organizations with long-term financial statements and complex control systems for accounting.
Cash basis accounting relies upon the merchant’s records to report cash payments. An expense is recognized only when the cash received for an outstanding transaction is included in an operating income statement. Accrual accounting, by contrast, recognizes all-expense income at the time it occurs rather than after it is paid by applying a profit margin to account for anticipated income later. As a result, an accrual basis company will usually include more cash than a cash basis company for the same or similar assets under management because it has more liquidity and can afford to be more conservative in managing its liquidity.
Accrual Accounting vs. Cash Basis Accounting Example
Under the cash basis, if you purchase a machine for $5,000 in the US and sell it a few months later for $10,000, your bookkeeping records show the cash value of the machine as zero (no amount changed). Under the accrual basis, however, you record the asset’s increase in value as income when you purchase the asset, even though you may not have taken physical possession of the asset until much later (and may not even have paid cash for it yet).