Accounting Method

What is the Accounting Method?

Accounting method refers to the rules a company follows in reporting revenues and expenses. The two primary methods are accrual accounting and cash accounting. Cash accounting reports revenue and expenses as they are received and paid; accrual accounting reports them as they are earned and incurred.

Understanding the Accounting Method

Cash Basis

Accounting records prepared using the cash basis recognize income and expenses according to real-time cash flow. Income is recorded upon receipt of funds, rather than based upon when it is actually earned; expenses are recorded as they are paid, rather than as they are actually incurred. Under this accounting method, therefore, it is possible to defer taxable income by delaying billing so that payment is not received in the current year. Likewise, it is possible to accelerate expenses by paying them as soon as the bills are received, in advance of the due date.

Accrual Basis

A company using an accrual basis for accounting recognizes both income and expenses at the time they are earned or incurred, regardless of when cash associated with those transactions changes hands. Under this system, revenue is recorded when it is earned rather than when payment is received; expenses are recorded when they are incurred rather than when payment is made.

Difference Between Accrual and Cash Accounting Method

Below is the list of differences between cash and accrual accounting method

  • The accrual method recognizes revenues and expenses entirely during one period i.e. when earned/incurred.
  • The cash method, on the other hand, may result in transactions pertaining to a single sale/expense getting spread across several periods, based on the timing of payment. This leads to the accounts not accurately reflecting the financial performance in any given period.

For instance, a period showing higher revenues may not necessarily mean improved sales performance. It could rather simply mean that more cash was collected from customers against sales made in any period.

Why Method Matters

The accounting method a business uses can have a major impact on the total revenue the business reports as well as on the expenses that it subtracts from the revenue to get the bottom line. Here’s how:

  • Cash-basis accounting: Expenses and revenues aren’t carefully matched on a month-to-month basis. Expenses aren’t recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren’t recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available.
  • Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it’s spending to operate each month and how much profit it’s making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn’t paid out until the next month. Revenues are recorded in the month the project is complete or the product is shipped, even if the company hasn’t yet received the cash from the customer.

Considerations When Choosing an Accounting Method

The value of accrual accounting becomes more evident for large, complex businesses. A construction company, for example, may undertake a long-term project and may not receive complete cash payments until the project is complete. Under cash accounting rules, the company would incur many expenses but would not recognize revenue until cash was received from the customer. So the book of the company would look weak until the revenue actually came in. If this company was looking for financing from a bank, for example, the cash accounting method makes it look like a poor bet because it is incurring expenses but no revenue.

Under accrual accounting, the construction company would recognize a percentage of revenue and expenses corresponding to the portion of the project that was complete. This is known as the percentage of completion method. How much actual cash coming into the company, however, would be evident on the cash flow statement. This method would show a prospective lender a much more complete picture of the company’s revenue pipeline.

Accounting Methods and Taxes

The Internal Revenue Service requires taxpayers to choose an accounting method that accurately reflects their income and to be consistent in their choice of accounting method from year to year. This is because switching between methods would potentially allow a company to manipulate revenue to minimize their tax burdens. As such, IRS approval is required to change methods. Companies may use a hybrid of the two methods, which is allowable under IRS rules if specified requirements are met.

Change in Accounting Method

  • Companies are generally encouraged to use any one of the above methods consistently. This avoids the manipulation of accounts for representation and tax purposes.
  • The accounting method may be changed, depending on the rules and policies prevailing in the relevant jurisdiction/regulator of the company.
  • The IRS, for instance, requires all taxpayers to use a consistent accounting method, one which accurately reflects their financial affairs. It requires the taxpayer to seek special approval should they wish to change the accounting method after the first year. It also allows for a hybrid method of accounting, which is a combination of the accrual and cash methods, however subject to certain restrictions.