What Is an Accounting Method?
An accounting method refers to the rules a company follows in reporting revenues and expenses. The two primary methods of accounting are accrual accounting (generally used by companies) and cash accounting (generally used by individuals).
Cash accounting reports revenues and expenses as they are received and paid through cash inflows and outflows; accrual accounting reports them as they are earned and incurred through sales and purchases on credit and by using accounts receivable & accounts payable. Generally accepted accounting principles (GAAP) requires accrual accounting.
Key Takeaways
- An accounting method consists of the rules and procedures a company follows in reporting its revenues and expenses.
- The two main accounting methods are cash accounting and accrual accounting.
- Cash accounting records revenues and expenses when they are received and paid.
- Accrual accounting records revenues and expenses when they occur. Generally accepted accounting principles (GAAP) requires accrual accounting.
- The Internal Revenue Services (IRS) requires accrual accounting for businesses making an average of $25 million or more in sales for the preceding three years.
- Once a company chooses an accounting method, it has to stick to that method per rules set by the IRS and requires approval if it wants to change its accounting method.
Understanding an Accounting Method
All businesses need to keep accounting records. Public companies are required to do so. Accounting allows a business to monitor every aspect of its finances, from revenues to costs to taxes and more. Without accurate accounting, a business would not know where it stood financially, most likely resulting in its demise.
Accounting is also needed to pay accurate taxes to the Internal Revenue Service (IRS). If the IRS ever conducts an audit on a company, it looks at a company's accounting records and methods. Furthermore, the IRS 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.
Types of Accounting Methods
Cash Accounting
Cash accounting is an accounting method that is relatively simple and is commonly used by small businesses. In cash accounting, transactions are only recorded when cash is spent or received.
In cash accounting, a sale is recorded when the payment is received and an expense is recorded only when a bill is paid. The cash accounting method is, of course, the method most people use in managing their personal finances and it is appropriate for businesses up to a certain size.
If a business generates more than $25 million in average annual gross receipts for the preceding three years, however, it must use the accrual method, according to Internal Revenue Service rules.
Accrual Accounting
Accrual accounting is based on the matching principle, which is intended to match the timing of revenue and expense recognition. By matching revenues with expenses, the accrual method gives a more accurate picture of a company's true financial condition.
Under the accrual method, transactions are recorded when they are incurred rather than awaiting payment. This means a purchase order is recorded as revenue even though the funds are not received immediately. The same goes for expenses in that they are recorded even though no payment has been made.
Example of 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 accounting book of the company would look weak until the revenue actually came in. If this company was looking for debt 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 in the cash flow statement. This method would show a prospective lender a much more complete and accurate picture of the company's revenue pipeline.
