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 accounting is an accounting method that is relatively simple and is commonly used by small businesses. In cash accounting, transaction 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 of us use in managing personal finances and it is appropriate for businesses up to a certain size. If a business generates more than $5 million in annual sales, however, it must use the accrual method, according to Internal Revenue Service rules.

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 is intended to give 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 fund are not received immediately. The same goes for expenses in that they are recorded even though no payment has been made.

Key Takeaways

  • The two main accounting methods are cash accounting and accrual accounting.
  • Cash accounting is simple, but it doesn't work well for complex financial situations.
  • Companies over a certain size in terms of inventory or sales must use the accrual accounting method.

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.