Accounting methods refer to the different rules which are followed by the different companies for the purpose of recording and reporting the revenues and expenses incurred by the company over an accounting period, where the two primary methods include the cash method of accounting and accrual method of accounting.
What is an Accounting Method?
An Accounting Method refers to the set of rules that determine when the revenues and expenses of a company are recognized in its books of accounts. Different accounting methods lead to a different representation of a company’s financials, which makes the choice of method an important decision.
Top 2 Types of Accounting Method
#1 – Accrual Accounting
Under the accrual accounting method, all revenues and expenses are recognized based on their occurrence, regardless of when they are received/paid. Revenues are thus recognized when they are earned, while expenses are recognized when incurred. For example, a car servicing company would record revenue when it provides car services to a customer, whether or not it receives payment against the service by then.
- As for expenses, if the company uses a rented garage for its operations, the rent cost would be recognized in the period for which the garage is rented. For a year’s rental, 12 months’ worth of rent would be recorded as an expense, even if less than 12 months have been paid for.
- The accrual method is based on the ‘matching principle’ which means expenses are matched (reported together) with the revenues for which they are incurred.
- Expenses that are not directly tied to any portion of revenue are to be recognized as and when they are incurred.
#2 – Cash Accounting
Under the cash accounting method, transactions are recorded only when money changes hands. Revenues are recognized when actually received, while expenses are recognized when paid for.
- This method does not follow the matching principle due to the differences in timings of receipts and payments
- For example, a gymnasium would record revenues when it receives fee payments from its members. As for expenses, the gymnasium would record rent costs equivalent to the rent payments made to the landlord during the year.
Examples of Accounting Method
Below are the examples of the accounting method.
Consider a clothing manufacturer called Fabrix Inc. that maintains its accounts under the accrual method. On selling garments worth $10,000, Fabrix Inc. would record sales revenue of $10,000, regardless of whether it is a cash or credit sale.
Following the matching principle, any expenses incurred to gain the $10,000 revenue would also be recorded in the same period.
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Say, 30% of sales commissions are to be paid to agents who sold the garments on behalf of Fabrix Inc.
In this case, Fabrix Inc. would record revenue of $10,000 and commission expense of $3000 (30% of $10,000) together in the period of sale.
Consider another company, Silks Inc., that uses the cash method. In case of a similar sale like the above example, Silks Inc. would record only that portion of the $10,000 sales against which it has received payment.
In case of a 60% credit (40% cash) sales policy, Silks Inc. would recognize revenue to the extent of $4000 only i.e. 40% payment received on the $10,000 sale.
Any commissions or other expenses, even if directly tied to this sale, would be recorded only when Silks Inc. makes their payment.
Advantages of Each Type of Accounting Method
Below are the advantages and users of each type of Accounting Method –
#1 – Accrual Method
- The accrual method provides a more accurate, clearer picture of a company’s financial condition, in a particular accounting period.
- Most investors and analysts find financials reported using the accrual method more useful in gauging a company’s performance.
- The accrual method also provides a stronger base for forecasting future earnings and expenses and related decision-making.
- It is generally the large, well-established businesses and publicly listed companies that use the accrual method. In the U.S., the Internal Revenue Service (IRS), the government agency that administers and enforces U.S. federal tax laws, has laid out certain criteria for companies that are required to use the accrual method.
#2 – Cash Method
- The cash method requires relatively less effort and is easier to understand and report. It does not require much accounting staff and in most cases, can be handled solely.
- It directly reflects the value of cash inflows and outflows, which helps understand the current profitability in monetary terms.
- It allows only the actual receipts to be taxed, rather than the total earnings. This may help the company in tax planning and avoid a large tax burden in periods of cash crunch (lower net inflows).
- Smaller businesses with no/low inventory, start-ups, and individual taxpayers generally prefer the cash method for ease of accounting.
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.
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.
Cash accounting is based on cash values received and paid. It is the simpler method but is advisable only for small-scale businesses. Accrual accounting, along with the matching principle, is based on earned revenues and incurred expenses. It clearly reflects business performance, making it more reliable and widely accepted by users. Under the IRS rules, qualifying small businesses are permitted to use either of the two methods but on a consistent basis.
This has been a guide to what are Accounting Methods and its definition. Here we discuss the top two accounting methods – accrual and cash method along with examples, explanations, and advantages. You can learn more about accounting from the following articles –