Accounting Method

What exactly is an Accounting Method?

It refers to the procedures that a corporation uses to record its earnings and expenditures. The two basic accounting methods are accrual accounting (which is commonly used by businesses) and cash accounting (which is commonly used by individuals).

Cash accounting reports revenues and costs as they are collected and paid through cash inflows and outflows. In contrast, accrual accounting records them as they are earned and incurred through credit sales and purchases, as well as accounts receivable and accounts payable. Accrual accounting is required by generally accepted accounting principles (GAAP).

In-Depth Understanding of an Accounting Method

Accounting records are required for all firms, and public firms are obligated to do so. Accounting enables a company to keep track of all aspects of its finances, from revenues to costs to taxes and more. Without precise accounting, a company would simply have no idea where it stood financially, which would certainly lead to its downfall.

Accounting also helps pay correct taxes to the Internal Revenue Service (IRS). If the IRS audits a corporation, it examines its accounting records and practices. Additionally, the IRS expects taxpayers to select an accounting method that correctly reflects their revenue and be consistent in their method selection from year to year.

Moving between ways might allow a corporation to manipulate income to reduce its tax burden. As a result, changing procedures needs IRS clearance. Businesses may utilize a mixture of the two systems, permissible under IRS laws, provided that certain conditions are satisfied.

What are the types of Accounting Methods?

Cash Accounting

It is a straightforward accounting method that is often employed by small firms. Transactions in cash accounting are only recorded when cash is spent or received.

A sale is recorded in cash accounting when the payment is received, but an expense is recorded only when the bill is paid. The cash accounting technique is the approach most individuals use to manage their personal money, and it is suitable for small firms as well.

Nevertheless, suppose a company produces more than 2.5 crores in average yearly gross receipts over the previous three years. In that case, the Internal Revenue Service requires it to adopt the accrual method.

Accrual Accounting

It is actually based on the matching principle, which seeks to align the timing of both revenue and expense recognition. The accrual approach provides a more realistic picture of a company's financial status by aligning revenues with costs.

In the accrual accounting approach, the transactions are recorded as soon as (immediately) they are incurred rather than waiting for the payments to be made. This implies that a purchase order is reported as revenue even if the money is not received immediately. The same is true for costs, which are recorded even if no payment has been given or issued.

What are the pros and cons of Cash Accounting?

Pros

Cash accounting is easy and provides several benefits to extremely small enterprises that operate only on a cash basis. Some such advantages are:

• It only needs a little accounting expertise, and its simplicity allows anyone to keep or maintain their accounts without hiring an accountant.
• It also does not require accounting software because accounting tasks may be completed with a basic cash book or spreadsheet program.
• The most significant benefit of this system is that it only tracks your transactions in terms of cash inflows and outflows. This gives an accurate view of the organization's money at any one time.

Cons

Cash accounting has a few drawbacks, even though it is simple to adopt and offers precise information about the cash flow. Some such disadvantages are:

• Businesses that maintain accounts in cash only sometimes use an integrated accounting system. Because there is no built-in error-checking system, this can increase the likelihood of mistakes.
• It simply displays how much money one has, but not the financial position. This is because cash accounting makes it difficult to compile reports such as income statements and balance sheets, which are required to correctly establish the financial position.

What are the pros and cons of Accrual Accounting?

Pros

Accrual-based accounting is the most extensively utilized system adopted by all big corporations due to the several benefits it offers. Some notable advantages are:

• Accrual accounting is appropriate for companies that sell on credit. One can record transactions and invoices even if they have not transacted payments in cash.
• When one begins a transaction, it gets recorded using the accrual technique. This makes it simple for businesses to track what they owe to the vendors and what their customers owe them (businesses) at any moment.
• The accrual accounting strategy might help to gain a clearer view of the financial situation. This allows one to generate financial reports such as balance sheets and income statements, which are essential for understanding where the business stands currently.

Cons

The accrual basis for accounting suffers from disadvantages, too, such as:

• It is unsuitable for effective cash flow management. Because transactions are recorded at different times than currency is moved, knowing how much cash one has at any particular time is difficult.
• If one adopts accrual accounting, one must employ double-entry accounting. This complicates matters since every transaction must be documented under at least two accounts. This extends beyond the boundaries of a cash book and necessitates the use of accounting software as well as the services of an accountant.

When can someone use Cash Accounting?

Cash accounting is typically utilized by small enterprises. One might use cash accounting if:

• The company is a sole proprietorship or is privately held.
• One (individual or company) does not sell on credit, which means they only deliver things with immediate payment and then charge clients.
• One keeps a single-entry accounting system.
• One just has a few employees, and a cash accounting arrangement is sufficient to handle staff pay and reimbursements.
• One has a small number of daily transactions that can be documented in a cash book or a spreadsheet.
• One only has a few tangible assets, and thus inventory monitoring isn't required.

When can someone use Accrual Accounting?

The accrual accounting is appropriate when:

• The company is enormous, and one needs to produce financial reports such as balance sheets and income statements to monitor financial condition and performance.
• One gives their consumers credit and lets them pay later through an invoice.
• One employs a double-entry system where transactions are logged under at least two accounts.
• One has a large number of employees.
• One regularly deals with many financial transactions and utilizes accounting software rather than a cash book or spreadsheet.

What makes choosing the right method so important?

The accounting method one selects affects the firm in a variety of ways:

• Each method recognizes revenue differently. Individuals must ensure that the method they use is appropriate for calculating revenue for their organization.
• These systems provide various financial reports influencing how individuals estimate the company's financial status and make future business decisions. One must select the approach that provides the best financial reporting for the company.
• Individuals' selection method impacts how they file taxes and claim tax deductions. This is because the cash and accrual methods record taxes at various periods depending on when income is collected. During tax season, one must select the strategy that works best, adhering to laws and guidelines.

The Bottom Line

Selecting a suitable accounting method for a business is determined by what sort of business the business entity is in. So, when it comes to methodology, both strategies have advantages and a fair share of disadvantages. Cash accounting is useful for extremely small organizations since it gives a wonderful insight into the cash flow. The accrual approach is preferable for larger firms because it provides a more comprehensive picture of the company's financial status through insightful reports. Before coming to a final decision on the approach for the company, simply just compare the two accounting methods and grasp the distinctions between them so you can choose the greatest match for your company.