Accounting Method Refers is About Income and Expense Recognition with two primary methods of accounting are accrual accounting and cash accounting.
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 and cash accounting.
- Cash accounting reports revenues and expenses as they are received and paid.
- accrual accounting reports them as they are earned and incurred. Generally
Accounting Method Key Points:
- 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) require 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 Accounting Methods
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 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 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 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.
Use in construction accounting
The cash accounting method of accounting has historically been one of the four methods of recognizing revenues and profits on contracts, the other ones being the accrual method, the completed-contract method, and the percentage-of-completion method. Since the approval by Congress of the Tax Reform Act of 1986, the cash method could no longer be used for C corporations, partnerships in which one or more partners are C Corporations, tax shelters, and certain types of trusts.
Because of the 1986 regulation, in general, construction businesses do not use the cash method of accounting. Some construction businesses use the cash method; and there are many other companies that use a modified form of the cash method, which is acceptable under federal income tax regulations. Under the modified Cash method of accounting, most income and expenses are determined under cash receipts and disbursements, but the purchase of equipment and of items whose benefit will cover more than one year is to be capitalized, whereas such items as depreciation and amortization are charged to cost.
Use in other types of businesses
The cash method of accounting is also used by other types of businesses, such as farming businesses, qualified personal business corporations, and entities with average gross receipts of $5,000,000 or less for the last three fiscal years.
Advantages of tax planning and IRS stand
There are certain advantages in tax planning when the cash method of accounting is used: for instance, payment of business expenses may be accelerated before year-end, in order to maximize tax deductions, whereas billings for services may be postponed to after year-end, so that payments won’t be received until the new year, thus postponing tax payments on such income. Because of these advantages and the manipulations that can occur with it in order to minimize taxable income, the IRS has discouraged (although not prohibited entirely) the cash basis of accounting for tax purposes. For instance, companies that use the cash basis of accounting may not report any inventory in their financial statements, in fact, reporting of any inventory at year-end can lead to manipulation of taxable income to an enormous extent.
Cash method of accounting according to IFRS
While the standard accounting methods commonly used in first world countries such as the United States are more than adequate for the appropriate times and eras dependent upon the incumbents of the agencies which patrol the financial statements and account balances of both mom and pop shops and multinational conglomerates, it becomes increasingly obvious in more recent years that the international standard(s) of accounting found in IFRS and the field of forensic accounting itself benefit greatly due to the advantages found in the cash method of accounting according to IFRS.
“Imagine you purchase a car for $20,000 in 2015, but under a special promotion, no payments are due on your bill until 2018. In what year did you incur the $20,000 bill? Most people would say 2015, the year you acquired the car. That is the answer mandated under accrual accounting; a method of financial reporting required of all public companies by the Financial Accounting Standards Board. But many state and city legislatures disagree. They operate with the conviction that a bill is not incurred until the money leaves your bank account to pay it. So, if you choose not to pay the bill for your car until 2018, for accounting purposes the bill will only appear that year.