“Accounting is the language of business” – Warren Buffet
Accounting methods are foundational to how organizations record transactions, match expenditures, and evaluate their assets and liabilities. Simply put, an accounting method is an enterprise’s rule to report revenue and expenses.
With the correct method, businesses can portray their financial position accurately, meet regulatory compliance, and allocate resources strategically. That’s why enterprises pay close attention to the accounting method they use for financial reporting. In this article, you’ll learn more about different accounting methods, when to use them, and how to pick the one right for your organization.
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What is an accounting method?
An accounting method refers to an organization’s rules for reporting revenues and expenses in financial statements. Three popular methods are:
- Cash accounting
- Accrual accounting
- Hybrid accounting
Each method reveals a different profit amount in the short term, but they don’t significantly impact profitability reporting in the long run. However, based on their method, an organization’s tax liabilities may vary in the long run. The Internal Revenue Service (IRS) requires US-based organizations to consistently use a single accounting method so they don’t end up manipulating taxable income through adjustments.
The Indian Accounting Standards (Ind-AS) require Indian enterprises to follow accounting policies created by the Institute of Chartered Accountants of India. However, they can’t use single entry accounting for tax purposes.
Importance of using the right accounting method
A suitable accounting method is essential for efficient tax management, informed decision-making, financial reporting, and regulatory compliance.
- Financial reporting: Every accounting method recognizes revenue and matches expenses differently. That’s why what suits publicly traded organizations may not be ideal for solopreneurs and vice versa. Besides portraying your organization’s financial health to investors, the right accounting method is vital to profit analysis and resource allocation.
- Tax planning and management: Choosing the correct method aids businesses in managing tax returns efficiently as well. For example, organizations accelerate or delay revenue recognition to benefit from advantageous payment timing or reduce future tax obligations. Using an appropriate accounting method improves tax accounting efficiency and boosts the cash flow necessary for business expansion.
- Regulatory compliance: An accounting method is crucial for meeting financial transactions-related guidelines set in the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Following these guidelines also helps you avoid legal issues in the future.
- Investor confidence: Organizations consistently following a single accounting method can efficiently portray their financial positions, risk profiles, and growth forecasts to investors. As a result, these businesses are more likely to attract new investors and partners for capital investments.
Types of accounting methods
Two primary accounting methods are cash accounting and accrual accounting. Cash-basis accounting suits individuals and small businesses, whereas accrual accounting is ideal for large corporations. The IRS also allows organizations to use hybrid methods like modified cash-basis accounting under exceptional circumstances.
1. Cash accounting
Cash-based accounting is an accounting method that records transactions or income only after receiving payment or paying expenses. The key idea here is to record a transaction after receipt or payment of cash. Besides small businesses, individuals use the cash method of accounting for personal finance management.
Cash accounting enables companies to determine their perceived income accurately. However, it doesn’t let them track business liabilities, loans, and inventory. Moreover, these business owners also struggle with tracking unpaid expenses and transactions. That’s why enterprises don’t rely on cash accounting for record-keeping.
The IRS requires US-based C corporations or partnership organizations to adopt the accrual method once they exceed $26 million in average gross receipts over the past three years. In India, cash-based accounting is exclusively for non-corporate entities. The Income Tax Act 1961 requires partnership firms, Hindu Undivided Families (HUFs), trusts, public, and private limited companies to use accrual accounting.
1.1 How cash basis accounting works?
Cash basis accounting records revenue and expenses only after cash is paid or received. There are no accounts receivables or payables since this method uses actual cash movements for record-keeping. However, this method eases how businesses track and manage regular cash inflow and outflow.
Below are the steps an organization follows for cash accounting:
- Set up a chart of accounts for managing transactions and recording income and expenses.
- Record income after receiving payment for goods or services sold.
- Record expenses after paying vendors, utility bills, and other payables.
- Use journals or ledgers for tracking income or cash inflows and expenses or outflows.
- Match statements against journals to find discrepancies and ensure accuracy.
- Calculate taxes based on the net cash inflow, the difference between income and expenses.
- Monitor cash flow regularly to know cash requirements for meeting expenses.
- Maintain financial records and transaction statements for a hassle-free audit.
1.2 Advantages and disadvantages of cash basis accounting
While cash basis accounting is easy to use and offers tax advantages to organizations, it restricts them from getting an accurate picture of their finances. Moreover, businesses opting for the cash method find it challenging to switch to accrual accounting. Consider weighing the pros and cons before using this method.
Advantages of cash accounting
Small businesses use cash-based accounting for the following advantages.
- Easy to use: Since cash basis tracks cash-only transactions, business owners find it easy and cost-efficient to use this method for accounting. Moreover, cash accounting follows fewer accounts, making learning it more straightforward than the accrual method.
- Cash on hand visibility: Cash accounting doesn’t consider future financial projections, making it easier for businesses to have a clear picture of their liquidity.
- Tax advantage: Some businesses use cash basis accounting to control when transactions appear on books. This control over transaction timing lets them recognize more expenses, have less revenue, and reduce tax liabilities.
Disadvantages of cash accounting
Below are some common disadvantages organizations experience while using the cash method.
- Limited understanding of receivables and payables: Companies using cash accounting often lack a holistic knowledge of their liabilities and unpaid customer debts. This lack of visibility into liabilities leads to poor decision-making.
- IRS restrictions: Businesses or partnerships with average annual gross receipts of less than or equal to $26 million can adopt the cash basis method.
- Difficult to switch to the accrual method: Companies looking to change from the cash to accrual method can only do so by adjusting accounts receivables, accrued business debts, customer prepayments, and prepaid expenses in their books. Also, they must file Form 3115 with the IRS.
1.3 Suitable businesses for cash basis accounting
The cash basis accounting system suits sole proprietorship businesses, individuals, and small business owners when they:
- Don’t extend credit while selling products or services
- Meet the gross receipts requirement set by the IRS or other regulatory requirements of the concerned government
- Don’t consider inventory in their income
2. Accrual basis accounting
Accrual accounting is a leading financial accounting method that recognizes revenue during product or service delivery to customers. Similarly, it also records expenses before paying vendors and suppliers. Unlike the cash method, it doesn’t wait to record transactions till the money exchanges hands.
In this method, enterprises must maintain revenue and expenses using different balance sheet accounts such as accrued expenses, accounts payable, prepaid assets, and accounts receivable. They quickly gain insights into profitability and financial status as they record revenue and expenses as they incur. GAAP and the Securities Exchange Commission (SEC) require publicly traded companies to use the accrual method because it provides an accurate picture of assets and liabilities.
2.1 How accrual basis accounting works?
Accrual accounting works by logging accounting journal entries when an organization sells or purchases goods or services. It also records due payments and debts. Instead of considering the payment schedule, this method combines real-time cash inflows and outflows to provide an organization’s current finances.
The accrual method of accounting uses two accounting principles:
- Matching principle to record expenses during the same period when a company generates revenue.
- Revenue principle to note payment either when an organization earns or realizes it.
Businesses using this method maintain four types of accrual accounts for ease of accounting.
- Accounts receivable is the amount customers owe an organization for credit sales.
- Accounts payable is what a company owes to vendors and suppliers.
- Accrued liabilities refer to the accrued expenses for products suppliers have provided but haven’t billed.
- Accrued revenue represents all payments due for goods a company has sold but has yet to bill customers.
2.2 Advantages and disadvantages of accrual basis accounting
Accrual basis is a GAAP-compliant accounting method that helps enterprises accurately understand their cash flow. However, it also requires monthly reporting, which small businesses may not have the resources to do.
Advantages of accrual accounting
Below are some of the main advantages of this method.
- Accurate financial picture: Enterprises prefer the accrual method for accurately depicting their financial responsibilities and resources. This clarifying relationship between revenue and expenses helps companies in strategic resource planning.
- Real-time bookkeeping: Accounting teams using the accrual method also record transactions as they happen instead of when they receive or pay cash. This instant bookkeeping is crucial for estimating profits at any given time and adapting to changing market conditions.
- GAAP-compliant method: Growing businesses using the cash accounting method often struggle to switch to the accrual method in the future. Using the accrual method from the start offers a significant advantage for them.
Disadvantages of accrual accounting
The accrual method is complex, making it challenging for businesses to track cash flow.
- Complexity: Accrual accounting is complex because it requires organizations to track multiple accounts like account receivables, payables, unearned revenue, and liabilities.
- Challenging cash flow tracking: The accrual method may not accurately represent the cash flow. Picture a company selling products worth $1,000. Since accrual accounting recognizes revenue at sale, they’ll record the $1,000 in their income statement even before receiving the payment. As a result, they may not have a clear picture of how much cash they have on hand.
2.3 Suitable businesses for accrual basis accounting
The IRS requires US-based publicly traded organizations or enterprises generating more than $26 million in revenue to use the accrual method. In India, all corporate entities must use the accrual method for tax purposes. This method also suits companies that:
- Run an inventory-based business
- Have long-term contracts or projects
- Enjoy multiple revenue streams from a diverse product range
3. Hybrid accounting method
Hybrid basis accounting or modified cash-basis accounting combines cash and accrual accounting methods for ease of cash flow prediction and budgeting.
Organizations use this method to recognize long-term asset sales and expenses using the accrual method and the same for short-term assets with the cash method. This method is permissible for internal accounting purposes. As per the IRS guidelines, companies must record inventory, expense, and income line items to be able to use the hybrid method. Section 145 of the Income Tax Act 1961 prohibits Indian business owners from using a hybrid system of accounting.
3.1 How hybrid accounting works?
Modified cash basis or hybrid accounting works by bringing the best of cash and accrual methods. It uses double-entry bookkeeping to match opposite entries for every corresponding entry in an account. For example, organizations using this method record short-term assets like inventory, accounts receivable (AR), depreciation, and amortization on the income statement. They also record long-term assets like debt and fixed assets on the balance sheet.
3.2 Advantages and disadvantages of hybrid accounting
The modified cash accounting method aids organizations in balancing short-term and long-term accounting items. They use the cash basis to record short-term bills and cash sales. Moreover, the accrual method is convenient for recording long-term investments. As a result, businesses using the hybrid method get a complete picture of their finances and business performance while lowering costs when possible.
However, organizations using the modified cash method can’t comply with GAAP and IFRS rules which they must follow while creating official financial statements. That’s why businesses must adjust their statements before audits.
3.3 Businesses that benefit from hybrid accounting
Hybrid accounting suits organizations with inventory, service-based companies, real estate agencies, and startups.
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Factors to consider when choosing an accounting method
Small businesses and enterprises should understand which accounting method is best for them. The cash method makes it quick and easy to record transactions. However, it doesn’t provide a comprehensive picture of a company’s financial health. On the other hand, accrual reporting offers an accurate financial overview but is more complicated to implement. Consider the following factors while evaluating the suitable method for your organization.
- Nature and size of the business: Companies can use their preferred accounting method. However, they should choose one that meets their bookkeeping requirements based on their industry, nature of work, and growth opportunities. For example, a corporation generating millions of revenue shouldn’t use the cash basis method. Similarly, it doesn’t make sense for a freelancer to use the accrual method.
- Reporting requirements: An accounting method determines how an organization records and reports revenue to stakeholders. For example, businesses using the cash method can’t show revenue until they receive payment for goods and services sold. Similarly, enterprises following subscription models are better off using accrual accounting as it lets them accurately show accounts receivables and payables.
- Tax implications and compliance: An organization’s tax liabilities vary depending on its accounting method. Businesses using the cash method benefit from lower tax burdens since they don’t necessarily recognize income in the same period as an expense. However, the accrual method temporarily increases the taxable income as businesses report income and expenses in the same period.
- Decision-making and management needs: While the cash method is ideal for understanding how much cash a business has in its hand, it doesn’t provide a comprehensive view of an organization’s financial health. On the other hand, the accrual method accurately depicts an enterprise’s financial situation by revealing its accounts receivables and payables. That’s why it’s essential to consider the needs of the management and investors before choosing an accounting option.
Transitioning between accounting methods
Companies switch accounting methods by changing how they record income and expenses or modifying accounting for material items. However, organizations must obtain consent from the IRS before transitioning from one accounting method to another.
Reasons for transitioning
Organizations usually change accounting methods to enhance financial reporting, adapt to operational changes, and meet regulatory guidelines.
- Improved financial reporting: Enterprises often switch from the cash method to the accrual basis method to improve how they report finances and create financial statements for investors and stakeholders.
- Operational changes: Changing business operations also cause organizations to adopt a new accounting method. For example, a company launching multiple product lines next year may switch from cash to accrual accounting this year.
- Regulatory compliance: Some companies also transition between accounting systems to minimize administrative complexities and meet IFRS and GAAP principles.
Steps and preparations for a smooth transition
US-based businesses use IRS Form 3115, the Application for Change in Accounting Method, to inform the IRS about their desire to switch accounting methods. This form is mandatory for changing the entire accounting approach or treating an item differently.
Business owners have two options for filing Form 3115.
- Duplicate form filing: An organization files the original form and income tax return in this method. Additionally, they must file a copy of the form at the IRS National Office after the first day of the year.
- Advance consent request filing: Companies using this method must file the form before the last day of the year when the change should occur.
Companies can e-file the form with their tax returns or mail it to the IRS, regardless of the method.
Some of the critical documents to add to the form are:
- Phone number
- Applicant type
- Balance sheets
- Accounting details
- Income statement
- Tax year information
- Statement of the accounting method used in the last year
The Indian Accounting Standard-8 (Ind AS-8) states that Indian organizations can modify accounting methods only if the change:
- Is an official order from regulatory bodies, or
- Results in financial statements and transactions that accurately capture the entity’s financial performance.
An organization must file a retrospective application to change the accounting method it has been using.
Potential challenges and how to address them?
Switching accounting methods can be tricky because of factors like lack of tools, accounting experience, or even the absence of a revenue recognition policy.
- Lack of technological tools: Choosing the right accounting software and preparing it for the new method is critical for accounting success. For example, accountants must add accrued expenses and accounts receivables and subtract cash receipts while moving from cash-based to accrual accounting. That’s why companies spend time on manual adjustments before switching methods.
- Lack of accounting expertise: Organizations using the cash basis method aren’t often familiar with the complexities of accrual or hybrid approaches. As a result, they may end up overlooking transactions or being lost in the logistics of switching. Hiring CFOs or full-time accounting teams efficient at using financial management tools is a great way to overcome these challenges.
- Lack of revenue recognition: Companies without a revenue recognition policy often struggle with successfully implementing the Accounting Standards Codification (ASC) 606 framework. This standard outlines how public and private companies can effectively recognize revenue from customer contracts. Setting up this framework is critical to ensuring revenue recognition consistency and a smooth audit.
Importance of consistency in accounting methods
The consistency policy requires organizations to follow a specific accounting policy to create financial statements consistently. When they switch methods frequently, they will likely mislead investors and creditors with inaccurate information. Following a single process prevents business owners from overstating revenue or manipulating financial statements. However, there’s no restriction on companies switching methods with proper disclosure in their statements.
1. Maintaining consistency in financial reporting
Organizations use a wide variety of measures to ensure financial reporting consistency. Below are the most important factors to keep in mind.
- Create well-defined policies on different accounting areas, such as inventory valuation, depreciation, revenue recognition, and expenses. These policies act as reference points for employees as they record various financial transactions.
- Use an account indexing system for separately categorizing assets, liabilities, expenses, equity, and revenue. This standardized chart of accounts ensures consistent financial data collection and analysis.
- Develop internal processes like period reconciliations and approval processes to spot and fix reporting inconsistencies.
2. Effects of inconsistent accounting methods
Lack of accounting system consistency results in operational inefficiencies, regulatory consequences, loss of investor trust, and misleading statements.
- Operational inefficiencies: Failing to follow an accounting method makes it challenging for an accounting team to reconcile accounts or match master data against departmental inputs. As a result, they are more likely to make errors that delay financial data validation during the audit.
- Legal consequences: Besides regulatory penalties or legal actions, inaccurate financial reports can also lead to organizations experiencing increased scrutiny and investigations.
- Misleading financial information: Organizations may not be able to reveal their financial performance accurately when following inconsistent accounting methods. This lack of reliable financial data impacts decision-making and investors’ trust negatively.
3. Best practices for ensuring consistency
Below are some tips companies can follow to ensure consistent accounting.
- Implement accounting tools to automate processes and adhere to regulatory requirements.
- Conduct regular training programs to keep the accounting team up-to-date about common mistakes and the latest changes.
- Promote collaborative efforts to encourage accountants to learn from each others’ mistakes and solve complex issues together.
Other accounting considerations
Enterprises should also consider other factors like inventory accounting methods and international accounting standards while choosing accounting methods.
1. Specialized accounting methods
Last in, first out (LIFO) and first in, first out (FIFO) are inventory accounting methods that organizations use to calculate the cost of goods sold (COGS). In LIFO accounting, enterprises calculate the COGS based on the assumption that the last produced items will be the first to sell. FIFO accounting considers that the earliest inventory items will sell first. An organization’s financial ratios and tax implications vary, depending on their chosen accounting method.
2. International accounting standards
Organizations also must follow GAAP or IFRS principles to ensure global comparability and seamless global operations. Companies following these reporting frameworks can efficiently appeal to a broader investor base during strategic partnerships or mergers and acquisitions. Moreover, these standards also support enterprises in fulfilling their global expansion plans.
3. Impact of accounting methods on financial statements
Accounting methods significantly impact how an organization reports assets, expenses, and revenue across its income statement, balance sheet, and cash flow statement. For example, a company’s balance sheet totals vary depending on its valuation method to report different assets. Similarly, the choice of accounting system also impacts how an enterprise recognizes revenue, cash flow from operating activities, and expenses.
The right accounting system is crucial for organizations to track their financial health, manage tax liabilities, meet regulatory guidelines, and win investors’ confidence. Consider carefully comparing the available methods and their pros and cons to determine what suits you the best. After choosing an accounting method, use an accounting solution and conduct regular training programs to ensure accounting consistency.
Three popular accounting methods are cash basis accounting, accrual accounting, and hybrid or modified cash basis accounting.
Accrual accounting is the most popular since it tracks account payables and receivables to offer an accurate overview of an organization’s financial health.
The modified accrual accounting method created by the Governmental Accounting Standards Board (GASB) is an alternative accounting method. It uses cash accounting to record short-term events and accrual accounting to record long-term events.
The eight branches of accounting are:
2. Tax accounting
3. Cost accounting
4. Forensic accounting
5. Fiduciary accounting
6. Financial accounting
7. Managerial accounting
8. Accounting information systems
Accrual accounting is ideal when organizations record expenses and revenues before issuing or receiving payments. It suits enterprises with an average income of $25 million over the last three years.
Cash accounting suits businesses that report revenue or expenses only when they receive or pay out cash. Besides small businesses, individuals use this method to manage personal finances.
Hybrid accounting methods combine cash and accrual accounting methods. Organizations usually report cash and accruals for efficient budgeting and cash flow management. Some companies also use these methods for inventory management benefits.
Single-entry is the simplest accounting method as it records transactions related to assets, income, liabilities, and expenses only once.
Despite being easy to use, offering visibility into cash at hand, and significant tax advantages, cash accounting is challenging to switch from. On the other hand, the accrual basis of accounting provides a comprehensive financial picture but can be highly complex.
The double-entry accounting method is a bookkeeping method that considers assets to be equal to the sum of owners’ equity and liabilities. Organizations using this method record every business transaction in debit and credit accounts. The total debits must match the total recorded credits amount.