Accounting Method

Collection of rules that a corporation follows when keeping financial records.

An accounting method is a collection of rules that a corporation follows when keeping financial records and reporting financial transactions. The transactions are recorded so that genuine income is correctly reflected. Cash, accrual, and modified cash basis are commonly used accounting procedures.

It is a legal requirement for public firms to complete accounting practices. It enables a company to keep track of all aspects of its finances, including sales, costs, taxes, and more. 

It is also required to provide information and pay the Internal Revenue Service taxes (IRS). The IRS examines a company's records and processes if it ever conducts an audit. 

Furthermore, the IRS requires taxpayers to select an accounting system that accurately reflects their income and use that method consistently every year.

This is because switching methods could allow a corporation to manipulate income to reduce its tax liability. As a result, changing procedures necessitates IRS clearance. 

Companies may combine the two ways, which is permissible under IRS laws if certain conditions are met.

Types of accounting methods

The following are the two primary accounting procedures that differ when revenue and expenses are recorded.

  • Method of Cash Accounting

This is a system in which transactions are recorded in the book of accounts when cash is received or paid. 

  • Method of Accrual Accounting

This is a method in which transactions are recorded in the book of accounts as they are entered, regardless of whether or not currency is received.

No proof or research exists that a single individual or company invented these approaches. However, both can be utilized in various settings, from a country's accounts, a large corporation's accounts, and even those of a small firm or person.

In many circumstances, regulatory organizations impose one or the other technique on individuals, businesses, or corporations. When this isn't the case, choosing which strategy to utilize is crucial, as both have benefits and drawbacks.

Cash basis

Cash basis is a system of accounting according to which transactions are recorded in the book of accounts when cash is received or paid. This means an entry is not recorded when a payment or receipt is merely due. Instead, it means revenue is recognized when cash is received.

Likewise, expenses are recorded when there is an actual outflow of cash. The difference between the total income and expenses represents the business's profit and losses for the period.

Thus, cash accounting does not consider prepaid and accrued income or expenses.

Examples of institutions that follow cash accounting include various schools and charitable institutions.

Example

Question 1

During the financial year 2011-2012, Romil had cash sales of $380,000 and credit sales of $180,000. His expenses during this year were $270,000, of which $90,000 is still to be paid. Find Romil's income for the 2011-2012 year following a cash basis method.

Solution

Cash Basis

Revenues ( inflow of cash i.e., cash sales)

$380,000

Less : Expenses ( outflow of cash ) ( $270,000 - $90,000) 

$180,000

Net income 

$200,000 

NOTE

Credit sales and outstanding expenses will not be considered under a cash basis.

Advantages 

1. It's simple to use

Because cash basis is the most straightforward accounting system, it is considerably easier for business owners to learn, execute, and maintain. Not to mention that it could be more cost-effective.

Cash basis has a substantially smaller learning curve than accrual basis. This is because there are fewer accounts to keep track of.

You don't have to plan or go into as much detail on a cash basis. 

2. It exists right now.

Another benefit of a cash basis is that it makes it simple to see how much money you have.

Cash basis solely deals with tangible monies that come in and out in the present, implying that it exists in the present. Therefore, you don't have to account for future expenses and revenue until the money is exchanged.

3. Appropriation of taxes

Regarding taxes, some organizations may profit from employing a cash basis. You can manage the timing of transactions since you only record income and costs when money truly changes hands.

You can speed up expenses while slowing down revenue by managing transaction timing. You can then legitimately increase your costs while decreasing your income to reduce your tax liability.

4. Objective

This approach is more objective as very few estimates and judgments are required. 

Disadvantages

Some main disadvantages are: 

1. It doesn't provide a complete picture

Cash basis only provides a limited view of your business's profits and expenses.

The liabilities of your company are not shown on a cash basis. As a result, you may mistakenly believe you have more money than you do.

Similarly, it does not display your customers' liabilities to your company, which may cause you to overlook unpaid consumer debts.

You may not have a good view of your long-term finances because a cash basis is merely a snapshot of your business's finances. This could have an impact on both decision-making and growth.

2. Not suitable 

A cash basis is not suitable for many organizations. For example, if you sell products or services on a credit basis, you can not use the cash basis method because:

  • You have more gross receipts than the IRS requires.
  • To account for income, you'll need inventory.

The IRS limits who can use cash basis accounting. Cash basis cannot be used for the following:

  • Corporations or partnerships with average annual gross receipts of more than $25 million in the three preceding tax years.
  • According to the IRS, you can't utilize a cash basis if you make, buy, or sell items and rely on inventory. There is, however, one exception.
  • If you are a small business taxpayer, you can choose not to hold inventory if your average yearly gross receipts for the three preceding tax years were $25 million or less.

3. Switching methods could be tricky.

You may opt (or be obliged) to alter methods as your company grows. First, you must make certain adjustments to switch from cash to accrual.

4. Exception 

Cash basis has some exceptions to principles and accounting concepts. One of them is it does not follow the matching concept.

5. No consistency

This system does not distinguish between capital and revenue items, and, as a result, there is no consistency in the profits over the two years.

When do you think you'll need to apply for a cash basis?

  • Very tiny enterprises typically employ cash-based accounting. If your company is small, runs as a sole proprietorship, or is privately owned, you may want to use the cash basis.
  • You don't sell on credit, meaning you don't deliver things without receiving cash and then invoicing customers later.
  • You keep track of your finances using a single-entry system.
  • You have a small firm with a few employees, and a cash basis system is sufficient to handle staff pay and reimbursements.
  • Each day, you have a limited number of transactions that can be documented in a cash book or spreadsheet.
  • You don't have many physical assets. Therefore inventory tracking isn't necessary.

Accrual basis

Accrual basis is a method in which transactions are recorded in the book of accounts as they are entered, regardless of whether or not currency is received. When money is earned or accrued, it is reported as income.

Credit sales, for example, are recognized as sales regardless of whether or not payment has been received.

In the same way, if an item is incurred but not paid for, it will be reported as an expense. Rent, for example, has not been paid for March 2013. Because it was past due, it will still be recorded as a cost.

The accrual basis is founded on realization and expiration, and it adheres to two essential accounting principles: revenue recognition and the matching principle.

As a result, outstanding and prepaid expenses are adjusted on an accrual basis. A similar distinction is made between accrued income and money received in advance for determining the right profit or loss for the accounting period.

As a result, under the accrual system, net income for the period results from matching revenue realized and costs incurred, whether paid or not. The profit or loss for the period is the difference between total income and total costs incurred.

Example

Taking the figures of Question 1 above, find out the net income according to accrual basis.

Solution

Accrual Basis
Total salesCash sales ( $ 380,000) + Credit sales ( $180,000) $560,000
LessTotal expenses for the year$270,000
Net income $290,000

NOTE

$90,000 expenses still to be paid belong to this year and hence are to be charged to this year's revenue. Similarly, credit sales of $180,000 are taken in the year a sales transaction is done.

Advantages 

1. It allows for more useful company analysis.

Using this strategy to match expenses and revenue allows you to conduct a more relevant business analysis. 

For example, suppose you buy expensive machinery that will be used over the following decade. In that case, the cost will be spread out over that period.

Similar to how this time frame will see some of the equipment's benefits, each year in the period will see some of the expenses through money generated from selling the machine's products.

2. It makes planning easier.

Planning is one step that an accrual basis makes easier, especially because it allows you to account for all of your spending and earnings in the correct period. 

This means you'll be able to plan your spending and forecast sales, which is crucial for inventory, staffing, and other aspects of your business.

This system can help you reduce your tax burden by issuing bills at the beginning and end of the year and making planning easier.

3. It follows GAAP guidelines.

Accrual enables financial statements unaffected by cash timing in company discussions since expenses and revenue are matched. 

Essentially, this will cause your financial statements to become more representative of the health of your organization rather than what the checkbook displays.

While not all small businesses must follow GAAP, those that seek to extend to outside investors will be in the future.

4. More scientific

It is more detailed and accurate than cash basis and hence is preferred by accountants.

Disadvantages

Some of the main disadvantages are: 

1. It has a few drawbacks.

One of the most significant disadvantages of an accrual basis is the complexity of the procedures for recognizing income and expenses.

You should now seek the assistance of an accountant if you wish to thoroughly and accurately document transactions in your small business in line with GAAP.

2. It has the potential to lead to deception.

It's vital to remember that the ambiguity that comes with this technique might lead to financial statement falsification. 

Some businesses, for example, have abused the system to conceal flaws and errors in their financial reporting. Put another way, it can be utilized to hide fraud.

3. Switching expenses is challenging.

Moving to the accrual basis can be challenging if you've previously used another way. This is because you may be experiencing cash-flow issues at the outset, which is why most start-ups utilize a cash basis.

When properly executed, an accrual basis can be helpful. You can choose if it is ideal for implementation in your organization or not by knowing the benefits and drawbacks that come with it and discussing them with your accountant.

4. True position 

A quick appraisal of the profit/loss is impossible because many adjustments are required to ascertain the actual financial position of the business.

When do you think you'll need to adopt accrual?

Accrual foundation is appropriate when: 

  • Your company is large, and you need to track your financial condition and performance with financial reports like balance sheets and income statements.
  • You give your consumers credit and let them pay you later via an invoice.
  • Transactions are recorded under at least two accounts in a double-entry system.
  • You have a large workforce.
  • You deal with many financial transactions daily and use software instead of a cash book or spreadsheet.

Difference between cash and accrual basis

Difference Between Cash & Accrual Basis
 BasisAccounting on Cash BasisAccounting on Accrual Basis
1.DefinitionIt is the principle that any income or expense is recognized only when there is a cash inflow or outflow.It is the principle that any revenue or expense is recognized when it is generated or incurred, regardless of when it is paid or received.
2.NatureThe nature of the cash basis is simple.The nature of the accrual foundation is complicated.
3.The accounting system was used.The cash basis uses a single entry system to record cash inflows and outflows.It uses a double-entry system, in which each transaction has two outcomes: debit and credit.
4.Income Statement VariationsUnder the cash basis, the income statement will show a lesser income.
 
The accrual approach will result in greater income levels on the income statement.
5.Accuracy The accuracy of the cash basis is poor.The accrual basis is more precise than the cash basis.
6.Financial Statement AuditingFinancial statements prepared on the cash foundation cannot be audited.Only financial statements generated on the accrual system can be audited.
7.Appropriate forMicro to small firms can use the cash basis.Large organizations benefit from the accrual foundation.

Modified cash basis

A hybrid of accrual and cash basis, termed modified cash basis, is a mixture of both accounting methods. Because it employs accrual accounting, it has more accounts than the cash-basis system.

However, you only record income and costs when money is received and paid on a cash basis. Therefore, double-entry bookkeeping is used on a modified cash basis.

What is the benefit of using a modified cash basis?

A modified cash basis gives you additional insight into your finances that you wouldn't get from just using a cash basis. In addition, modified cash accounting is less expensive than accrual.

Suppose you're a small business owner who uses a cash basis but needs more information about inventory or accounts receivable. In that case, a modified cash basis may be the answer.

Who should adopt a modified cash basis system?

Unless your organization requires it differently, anyone can choose to use a modified cash basis. However, the accrual method is essential for specific firms. Another caveat: if you need audited financial statements, you can't use the modified cash basis.

A modified cash basis can be used for individuals who want to personalize their books if your business is privately held and you don't have any regulated standards.

The following are examples of modified cash customizations:

  • Adjustments to the inventory
  • Asset depreciation adjustments
  • Payroll and other future payables

NOTE

Some businesses manage their books on a cash basis but must file their taxes on an accrual basis.

This means that they take steps to transform their cash basis into accrual once they begin their tax preparation. Therefore, if you use a modified cash basis, you can avoid some processes you'd otherwise have to complete.

What makes picking the best strategy so crucial?

In many respects, the technique you adopt has an impact on your business:

Each system recognizes revenue differently. Therefore, you must ensure that the method you select is appropriate for the way you want to measure income for your business.

Both systems provide various financial reports that influence how you assess your company's financial situation and make future business decisions. You must select the approach that will give you the most accurate financial reporting for your company.

How you file taxes and claim tax deductions is influenced by your chosen method. This is because the cash and accrual techniques record taxes at various times depending on when revenue is collected.

During tax season, you must choose the method that works best for you.

Changing methods

Because it is more straightforward, many small businesses begin by adopting the cash basis or hybrid technique. However, as your company expands, you may feel compelled to adjust your approach.

So, how do you go from one system to the next? To begin, make the necessary adjustments to your company's accounts to reflect the switch from one system to another.

We will concentrate on transitioning from cash basis to accrual basis because switching from accrual to cash basis is uncommon.

Complete the following steps to make the necessary changes in your books:

  • Expenses that have been paid in advance and those that have been incurred should be added together.
  • Keep track of any accrued expenses (e.g., unpaid invoices and salaries earned) for employees who have not yet been paid.
  • Prepaid expenses from the current period should be transferred to an asset account.
  • Add accounts receivable to the list. Incorporate any unpaid customer invoices into your records.
  • Subtract cash payments, prepayments from customers, and cash receipts.
  • Remove cash payments from the previous period to reduce the current period's beginning retained earnings.
  • Prepayments should be treated as sales and recorded as a short-term liability until the good or service is delivered.
  • If a sale started in the prior period, review and remove cash receipts received during the current period. In the previous period, record the sale as a receivable.
  • Adjust the initially retained earnings for the current period.

NOTE

You must tell the IRS once your book changes are complete. To get approval for the change, fill out Form 3115, Application for Change in Accounting Method. You can use Form 3115 to request a change of your method in writing.

Fill out the form as soon as possible. Also, attach your profit and loss statement, balance sheets, and any previous-year revisions to the form. This is not intended to be legal advice. For further details, click here.

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Researched and authored by Deeksha Pachauri | Linkedin

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