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Understanding the Two Methods of Accounting

Written by prositesfinancialJan 8 • 3 minute read

accounting methods

Accounting is an essential aspect of running a business. It involves recording, interpreting, summarizing, classifying, and communicating financial information. As a business owner, there are two main accounting methods you can use.

The first is cash accounting, which records expenses and revenue as you pay or receive them in the form of cash inflow and outflow. The second is the accrual method, which recognizes transactions once they happen, regardless of when payments occur.

Cash Basis Accounting Method

There are essential guidelines you must follow for your business to successfully implement cash accounting. Where you have barter arrangements with other entities, you must perform a fair cash valuation of such transactions. Secondly, you must record all income promptly. That includes whenever you receive deposits in your bank account or payment through agents.

For example, you may receive a check towards the end of the month but cash it the next. Record that income under last month’s transactions on the day you received the check. If you bill a customer today, but they pay weeks later, you’ll record the amount on the day of payment. Similarly, you’ll record expenses on the day you pay them, even if you received the invoice weeks earlier.

One of the benefits of cash accounting is that it gives you an accurate assessment of your balances and cash flow strength. It’s suitable if you want to avoid unsustainable debt. This method also has tax implications. Since you record a particular year’s expenses immediately when they’re incurred, it will affect your net income. Cash accounting is generally attractive to individuals and small businesses like sole proprietorships because it’s simpler to implement.

Accrual Accounting Method

This accounting method works well for large or more established businesses. It allows your business to list anticipated cash inflows and outflows, along with current revenue and expenses. For example, you may bill a customer for a $100 item that they’ll pay later. No matter when you receive payment, you’ll record the sale immediately when you bill them.

An advantage of accrual accounting is that it provides a clear view of your overall cash flow situation. That’s because most business transactions are not instant. This method reflects the spread of income and expenses over several months or even more than one accounting period. Investors prefer a company that follows the accrual accounting method. It also shows that your company has robust internal structures.

Why the Method Matters

Various factors determine the kind of accounting method your business will use. They include:

1. Type of business: The accrual method works best for large organizations such as construction companies. That’s because they engage in long term projects that attract full payment on completion. If they pick cash accounting, the business will register more expenses than revenue for particular periods. Lenders wouldn’t consider them creditworthy.

2. Tax implications: The IRS expects you to use the accounting method that consistently captures your income. Although you can use a hybrid model, the tax agency takes a hardline stance against suspicious activity. Those include organizations that switch between accounting methods to manipulate revenue and ultimately pay low tax.

3. GAAP requirements: The Generally Accepted Accounting Principles prefer accrual accounting over the cash accounting method. The former shows your partners, financiers, suppliers, regulators, and other stakeholders that you have firm management structures in place.

If your average revenue for three years is $ 1 million or less, you can use the cash accounting method. If your company sells general merchandise, you’re required to use the accrual method to record sales and purchases.

Apart from farms, C Corporations with average annual receipts of above $5 million for the past three years must utilize accrual accounting. If you run more than one business, you can use different accounting methods for each.

Changing Your Accounting Method

There are various reasons for changing accounting methods. They include personal preference, the desire to conform to regulations, and the need to streamline operations.

The IRS relaxed most of the stringent rules it previously had on changing accounting methods. If you run a business entity, you can do so by filing Form 3115. The tax agency is generally cooperative if you apply for change before it scrutinizes your accounting method.

You can either request to change your accounting option for specific items or the overall organization. Modern accounting software such as QuickBooks offers the convenience of switching to an alternative method without losing your financial data.

Make an Informed Decision

Before settling on a suitable accounting method, it’s advisable to study business functions such as sales, purchases, and expenses. Other factors are the size of your organization and your industry. Both methods have their pros and cons, so it’s essential to understand them before picking the most beneficial. If you’re not sure which one will be ideal for you, a professional CPA can recommend the most effective method after performing a thorough analysis of your company.

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