Understanding Types of Accounting Methods | How To Choose

The rules of accounting. Certainly a confusing subject for many, but understanding types of accounting methods will help you get an accurate calculation of your business’s revenue and expenses. That being said, how do you know which rule to choose and when to apply it?

That’s exactly what we’re going to discuss here today. Whether you just started your own small business or you’re a seasoned business owner, having a firm grasp of accounting methods is key in growing your company. 

The more accurately that you can report how your money is coming in and where it’s going will only serve to improve your performance as a business.

Cash Accounting and Accrual Accounting

Cash Accounting

Whenever your cash revenue and expenses are reported as they come in and are paid out, you are utilizing cash accounting. The moment that your company brings in cash revenue or pays an expense in cash, it needs to be recorded. This ensures that you have a tight rein on both your cash inflow and outflow. 

Cash accounting is generally regarded as being the easier of the two accounting methods. Small businesses often implement this method, as reports are only logged when cash is exchanged, thus simplifying any accounting records.

For example, when your business makes a sale, that transaction is reported as soon as payment is received. And whenever you pay a bill (expense), this transaction is reported, as well.

Cash accounting is widely used for managing personal expenses due to its simplicity. Moreover, it’s also why smaller businesses make use of it. There is less to calculate in keeping track of finances. 

Accrual Accounting

Conversely, accrual accounting applies to reporting on revenue that is earned via credit, while your expenses are paid through accounts payable and accounts receivable. Based on the matching principle, accrual accounting is designed to recognize the matching of your revenue and costs.

This accounting method is revered as being far more accurate in giving you a clear picture of your company’s finances. Whereas cash accounting makes a record of a transaction when cash is received or spent, accrual accounting does so when a transaction occurs but before payment is actually received.

For example, under accrual accounting, a purchase order would be regarded as revenue. Although you won’t have received any payment yet, you will still record the purchase order as revenue. The same is true for any expenses paid.

Although the money might not be taken out of your business’s bank account yet, you would still record it as if it were.

Which Method Should You Use?

Public companies here in the United States have to follow Generally Accepted Accounting Principles (GAAP) in their accounting practices. These are standards and procedures that are issued by the Financial Accounting Standards Board (FASB). 

As such, if your company uses GAAP, that means it will have to implement accrual accounting. Fortunately, it isn’t difficult to determine which accounting method your company has to use. The IRS makes it pretty easy, as businesses that bring in an average of $25 million over a three-year period must use accrual accounting.

While you may certainly begin using the cash accounting method in your business, if your sales ultimately average $25 million over three years, you will have to switch to accrual accounting. And once your company starts using an accounting method, it will have to continue doing so unless you get direct approval from the IRS.

What Are Accounting Methods?

Every business should keep records of their accounting, and if your company is a public one, it’s a requirement. Accounting is necessary if a company wants to be able to monitor its finances. This will allow you to see what taxes are being paid, the revenue you’re bringing in, and all other aspects of your finances.

Without a clear understanding of where your finances are coming from and how they are being spent, your business likely won’t last long. Poor accounting practices have led to the fall of many startups, as they didn’t have a concrete way to keep track of their money.

What’s more, you need rock-solid accounting to ensure that you know the right amount of taxes to pay to the IRS. Any time that a company is audited by the IRS, that business’s accounting records are closely examined by IRS officials.

The IRS is also responsible for having you choose the most suitable accounting method for your business. As such, your accounting method must reflect the level of income that your company brings in, as outlined above.

And as we discussed earlier, you will need to follow the same accounting method unless your revenue changes. The IRS takes this very seriously, as changing your accounting method without permission or reason could potentially open the doors to cheating on your taxes.

Business owners have done this in the past as a means to lower their tax responsibilities. If the IRS catches on to this manipulative practice, and rest assured, they will, it is likely to land you in serious trouble.

One of the last things a business owner needs is trouble with the IRS. It is therefore imperative that you follow the IRS’s guidelines on accounting methods, only switching if you have their express permission. 

In some instances, a company may use a combination of cash accounting and accrual accounting, but only if the IRS deems it so. A business will have to meet specific criteria to be allowed to use both of these accounting methods, however.

Accounting Method Example

You can really see how valuable accrual accounting is in larger businesses. Operations are often far more complex compared to smaller businesses, thereby making accrual accounting necessary. In smaller businesses, like a small retail store, money is usually exchanged the moment a sale takes place.

A customer buys your product and immediately gives you the payment for it. As you can see from the description of cash accounting that we outlined above, it is the accounting method most suitable for this type of business.

Now imagine a construction company. This business usually undertakes lengthy projects that don’t see completion until after several months of services have been provided. As such, a construction company may not get paid until it has completed its contract for a job.

Building a home or business isn’t something that is done in a day. Thus, it’s going to be a while before they get paid for their services. This line of operation is ideal for accrual accounting. 

The construction company knows what it is going to make when the project is finished, so they use this accounting method to record the money they are going to ultimately receive by using the percentage of completion method.

This allows them to record a percentage of the revenue they will receive based on how much of the project has been completed thus far. If they need to see an accurate representation of their cash flow, the construction company could look at its cash flow statement.

Conversely, under the rules of cash accounting, many expenses could be incurred before revenue is recognized since cash must first be received from the customer. This can make a business’s accounting books look relatively weak since actual income isn’t reflected until the money actually comes in. 

If a small business using cash accounting were to go to a bank seeking debt financing, it might have a hard time getting help. This is because the cash accounting method can make it appear as if a company is spending money but not receiving it.

Because of this, there are certainly advantages to using the accrual accounting method. If a business using the accrual accounting method were to seek assistance from a lender, it would be far easier to show an accurate representation of revenue and expenses.

This is why small businesses may need to utilize other tips and methods to help improve their chances of getting financial assistance. If their books aren’t going to help their chances, small businesses will need to rely on other resources.

Summary

Knowing the difference between accounting methods will give you something to work toward. While you may feel like it’s a burden to use the cash account method, it’s important to remember that this can change if you improve sales and increase revenue. 

You will need to speak with the IRS if you think you have to switch accounting methods. Just keep in mind that you’ll need to get their permission before you make any changes. If this currently isn’t an option for you, it’s a good idea to learn how to improve your operations and performance. 

We invite you to explore our many business-related articles that will show how to do precisely that. We have compiled a wealth of tips and guidance for growing your company and so much more, and if your accounting method is making it hard to secure financing, let us take a shot at getting you the business funding you need

 

Sources

https://www.accounting.com/resources/gaap/

https://www.fasb.org/home

https://www.irs.gov/

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