The two primary accounting methods are accrual and cash basis
The main difference between the two methods is the timing of when expenses and revenues are recognized. There are advantages and disadvantages to both methods, so depending on your company’s operations and goals, you can decide which method best aligns with your company’s needs and preferences.
Consult with a Certified Public Accountant or tax professional to ensure the appropriate accounting method is used.
Accrual Accounting
Under this method, revenue is recognized when a sale transaction occurs and expenses are recognized when the purchase of goods or services occur, regardless of whether any cash was received or dispersed.
The Accrual method is more complex but provides a more accurate picture of a company’s financial position due to its recognition of payables and receivables. However, because some transactions are recorded before cash is actually received, a company’s revenue books will not be aligned with the current amount of cash in their bank account.
The Accrual method is most commonly used by publicly traded companies that are required to receive a financial audit and is accepted under the Generally Accepted Accounting Principles (GAAP).
One example of revenue recognition under the Accrual method: You work for a landscaping company, you mulched a lawn for a client and you invoice the client $200 on December 31. You will recognize revenue on December 31 because the service was performed that day, regardless of whether you received a form of payment from the client.
Cash Accounting
This method is known for its simplicity of keeping track of cash flow because revenue and expenses are accounted for only when cash is received or dispersed.
The Cash method gives you an accurate picture of the cash in your bank account today but does not account for payables or receivables; therefore, the risk of overstating the health of a company is present and does not provide an accurate representation of a company’s financial position. Typically, this method is most used for small businesses and sole proprietorships.
The Cash method is not acceptable under the Generally Accepted Accounting Principles (GAAP).
One example of a revenue recognition under the Cash method: Let’s use the same example from above. You work for a landscaping company, you mulched a lawn for a client, and you invoice the client $200 on December 31. You do not recognize revenue on December 31, because you have not received any form of payment. You will record revenue on the day you receive cash, a check, or a credit card payment from the client for your mulching services.
Why is it important to choose the correct accounting method?
- It is useful to track your cash flow and understand the future of your company’s financial position
- It is important for tax purposes in order to determine the accurate amount of annual taxes you will need to pay to the Internal Revenue Service (IRS)
- It is important to ensure compliance of state and federal regulations. Some states have a preferred accounting method to be used by businesses
Can a company change its method of accounting?
Yes, but a tax return must be filed and approved by the Internal Revenue Service (IRS) before changing its accounting method. To make this legal change, Form 3115, Application for Change in Accounting Method, must be filed by the taxpayer.
Disclaimer: The information provided above is not meant to be legal or tax advise. You should consult your CPA and attorney to determine the best course of action for your situation.
Mitzi E. Sullivan, CPA is a cloud based professional services provider specializing in cloud accounting.