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METHODS OF ACCOUNTING
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METHODS OF ACCOUNTING
Method Definitions
Cash Method: Actual money received and actual money spent. This method of accounting does not take into account outstanding invoices or unpaid bills. This is by far the easiest form of accounting.
Accrual Method: The accrual method, simply stated, is an account of all income and expenses you ACCRUED for the stated period. It does not necessarily take into account actual cash collected or expenses paid.
The definition of Accrue is to accumulate. It means the continually increasing or decreasing amounts of something in a given period. Bills will accumulate over a period of time whether paid or not. Same with receivables (money customers or clients owe you). When a receivable is generated the accrual method counts it as income whether the cash has been received from the client or not.
An important principle to remember regarding Accounting Method is to be consistent. Changing accounting methods from one period to the next will result in inaccurate financial reports and information the manager cannot use to manage the business correctly.
Additionally, once you have chosen either Cash or Accrual you will not be able to change the method without IRS approval.
Cash Method: The simplest method but it falls short for companies who rely on Accounts Receivables and Inventory reports to manage their businesses. The Cash method will show you exactly how much money banked and how much money spent, but it won’t show you how much book income was generated or how much it cost you to generate that income.
The Cash Method is not recommended for businesses that do costing or have inventory, as it does not give you accurate figures on the cost to produce and deliver a product or service.
Any business paid upon completion of the service or product, which does not have account receivables or inventory, can use the Cash Method and it will provide the basic and necessary information with which to make sound managerial decisions.
Accrual Method: This method is especially useful for the business manager to see the value of the goods being sold and the actual cost of providing those goods or services. If you have inventory this is the best method to use. Although the Accrual Method is more complex, when properly maintained it will provide information as to the state of the business or company at any moment. It will for example show you:
- Inventory cost
- Monies owed to the company by clients and/or customers
- Exactly how much it is costing to stay in business and provide its product or service
- Due to the complexity of the Accrual Method it is essential a trained bookkeeper handle the books.
To demonstrate how different the financial information generated by either method can be here is an actual example of a company’s income and expenses (Profit & Loss Statement) using:
(A) Accrual Method,
(B) Cash Method:The statements show a vast difference between the two methods. Using Accrual method there the company profited $34,544.65. Using Cash Method the company had a loss of $2,917.91.
The Cash method Profit & Loss Statement shows the actual money the company received and paid out during the period. The Accrual method statement shows what income the company generated in receivables and expenses it accrued to generate that income.
If you don not choose the right method of accounting for your business, the wrong decisions can be made. Additionally, more financial reports (such as a Balance Sheet) need to be reviewed to provide an accurate picture of the financial condition of the company.
Some businesses may best need a combination of the two accounting methods. A Company can use the Cash Method but also maintain accounts receivables and accounts payables. Use an accounting system that provides the necessary information to generate the financial reports that enable proper management and expansion of the business.
Total Tax Solutions can help you decide on the best accounting method to use for your business. After choosing the method, or combination of methods, we will set up your accounting books to reflect the exact information you or your manager will need to properly manage the business.
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