Accounting Method – Definition, Types and How to Select It

July 10, 2021 By Hitesh Bhasin Tagged With: Accounting

Table of Contents

What is Accounting Method?

Definition: An accounting method is defined as a set of rules which are adhered to by a company while maintaining its financial records and transactions. The company’s financial statements consist of revenues and expenses, which reflect their chosen accounting method.

An accounting method may be termed as the system or the modus operandi practiced by a company regarding recording its revenue and expenses. Simply put, a set of rules determines how a company will record and port its expenses and revenues.

There are two primary methods of accounting, viz. Cash Accounting and Accrual Accounting. The former is generally used by individuals and small firms, whereas big firms use the accrual method.

Cash accounting involves reporting the expenses and revenues when paid and received, whereas accrual accounting records expenses and revenues as soon as they occur. Cash accounting is the method of choice for small businesses, and accrual accounting, which involves matching revenues with expenses and is, as a consequence, a better fit for big firms.

A third hybrid method combines the two methods mentioned above with other accounting methods and is helpful for taxation and internal accounting.

2 Accounting Methods- Cash and Accrual Accounting

Cash-Basis Accounting Method

The cash method involves the recording of transactions as and when they occur. So, for instance, income is recorded as soon as the amount is received in cheque or cash.

Small businesses, community associations, government agencies, non-profit organizations, and/or sole proprietorship firms typically use this method to record their financial transactions. It is also used to manage personal finances.

Cash basis accounting is considered relatively easy to implement while maintaining income and expenses but it does not conform to the conventions of Generally Accepted Accounting Principles (GAAP). This method may portray an unrealistic picture of an entity’s financial condition, as transactions such as outstanding receivables, cash receipts, or unpaid expenses are not mentioned in financial statements that employ this method.

The most significant disadvantage of a cash-based system is that it doesn’t capture economic transactions in the correct period. If a company incurs expenses for electricity, it is recorded when the expense occurs and not when the bill is paid next month.

Another disadvantage is that this method is an inferior way to present the firm when borrowing funds from banks or other debtors, as there will in some cases be a noticeable gap before income flows in for the firm.

On a side note, one of the benefits of this method is that a business using this method can accelerate their payments and pay off liabilities to reduce their taxable profit. There is a modified accrual accounting method that government agencies in the United States use. It works by combining the cash-based accounting method with the accrual-based accounting method.

Accrual Basis Accounting Method

Accrual accounting, also known as the mercantile method of accounting, works by matching revenue and expense. This process of matching revenue portrays a better picture of the company’s financial condition. For instance, if an order is received, it is recorded as sales despite not receiving the payment for it. Expenses are recorded despite not having made any immediate payment.

Accrual accounting, in essence, is a method of accounting that measures all financial transactions regardless of the actual date when the money changes hands.

Since revenues and expenses are matched in the same period, the accrual method of accounting manages to achieve an accurate measurement of the business’s net income.

This method is especially useful for construction companies because the latter would be able to present reports of the work in progress and earn a corresponding amount of revenue for the same. This method is also known as the percentage completion method. However, a cash flow statement is necessary to determine the inflow and outflow of cash for a business.

There is a modified accrual accounting method that government agencies in the United States use. It works by combining the cash-based accounting method with the accrual-based accounting method and is particularly effective.

Choosing an Accounting Method for Taxation

The Income Tax Act, 1961 has specified that salaries, income accrued from a household property, and capital gains must be recorded with the accrual method.

Other income sources, such as return on investments, profits from business and professional income, can be recorded as per cash or accrual method of accounting, as stated in Section 145. Before this, the hybrid method was primarily used for recording these sources of income.

Wrap Up!

On the concluding note, it is clear that there are two accounting methods that you can use for managing your financial transactions.

You can opt for the cash accounting method if you own a smaller business and you are looking for a simple and easy-to-implement accounting method, while you can opt for while the accrual accounting method if you own a large and complex business entity.