Accounting Methods

Another decision faced by a new business is what accounting/bookkeeping method is going to be used to track revenues and expenses. An accounting method is just a set of rules used to determine when and how income and expenses are reported.

If inventories are a major part of a business, the decision is made for the business owner by the Internal Revenue Service (IRS). Some business will be required to use the accrual method of accounting while others may be granted an exception and allowed to use the cash basis along with some special rules.

You're more than likely to encounter both the term method and basis used when this topic is discussed. In some cases you'll see the term cash method used and other cases see the term cash basis used. Likewise you'll see the term accrual method used and the term accrual basis used. They both refer to the same concept and are used interchangeably.

* Cash Method
The cash method or basis of accounting recognizes revenues (earnings) in the period the cash is received and expenses in the period when the cash payments are made. Actually, two types of cash methods (basis) of accounting exist:

o strict cash method (basis)
o modified cash method (basis)

A strict cash method follows the cash flow exactly. A modified cash method includes some elements from the accrual method of accounting and provides special methods for handling items such as inventory and cost of goods sold, payroll tax expenses and liabilities, and recording and depreciating property and equipment.

Many small businesses, whether they know it or not, are actually using a modified cash method.

By concentrating on recording revenues and expenses, the purpose of the cash or modified cash method of accounting is on determining the net income or loss for a period based on the cash received and the cash spent.

Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is not normally recorded and maintained in the "books" using the cash method.

Many small businesses start out using the cash basis rather than the accrual basis of accounting.

Use of the cash basis generally is not considered to be in conformity with generally accepted accounting principles (GAAP). Is this necessarily bad ? No, if no need is foreseen for what are called audited financial statements there's no need for concern. In most cases, audited statements are only required for the "big boys" (companies whose ownership interests are publicly traded). The "little guys" like the ma and pa shops don't need to worry. Still, when possible, a business should strongly consider using the accrual method of accounting.

* Accrual Method
The accrual method or basis of accounting records income in the period earned and records expenses and capital expenditures such as buildings, land, equipment, and vehicles in the period incurred.

The purpose of the accrual method of accounting is to properly match income and expenses in the correct period.

In order to accomplish this, the accrual method of accounting records revenue as earned when the product and/or service is shipped or rendered and invoiced (billed) to customers. Likewise, expenses and capital expenditures are recorded as incurred when the product and or service is shipped or rendered and invoiced (billed) by the supplier.

Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is recorded and maintained in the "books" using the accrual method. This is the accounting method that is required to be used in order to conform to generally accepted accounting principles (GAAP) in preparing financial statements for external users.

Difference Between The Two Methods
The difference between the two methods used for recording revenues and expenses results from when the business transaction is recorded in the "books" (timing). A business using the accrual method will record revenues and expenses in their "books" before a business using the cash method. In other words, unlike the cash method, they don't wait until they get paid by the customer or wait until they pay a supplier to record the transaction.

Comment: I've heard that "forewarned is fore armed" so here goes. Cash Flow and Profits are two different "animals". Due to the timing difference as to when revenue and expenses are recorded and when the cash resulting from the revenue and expenses is actually received or paid out , a business using the accrual method of accounting and reporting a "hefty" profit does not necessarily mean that they have the cash to pay their bills.

Even though the accrual method provides a better measure of profit and loss, many small businesses still use the cash basis of accounting. I think with the advent of easier to use computer accounting and bookkeeping software, we'll see more businesses adopting the accrual basis of accounting.

Relationship Between the Type of Bookkeeping System Used and the Accounting Method Used
What if any is the relationship between the type of bookkeeping system used and the method of accounting ?

The Single Entry bookkeeping system is used along with the Cash Method of accounting.
Debits and Credits are not used to record financial events.

The Double Entry bookkeeping system can be used with both the Cash and Accrual methods of accounting.
Debits and Credits are used to record financial events.

So You Know
You can use a different accounting method, the cash method or the accrual method, for each business that you set up.

Also, you can keep two sets of books, one on the cash basis and the other on the accrual basis, for the same business. You do; however, have to select one of the methods for tax purposes and continue to use it in the future. This is perfectly legal. It's when you keep two sets of books to hide your true earnings when the trouble begins.

Accounting and Bookkeeping Software
Let's muddy the water about the single and double entry accounting method at least as to how it relates to using bookkeeping and accounting software.

Single or Double Entry ?
Accounting and bookkeeping software programs actually allow the user to make a single (one) entry and the software handles creating the debit and credit entries "behind the scenes". The double-entry system is still there, but it's hidden from the user. The one exception is the general journal where the user does enter debits and credits.

Let's look at a sample transaction of invoicing (billing) a customer to illustrate what I'm talking about.. An invoice to a customer is created and printed and the resulting transaction is automatically recorded in the "books" as an increase to the amounts owed by customers and an increase to revenues (sales) using debits and credits.

Wow, since it's automatic, does that mean we don't need to learn about debits and credits later ? Only in your dreams. Although an airplane can be flown on auto-pilot, would you want to be on that plane without a trained pilot ? The same applies to using accounting and bookkeeping software. You need a properly trained bookkeeper or accountant that is also familiar with the software product in order to properly use the software. That ole saying "GIGO" (Garbage In - Garbage Out) definitely applies here.

Let's also muddy the water regarding the cash method and accrual method of accounting.
Some accounting software allows you to convert data back and forth between a cash basis and accrual basis of accounting. As I stated earlier, you do have to select one of the methods for tax purposes and continue to use it in the future.