What is an accounting method?
Definition: An accounting method is defined as a set of
rules that a business adheres to in maintaining its financial records and
transactions. The financial statements of a company consist of income and
expenses that reflect the chosen accounting method.
The accounting method can be called the system or way of
working that a company uses to record its income and expenses. In simple terms,
a set of rules determines how a business will record and transfer its expenses
and income.
There are two main methods of accounting, viz. Cash and
accrual accounting. The former is usually used by individuals and small
businesses, while large companies use an accrual basis.
Cash accounting involves reporting expenses and income when
you pay and receive, while accrual accounting records expenses and income as
soon as they occur. Cash accounting is the method of choice for small
businesses, while accrual (or accrual) accounting, which involves matching
income to expenses and as a result is more suitable for large businesses.
The third hybrid method combines the two methods
mentioned above with other accounting methods and is useful for tax and
internal accounting.
2 Accounting methods: cash and accrual accounting
Accounting methods: cash and accrual accounting
Cash accounting method
The cash method involves recording transactions as they
occur. So, for example, income is recorded as soon as the amount arrives by
check or cash.
Small businesses, community associations, government
agencies, non-profit organizations, and / or sole proprietors often use this
method to record their financial transactions. It is also used to manage
personal finances.
Cash accounting is considered relatively easy to implement
while maintaining income and expenses, but it does not follow generally
accepted accounting principles (GAAP). This method can present an unrealistic
picture of the financial position of the company because transactions such as
outstanding accounts receivable, cash receipts or unpaid expenses are not
mentioned in the financial statements that use this method.
The most important drawback of the cash system is that it
does not record economic transactions in the required period. If the business
incurs electricity bills, they are recorded when the expense is incurred,
rather than when the bill is paid the following month.
Another downside is that this method is the worst way to
represent the business when borrowing from banks or other borrowers, as in some
cases there may be a noticeable gap before the business begins to generate
income.
By the way, one of the advantages of this method is that a
company that uses this method can accelerate its payments and settle
liabilities to reduce its taxable profits. There is a modified accrual basis
used by US government agencies It works by combining cash accounting with an
accrual basis.
Accrual basis
Accrual (or accrual) accounting, also known as business
accounting, works by comparing income and expenses. This revenue comparison
process provides a more complete picture of the financial health of the
business. For example, if an order is received, it is recorded as a sale even
though no payment has been received for it. Expenses are recorded even if no
immediate payment has been made.
Accrual (or accrual) accounting is essentially an accounting
method that measures all financial transactions regardless of the actual date
that money changes hands.
Since income and expenses coincide in the same period,
the accrual method allows you to accurately measure the net profit of the
company.
This method is especially useful for construction companies,
since the latter will be able to submit work in progress reports and receive an
adequate amount of income for it. This method is also known as the percentage
complete method. However, a statement of cash flows is required to determine
the cash inflows and outflows of a business.
There is a modified accrual basis used by US government
agencies It works by combining cash and accrual accounting and is particularly
effective.
Choice of accounting method for taxation
The Income Tax Act of 1961 specified that wages, income
earned from household assets, and capital gains must be recorded on an accrual
basis.
Other sources of income, such as investment income, business
income, and professional income.
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