Types of accounting methods
/What is an Accounting Method?
An accounting method is a set of rules under which revenues and expenses are reported in financial statements. The choice of accounting method can result in differing amounts of profit being reported in the short-term. Over the long-term, the choice of accounting method has a reduced impact on profitability. There are also tax implications associated with the choice of accounting method. The IRS requires a business to consistently use just one accounting method, which prevents it from adjusting its taxable income by manipulating the accounting method used. The different types of accounting methods are noted below.
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The Accrual Basis of Accounting
The primary accounting methods are the accrual basis of accounting and the cash basis of accounting. Under the accrual basis, revenue is recognized when earned, and expenses are recognized when consumed. Accrual basis accounting is required for publicly-held entities, and for any organization that wants to have its financial statements audited. This is considered the most theoretically correct accounting method, but also requires a greater knowledge of accounting, and so is less likely to be used by smaller organizations.
The Cash Basis of Accounting
The other main accounting method is the cash basis of accounting. Under the cash basis, revenue is recognized when cash is received from customers, and expenses are recognized when cash is paid to suppliers. This method is more likely to result in lumpy profitability in any given period, since a large cash inflow or outflow can sharply alter profits. The IRS caps the revenue level at which a company can report taxable earnings using the cash basis; above that level, organizations must use the accrual basis of accounting.
The Modified Accrual Basis of Accounting
The accrual basis of accounting is adjusted when dealing with governmental funds. The sum total of these adjustments is referred to as the modified accrual basis. Revenue and governmental fund resources (such as the proceeds from a debt issuance) are recognized when they become susceptible to accrual. This means that these items are not only available to finance the expenditures of the period, but are also measurable. The “available” concept means that the revenue and other fund resources are collectible within the current period or sufficiently soon thereafter to be available to pay for the current period’s liabilities. The “measurable” concept allows a government to not know the exact amount of revenue in order to accrue it. For example, an accrued revenue figure could be based on actual cash collections subsequent to the fiscal year end, or on historical collection patterns. Another possibility would be to accrue the revenue associated with a cost-reimbursement grant based on the amount of costs incurred to date.
Hybrid Accounting Methods
There are also variations on the cash and accrual methods that are considered to be hybrid accounting methods. These may be allowable under special circumstances, but will not normally result in financial statements that can be audited.
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