The Two Types of Accounting Methods
There is potential for significant differences in your books depending on which of the two accounting methods that you use. Learn which is best for your business here.
Accounting seems relatively straightforward and somewhat simple, but it actually gets pretty complicated, depending on the method that you are using. For the most part, accounting largely boils down to keeping a financial record of your expenses and revenues.
If you have more revenues than expenses, you are probably doing well. If you have more expenses than revenues, you might need to secure additional funding.
You might think that these records end up the same regardless of how you keep your books. However, these numbers and records vary greatly depending on the accounting method you use.
Whether by human error or intentionally manipulated, these discrepancies are often how corporations end up in financial or legal trouble.
What Are the Accounting Methods?
An accounting method represents the specific rules that a business follows for reporting transactions and recording its revenue and expenses. There are quite a few accounting methods, but the two most prominent are accrual accounting and cash accounting. Companies use accrual accounting, and individuals use cash accounting, but there are exceptions.
There are critical differences between the two methods, but both are effective when used properly.
The more simple of the two methods is cash accounting. Primarily used by smaller businesses and individuals in their daily lives, cash accounting means that you do not record incomplete financial transactions.
No revenue enters into the financial records until the money arrives in the bank account of the company. This method means that you do not record any outstanding bills or debts owed. For example, when you have a landscaping business and complete a job for your customer, you present them with an invoice. Although the work is complete, the invoice has yet to be paid. Using the cash accounting method means that you wouldn’t record this transaction until the client settles the bill and you receive payment.
Alternatively, you wouldn’t record any expenses on your books until you send the money to settle the bill. This method of accounting leads to a misleading picture of the financial status of a business because it doesn’t take into account any debts owed to outside companies.
Pros of Cash Accounting
- Record keeping is easier when using the cash accounting method. Bills and invoices are not updated in your accounting software or on your financial statements. Instead, you record your revenue once the funds are available. You record expenses once the funds you transfer the funds away.
- You can track cash flow efficiently. Using cash accounting mirrors the numbers reflected in your cash flow statements. These statements provide an excellent indicator of the company’s cash position, holdings, and liquid assets. They also accurately display the influx of your cash flow as it changes over time.
Cons of Cash Accounting
- It provides a wildly inaccurate picture of your finances and overall business performance. You have false monthly financial reports since you are not reporting revenue and expenses until you receive or send cash. For example, if you undertake and complete a highly lucrative 3-week job in March, but they pay the bill in May, your reports are skewed. The reports show March as a dreadful business month because you only have expenses. Cash accounting also dramatically impacts the revenue report for May as the money finally arrives in that accounting month.
- You track accounts receivable and accounts payable separately. Although you might not record them, you must keep track of revenue owed and bills paid. Since you do not update your financial reports and records until the payments are complete, you must create a separate tracking system.
Businesses using accrual accounting have a more accurate idea of their current finances, instead of waiting for the arrival or sending of payments, accrual accounting factors in the difference once the work is complete.
In our earlier example, the accrual accounting method adds in the fee for completing the landscaping job as soon as the project is complete. So even though settling the bill takes a few days or weeks, you still report the money and enter it into the financial records as revenue immediately.
You’ll handle your expenses in the same manner. Instead of waiting for payments on expenses, accrual accounting records the cost immediately.
Accrual accounting offers an accurate financial record in real-time. This accounting method records both accounts receivable and accounts payable as though they happen immediately.
Pros of Accrual Accounting
- Accrual accounting provides a better ability to track your profits and performance. Since financial reports and records are accurate up to the minute, you can better track your finances. There is no potential for severe lags in collected revenue or with sent payments. You know if you have enough income for upcoming expenses such as taxes or wages.
- Lenders and investors heavily prefer this method. There are no scenarios where an investor likes to be kept in the dark about your business's profitability. The cash accounting method leads to financial swings that create doubt in the investor’s or lender’s mind. The accrual method provides an accurate and consistent financial record that calms their potential concerns about providing money to your business.
Cons of Accrual Accounting
- Cash flow problems are difficult to discover. In accrual accounting, just because someone owes you money doesn’t mean that you have that money in your accounts. If they do not pay on time, you can end up with a serious cash-flow problem.
- It leads to paying higher taxes. The IRS requires your business to use accrual accounting if it makes a certain amount of money. The IRS requires this due to the possibility of cheating on your taxes using the cash method. With the accrual method, you must record the amount of revenue on the day it’s earned instead of when paid, so you might end up paying taxes on money that you haven’t received yet.
Why Do These Accounting Methods Matter?
The accounting method that a business uses has an enormous impact on the revenue reports for a business. The tax ramifications alone result in a very significant disparity between the two methods.
For example, a business using accrual accounting sets aside the amount of money it anticipates spending on quarterly tax bills each month. Although the money has not exited the business’s possession, the company moves it into a tax liability account and records the movement as an expense.
You’ll handle money differently in cash accounting. The business does not record the tax expenses until paying them. As a result, the company often shows a higher record of profits during the first two months of a quarter and a substantial loss during the third month when they record the payment.
For these reasons, the IRS has instituted policies on accounting methods for certain types of businesses. If a business averages a gross receipt of more than $26 million over three years, it must use accrual accounting.
What Is The Hybrid Method Of Accounting?
Most businesses use the cash accounting method until they become large enough to start using the accrual accounting method. However, some businesses function better using a hybrid of both accounting methods.
The hybrid accounting method is beneficial for businesses requiring a product inventory. Using a cash accounting method means that these products have no value until you sell them and receive payment.
Using cash accounting with inventory is tricky because the product’s expenses can become due before selling the product. Using this method means that the business sometimes falls into debt according to the financial records, but it actually has revenues in its product inventory.
You can create a unique hybrid method that specifically meets the needs of your business, as long your hybrid accounting methods meet the regulations set forth by the IRS.
Your financial records and reports vary significantly depending on the accounting method that you select. There are several different pros and cons associated with both methods, so make sure you are well-read on the differences.
Using the incorrect accounting method leads to financial and legal trouble. If your current accounting method points out difficulties with keeping your revenue where it needs to be, Ampla can help you grow your business responsibly.