There a number of accounting methods – eight, to be precise – you can use to track your business’s finances. We will be discussing the Cash and Accrual basis of accounting today.
Each branch has its own specialized use that reveals different insights into a business’s financial status.
Understanding the different branches of accounting is important for business owners, as it can have a significant impact on the long-term success and viability of your business.
Single-entry accounting type
Single-entry accounting is just what it sounds like. You record each transaction in your books as one entry. Cash-basis accounting uses the single-entry method (and we’ll get to that in a minute).
The single-entry method most commonly records cash disbursements and cash receipts. If you use single-entry accounting, you record all incoming and outgoing funds in the cash book. And, you typically track assets and liabilities separately.
Double-entry accounting type
In contrast to single-entry accounting, you record two or more entries for every transaction in double-entry accounting. Each transaction consists of a debit and a credit to different accounts. You record a credit in at least one account and enter a debit in at least one other account.
The basis of double-entry accounting is that each transaction has equal and opposite effects on at least two accounts. While double-entry accounting is more complex than single entry, this method can help you:
- Maintain accurate bookkeeping records
- Find and reduce accounting records
- Make better, more informed financial decisions
- See a clear snapshot of your business’s finances
Both modified cash basis and accrual accounting use double-entry bookkeeping.
What is an Accounting Method?
An accounting method refers to a set of rules that a company adheres to when keeping its financial records and reporting financial transactions. The transactions are recorded in a manner that accurately reflects true income. The two basic methods of accounting are cash accounting and accrual accounting.
Accrual Accounting Method
The accrual method of accounting is founded on the matching principle, whose aim is to match income and expenses in the correct year. The criterion is further based on a cause-and-effect relationship between reported revenues and expenses, making it a prerequisite for the matching principle.
Matching revenues and expenses helps the accrual method to achieve a more accurate measurement of periodic net income of business since transactions are recorded together in the same period.
Under accrual accounting, profits are only recorded after they are earned, and expenses are recorded after they are incurred. It implies that an invoice can be recognized as revenue, even though funds are not yet received.
Similarly, expenses are recorded even though payment can be deferred. It is important to note that when receiving an advance payment under the accrual method, the recognition of advance payment is postponed until the following period when the revenue is earned.
It is, however, impossible to postpone beyond the next tax year. As a result, the advance payment must be included in the income in the relevant financial reports and gross receipts for tax purposes.
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. Different regulatory bodies around the world 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.
Selecting an Accounting Method
The accrual accounting method becomes valuable in large and complex business entities, given the accurate picture it gives about a company’s true financial position. A typical example is a construction firm, which may win a long-term construction project without full cash payment until the completion of the project.
Under the cash accounting guidelines, the company would accrue many expenses, and until the entire revenue payment is received, it would not realize revenue.
It means that the company’s book of accounts would look weak until the cash is recorded. A lender, for example, would consider the company as not creditworthy because of its large expenses and is in a large loss position.
Accounting method example
Company A has an annual rent of $12,000. The company has a policy of paying this amount at the beginning of the year. If the firm records the transaction on a cash basis, the rent expense will be recorded in January as $12,000. On the other hand, if the firm uses the accrual basis, the account entry for rent in January will be $1,000 ($12,000 divided by 12 months).
The accrual method is most commonly used by companies, particularly publicly-traded companies. One reason for the accrual method’s popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they’re generated instead of being recorded intermittently under the cash-basis method.
For example, under the cash method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season but would look unprofitable in Q1 as consumer spending declines following the holiday rush.
Both methods have their advantages and disadvantages, and each only shows part of the financial health of a company. Understanding both the accrual method and a company’s cash flow with the cash method is important when making an investment decision.