What is an accounting method?
An accounting method is the set of rules a business uses to decide when to record revenue and expenses. The two primary approaches are cash basis accounting and accrual basis accounting. The choice affects reported profit, tax timing, and how outsiders (lenders, investors, auditors) view a business’s financial health.
Key definitions
– Cash basis accounting: record income only when cash is received and record expenses only when cash is paid.
– Accrual basis accounting: record income when it is earned (regardless of when cash arrives) and record expenses when they are incurred (even if not yet paid). This approach relies on the matching principle — matching income to the expenses used to generate that income.
– Hybrid method: a combination where a business may use accrual for some accounts (like inventory) and cash for others, if permitted under tax rules.
– Accounts receivable/payable: unpaid amounts owed by customers or to suppliers; used in accrual accounting to show credit sales and purchases.
Why accurate accounting method selection matters
– Taxes: timing of revenue and expense recognition affects taxable income in a given year.
– Compliance: tax authorities require a method that “clearly reflects income” and consistency from year to year; changes often need approval.
– Reporting and decisions: accrual accounting usually gives a fuller view of performance for complex or credit-heavy businesses; cash basis shows actual cash flow.
– External users: lenders and investors often prefer accrual financials because they reveal obligations and earned but unpaid revenues.
Comparing cash and accrual accounting — practical differences
– Timing: cash basis recognizes transactions only when money changes hands; accrual recognizes transactions when they are earned or incurred.
– Complexity: cash basis is simpler to maintain and common for very small operations; accrual requires tracking receivables, payables, and sometimes inventory and contract accounting.
– Regulatory requirements: generally accepted accounting principles (GAAP) require accrual accounting for public companies and many larger entities.
IRS rules and thresholds
– The Internal Revenue Service (IRS) requires taxpayers to use a method that accurately reflects income and to apply it consistently. For many businesses, changing methods requires IRS approval.
– A business whose average annual gross receipts exceed a statutory threshold (about $25 million in gross receipts averaged over the three prior years, subject to legislative updates and exceptions) generally must use an accrual method for tax reporting.
Can a hybrid be used?
– Yes for many businesses (but typically not individuals). Under tax rules, a company can combine elements of both methods for different parts of its accounting if conditions are met and the result still clearly reflects income.
A short checklist for choosing an accounting method
1. Measure scale: Are average annual receipts close to or above the IRS threshold (~$25M)? If yes, accrual is likely required.
2. Assess complexity: Do you sell on credit, hold inventory, or run long-term contracts? If yes, accrual usually gives a clearer picture.
3. Consider stakeholders: Do lenders, investors, or regulators require GAAP-style (accrual) statements?
4. Evaluate cash visibility needs: Do you need simple cash tracking for day-to-day operations? Cash basis may suffice.
5. Confirm software and expertise: Can your systems and staff handle accrual accounting (AR/AP, deferred revenue, etc.)?
6. Document and stay consistent: Record the chosen method in your books and apply it year to year; get professional or IRS approval before switching.
7. Consult a tax professional or CPA before finalizing the method.
Small worked example — how timing changes net income
Assumptions:
– Company completes a sale on credit for $50,000 on December 15 (invoice issued).
– The customer pays on January 20 next year.
– Related expense incurred on December 20 of $30,000 and paid on January 10 next year.
– Year-end is December 31.
Accrual basis (records when earned/incurred):
– Year 1 revenue: $50,000 (sale is earned)
– Year 1 expense: $30,000 (expense incurred)
– Year 1 net income: $20,000
Cash basis (records when cash moves):
– Year 1 revenue: $0 (cash not yet received)
– Year 1 expense: $0 (cash not yet paid)
– Year 1 net income: $0
Implications:
– Under accrual accounting Year 1 shows profit of $20,000, which may affect tax liability and investor/lender perception.
– Under cash accounting, Year 1 looks break-even even though the business has earned revenue and incurred costs; cash year (Year 2) will reflect both the inflow and outflow.
Special application: long-term contracts
– For long-duration projects (construction, engineering), accrual methods like percentage-of-completion spread revenue and expenses across project phases so financial statements reflect progress rather than waiting for final payment.
Practical steps to implement or change a method
1. Decide with qualified accounting/tax advice which method suits your business and obligations.
2. Configure accounting software and internal controls to capture required data (AR, AP, inventory, deferred items).
3. Keep clear documentation of the chosen method in accounting policies.
4. If changing methods, follow IRS procedures and obtain any necessary approvals.
5. Produce both income and cash flow statements so users can see profit and cash position.
Reputable sources
– Investopedia — Accounting Method (overview)
https://www.investopedia.com/terms/a/accountingmethod.asp
– Internal Revenue Service — Publication 538, Accounting Periods and Methods
https://www.irs.gov/publications/p538
– Internal Revenue Service — Accounting Methods (business page)
https://www.irs.gov/businesses/small-businesses-self-employed/accounting-methods
– Financial Accounting Standards Board (FASB) — Standards and guidance (GAAP)
https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — Financial reporting and GAAP requirements for public companies
https://www.sec.gov
Educational disclaimer
This explainer is for educational purposes and does not constitute individualized tax, accounting, or investment advice. For decisions about which accounting method to use or how to change methods, consult a licensed CPA or tax attorney who can consider your specific facts and current law.