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- July 12, 2024
Methods of Accounting
For business, it’s very important to pick a perfect accounting method. So it’s importance to make the right choice. Reason? The method you pick can impact your financial statemetns and tax obligations. The main accounting methods are the Cash Method, Accrual Method, Special Method, and Hybrid Method. In this blog, we will take a look at these primary methods.
Cash Method
This is the simplest accounting method. In this method, the income is recorded when received, and expenses are recorded when they are paid. It’s most suitable for individuals and small businesses as it is super simple and demands a lot less record-keeping.
Under the Cash Method, gross income includes all items actually or constructively received during the tax year. Constructive receipt occurs when an amount is credited to the taxpayer’s account or made available without restrictions. For example, income received by an agent on behalf of the taxpayer is considered received by the taxpayer when the agent receives it.
Expenses are deducted in the tax year when they are paid. However, prepaid expenses are generally deductible only in the year to which they apply unless they qualify for the 12-month rule. This rule allows expenses to be deducted in the year paid. But only if the benefit does not go beyond the earlier of 12 months after the first date on which the taxpayer realizes the benefit or the end of the tax year following the tax year in which the payment is made.
Accrual Method
The Accrual Method records income when earned. Similalrly, it records expenses when incurred. Both of these steps are taken regardless of when cash is received or paid. This method provides a the perfectly accurate picture of a company’s financial position.
Income is reported in the year it is earned. This includes amounts earned but not yet received. The earliest of the following dates is used to determine the income reporting year:
- When the income is earned.
- When the payment is received.
- When the income is due.
- When the title passes to the taxpayer.
Expenses are deducted in the year they are incurred, meeting the all-events test and economic performance test. The all-events test is met when all events have occurred that fix the liability, and the amount can be determined with reasonable accuracy. The economic performance test is met when the underlying activity occurs, such as the delivery of goods or services.
Special Method of Accounting
The Special Method of accounting applies to certain items that require specific treatment, ensuring the correct matching of income and expenses within the relevant period. This method is particularly relevant for long-term contracts, installment sales, and specific types of inventories. Each of these areas necessitates a unique approach to recognize income and expense correctly.
For long-term contracts, the Percentage of Completion Method and the Completed Contract Method are commonly used. The Percentage of Completion Method recognizes revenue and expenses proportionally to the work completed during the accounting period. This method is preferred when the outcome of the contract can be reliably estimated. It ensures that the income is matched with the expenses incurred to achieve that income, a more accurate reflection of the company’s financial performance over the contract’s duration. The Completed Contract Method, on the other hand, recognizes revenue and expenses only when the contract is completed. This method is simpler but may not always provide a timely representation of the financial status of projects spanning multiple accounting periods.
In installment sales, the installment method is used to recognize income as payments are received. This method defers the recognition of income until cash is actually collected, spreading the tax liability over the period the payments are received rather than recognizing the entire gain at the point of sale. This method could prove to be extremely useful for businesses that sell high-value items on credit. For example, real estate or expensive equipment. This allows them to match income with cash flow more accurately.
Certain inventories may also require special accounting methods. For example, the Retail Method can be used to estimate the ending inventory and cost of goods sold based on the relationship between the cost and the retail price of inventory items. This method is useful for businesses with a large volume of merchandise where tracking individual items might be impractical.
Hybrid Method of Accounting
The Hybrid Method of accounting combines elements of both the Cash and Accrual Methods, allowing for a more tailored approach to financial reporting. This method is particularly beneficial when different transactions within the same business require different accounting treatments.
Under the Hybrid Method, a business might use the Cash Method for most of its transactions, recording income when received and expenses when paid. This approach simplifies the accounting for many routine transactions. However, for items like inventory, the business would record income when earned and expenses when incurred. This combination ensures that the financial statements reflect the true economic activity of the business.
For example, a retail business might use the Cash Method for its sales transactions but apply the Accrual Method for inventory purchases. By doing this, the business can manage its cash flow effectively. Similalry, this also ensures that the cost of goods sold is matched with the related sales revenue. This method gives a better and more accurate idea about profitability, particularly in businesses where inventory plays a significant role.
Businesses that engage in long-term contracts can also benefit from Hybrid Method. The revenue and expenses from these contracts can be used for the Percentage of Completion Method, while other transactions follow the Cash Method. Such a flexibility allows businesses to meet their specific financial need. The best part? They can do so without compromising the accuracy and reliability of their financial statements.
Bookkeeping Systems
Bookkeeping systems are essential for maintaining accurate financial records. The two primary systems are Single-Entry and Double-Entry.
- Single-Entry System: Uses cash receipts and disbursements and is built around the income statement.
- Double-Entry System: Uses journals and ledgers, based on the income statement and balance sheet, and is self-balancing. This system records every transaction as both a debit and a credit, ensuring accuracy and completeness.
Wrapping Up
When you select an accounting method, it’s very important to weigh in all the factors. Reason? If you pick a wrong method, your entire accounting and financing goes haywire. Moreover, each method has specific rules and applications, and the choice depends on the nature of the business and regulatory requirements. Proper bookkeeping practices support the chosen accounting method, ensuring accurate and reliable financial information.
All this can feel overwhelming, and that’s totally understandable. So, if you need any assistance with accounting method selection or accounting services, our experts at CROWNGLOBE can help. Feel free to reach out to us.
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