Accounting / Bookkeeping Basics: Accounting Methods And Statements

An accounting method is a process that a business uses when reporting their income and expenses. In the United States, the two methods of accounting accepted by the Internal Revenue Service (IRS) are cash accounting and accrual accounting. Most people use the cash method of accounting when recording expenses. It is also the method most commonly used by small businesses.

According to the regulations of the IRS, businesses that have over $5 million in sales annually are required to use the accrual accounting method.

When a business is especially large, the accrual method offers a more accurate portrayal of their finances. These methods are used whenever a company completes its accounting statements.

Each accounting statement offers insight into a business’ financial stability, cash flow, sales and expenses, and other information over a given time period.

Cash Accounting Method
The cash basis of accounting is the simpler of the two methods. Revenues and expenditures are recorded when received and sent, rather than anticipating when they will be received and sent. This is straightforward and less confusing, especially for smaller businesses that may not have as much revenue and who do not retain large amounts of inventory. When people are writing a balance sheet or considering personal finances, they often compare their current amounts of cash in hand to the debts that they currently owe, rather than  looking to the future.
Even though the cash accounting method is easier for small businesses to use, it is not the preferred method of the IRS for larger companies. This is because it is easy to alter payments when using the cash basis method of accounting. For example, a company might alter its revenue by receiving a check from a customer and holding onto it until the next fiscal year to avoid paying taxes on the amount. A company might also pay suppliers early so they can recognize more expense in the current year, which would also reduce the amount of taxable income. These are unethical behaviors that are strictly prohibited by the IRS, however, it is difficult to detect this type of behavior.
This does not mean that all delaying of reporting is unethical. For example, it is not uncommon for businesses to have a spike in sales during the holiday season. Some companies may not recognize the sales until the following fiscal year, especially if the cash receipts for credit card payments and checks will not be processed in time to be added to the current year’s financial reports.
As it is easy to misconstrue financial information using the cash accounting method, there are limits on the people and businesses allowed to use it. Tax shelters and C corporations are prohibited from using the cash method. However, entities that have less than $25,000,000 in gross receipts for the last three tax years can use this method. Businesses that provide a personal service and receive at least 95% of their revenues related to their provided services may also use the cash method.

How to Use the Cash Accounting Method
The two most common statements for businesses using the cash accounting method are the income statement and the balance sheet. The income statement is produced monthly and it details all activity within that accounting period.  
The balance sheet of a company using the cash method will not show accounts payable or accounts receivable, as they do not calculate future revenues and expenditures. It also does not report information on inventory or work that is done in the current period, unless the customer pays for the work in the same period.
When creating a cash basis income statement, it is important that it is distinguishable from an accrual basis statement, particularly because the changes are vastly different and the way a statement is prepared effects the way it can be interpreted. Most companies using this method change their heading for statements. For example, the might write their company name, go down a line and write “Cash Basis Income Statement” and then go down another line and write ‘for the month ended (date)’. Additionally, rather than labeling the results of the income statement as ‘net income’, it should be labeled as ‘cash basis net income’.

The reason for this is that the net income of companies using  cash basis accounting can change drastically from one month to the next. We will focus on the accrual basis system of accounting. As cash basis accounting is not as closely regulated as accrual basis accounting, it is easier for results to be misconstrued and misinterpreted. Sometimes, companies that use cash basis accounting for their books may create internal reports using accrual basis accounting.. This helps make more informed decisions about the business, as it can be difficult to interpret a cash-basis statement, especially by companies that enter service contracts or get prepaid for services.
To make information relevant to accrual basis account, the revenue and expenses must be adjusted. For the revenue account, the following adjustments should be made:
- Receivables from customers that have paid bills should be subtracted
- Cash deposits for which the service or good has not been provided should be subtracted
- Bills that have been invoiced for work done in the period should be added
- Products/services that have been earned but not paid for should be added

To adjust the expenses for accrual basis accounting, the following changes should be made:
- Payments for expenses of a previous period should be subtracted
- Deposits for expenses that have not yet been paid should be subtracted
- Accumulated expenses that have not yet been invoiced by suppliers should be added
- Supplier invoices for the present period should be added
- Amortization, depreciation expense, and other non-cash expenses should be added
When a cash basis company undergoes an audit, they often must prepare their statements in this way. Auditors will not certify income statements that have been prepared according to cash accounting.

Accrual Accounting Method
The accrual method of accounting reports income and expenses when they are earned and incurred, rather than waiting until debts are paid. The biggest problem with the accrual method of accounting is that companies must make estimates. One of the biggest differences is the recognition that not all customers will pay the debt on time, in full, or at all. For this reason, companies that use the accrual method of accounting also have an account recorded as a bad debt expense.Once a business generates a lot of sales, accrual accounting gives stockholders, investors, and creditors a better idea of how well the company is performing financially. It works well for companies that have lengthy contracts as well since there might not be as clear of a picture with the cash method of accounting.