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Understanding Accounting Methods

Officially, there are two types of accounting methods, which dictate how the company's transactions are recorded in the company's financial books: cash-basis accounting and accrual accounting. Officially, there are two types of accounting methods, which dictate how the company's transactions are recorded in the company's financial books: cash-basis accounting and Accrual accounting. The key difference between the two types is how the company records cash coming into and going out of the business. The key difference between the two types is how the company records the cash coming into and going out of the business. Within that simple difference lies a lot of room for error — or manipulation. Within that simple difference lies a lot of room for error - or manipulation. In fact, many of the major corporations involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method. In fact, many of the major corporations involved in financial scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method.

Cash-basis accounting Cash-basis accounting

In cash-basis accounting, companies record expenses in financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. In cash-basis accounting, record companies expenses in the financial accounts when the cash is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. For example, if a painter completed a project on December 30, 2003, but doesn't get paid for it until the owner inspects it on January 10, 2004, the painter reports those cash earnings on her 2004 tax report. For example, If a painter completed A Project on December 30, 2003, but does not get paid for it until the owner inspects it on January 10, 2004, the painter cash those reports earnings on her 2004 tax report. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers. In cash-basis accounting, cash earnings include checks, credit-card receipts, or any other form of revenue from customers.
Smaller companies that haven't formally incorporated and most sole proprietors use cash-basis accounting because the system is easier for them to use on their own, meaning they don't have to hire a large accounting staff. Smaller companies that have not formally incorporated and most sole proprietors use cash-basis accounting because the system is easier for them to use on their own, meaning they do not have to hire a large accounting staff.

Accrual accounting Accrual accounting

If a company uses accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customer), not when it receives the cash. If a company uses Accrual accounting, it records revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement between the company and its customers), not when it receives the cash. That is, the company records revenue when it earns it, even if the customer hasn't paid yet. That is, the company records revenue when it Earns it, even if the customer has not paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue earned when he completes the job, even if the customer hasn't paid the final bill yet. For example, a carpentry contractor who uses the Accrual accounting records revenues earned when he completes the job, even if the customer has not paid the final bill yet.
Expenses are handled in the same way. Expenses are handled in the same way. The company records any expenses when they're incurred, even if it hasn't paid for the supplies yet. The company records when they're any expenses incurred, even if it has not paid for the supplies yet. For example, when a carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill. For example, When a Carpenter buys lumber for a job, he may very likely do so on account and not actually lay out the cash for the lumber until a month or so later when he gets the bill.

All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP). All incorporated companies must use Accrual accounting according to the generally accepted accounting principles (GAAP). If you're reading a corporation's financial reports, what you see is based on accrual accounting. If you're reading a corporation's financial reports, what you see is based on Accrual accounting.

Why method matters Why method matters

The accounting method a business uses can have a major impact on the total revenue the business reports as well as on the expenses that it subtracts from the revenue to get the bottom line. The accounting method uses a business can have a major impact on the total revenue the business reports as well as on the expenses that it subtracts from the revenue to get the bottom line. Here's how: Here's how:

• Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month basis. Cash-basis accounting: Expenses and revenues are not carefully matched on a month-to-month basis. Expenses aren't recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren't recognized until the cash is actually received. Expenses are not recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months are not recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual cash available. However, cash-basis accounting excels in tracking the actual cash available.

• Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it's spending to operate each month and how much profit it's making. Accrual accounting: Expenses and revenues are matched, providing A Company with a better idea of how much it's spending to operate each month and how much profit it's making. Expenses are recorded (or accrued) in the month incurred, even if the cash isn't paid out until the next month. Expenses are recorded (or Accrued) in the month incurred, even if the cash is not paid out until the next month. Revenues are recorded in the month the project is complete or the product is shipped, even if the company hasn't yet received the cash from the customer. Revenues are recorded in the month the project is complete or the product is shipped, even if the company has not yet received the cash from the customer.

The way a company records payment of payroll taxes, for example, differs with these two methods. The way A Company records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month a company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper transaction in which no money changes hands, which is called an accrual). In Accrual accounting, each month A Company sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an Accrual (paper transaction in which no money changes hands, which is called an Accrual). The entry goes into a tax liability account (an account for tracking tax payments that have been made or must still be made). The entry goes Into a tax liability account (an account for tracking tax payments that have been made or must still be made). If the company incurs $1,000 of tax liabilities in March, that amount is entered in the tax liability account even if it hasn't yet paid out the cash. If the company incurs $ 1,000 of tax liabilities in March, that amount is entered in the tax liability of the account even if it has not yet paid out the cash. That way, the expense is matched to the month it is incurred. That way, the expense is matched to the month it is incurred.
In cash accounting, the company doesn't record the liability until it actually pays the government the cash. In cash accounting, the company does not record the liability until it actually pays the government the cash. Although the company incurs tax expenses each month, the company using cash accounting shows a higher profit during two months every quarter and possibly even shows a loss in the third month when the taxes are paid. Although the company incurs expenses tax each month, the company using the cash accounting shows a higher profit during two months every quarter and possibly even shows a loss in the third month when the taxes are paid.
To see how these two methods can result in totally different financial statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. To see how these two methods can result in totally different financial statements, imagine that a Carpenter contracts a job with a total cost to the customer of $ 2,000. The carpenter's expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. The Carpenter's expected expenses for the supplies, labor, and other Necessities are $ 1,200, so his expected profit is $ 800. He contracts the work on December 23, 2004, and completes the job on December 31, 2004. He contracts the work on December 23, 2004, and completes the job on December 31, 2004. But he isn't paid until January 3, 2005. But he is not paid until January 3, 2005. The contractor takes no cash upfront and instead agrees to be paid in full at completion. The contractor takes no cash upfront and instead agrees to be paid in full at completion.
If he uses the cash-basis accounting method, because no cash changes hands, the carpenter doesn't have to report any revenues from this transaction in 2004. If he uses the cash-basis accounting method, because no cash changes hands, the Carpenter does not have to report any revenues from this transaction in 2004. But say he lays out the cash for his expenses in 2004. But say he Lays out the cash for his expenses in 2004. In this case, his bottom line is $1,200 less with no revenue to offset it, and his net profit (the amount of money the company earned, minus its expenses) for the business in 2004 is lower. In this case, his bottom line is $ 1,200 less with no revenue to offset it, and his net profit (the amount of money the company earned, minus its expenses) for the business in 2004 is lower. This scenario may not necessarily be a bad thing if he's trying to reduce his tax hit for 2004. This scenario may not necessarily be a bad thing if he's trying to reduce his tax hit for 2004.

If you're a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, if you want to lower your tax payments for the year. If you're a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, if you want to lower your tax payments for the year.

If the same carpenter uses accrual accounting, his bottom line is different. If the same Carpenter Accrual accounting uses, his bottom line is different. In this case, he books his expenses when they're actually incurred. In this case, he books his expenses when they're actually incurred. He also records the income when he completes the job on December 31, 2004, even though he doesn't get the cash payment until 2005. He also records the income when he completes the job on December 31, 2004, even though he does not get the cash payment until 2005. His net income is increased by this job, and so is his tax hit. His net income is increased by this job, and so is his tax hit.