Accounting methods: Overview, definition, and example
What are accounting methods?
Accounting methods refer to the specific principles or rules that a business uses to record and report its financial transactions. These methods help determine how financial information is tracked, reported, and interpreted for various purposes, such as preparing financial statements or filing taxes. There are two main types of accounting methods: cash basis and accrual basis.
- Cash basis accounting recognizes revenue and expenses when cash is actually received or paid. It is simpler and more commonly used by small businesses or those with less complex financial transactions.
- Accrual basis accounting recognizes revenue and expenses when they are earned or incurred, regardless of when cash changes hands. This method provides a more accurate picture of a business’s financial health and is typically used by larger businesses or those that maintain inventory.
Why are accounting methods important?
Accounting methods are important because they affect how a business reports its income, expenses, and overall financial performance. The method chosen can impact the financial statements and the company’s tax liability. Additionally, the chosen method ensures consistency in reporting, which is essential for financial planning, analysis, and decision-making.
For SMBs, selecting the right accounting method is crucial for accurate financial reporting, effective budgeting, and maintaining compliance with tax regulations. The method can also influence business decisions, such as cash flow management and investment strategies.
Understanding accounting methods through an example
Imagine your small business is using cash basis accounting. You sell a product to a customer in December but don’t receive payment until January. Under cash basis accounting, you would not record the revenue from the sale until January, when you actually receive the payment.
In another example, your business uses accrual basis accounting. If you make the same sale in December but recognize the revenue at the time of the sale, even though the payment is received in January, the revenue would be recorded in December. This method helps provide a clearer picture of your business's financial situation at year-end, showing both the revenue earned and the expenses incurred, even if they haven’t yet been paid.
An example of accounting methods in action
Here’s how accounting methods might be referenced in a financial policy or tax document:
“The business uses the accrual basis of accounting for financial reporting, recognizing revenue when earned and expenses when incurred, regardless of when cash transactions occur.”
Conclusion
Accounting methods define how a business records and reports its financial transactions. The two main methods are cash basis and accrual basis accounting, each with its own advantages depending on the complexity of the business. For SMBs, choosing the right accounting method is important for maintaining accurate financial records, staying compliant with tax laws, and making informed financial decisions.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.