Accounting Method

What is the Accounting Method?

Accounting method defines the rules that a company follows while reporting expenses and revenues. The two primary approaches are Cash Accounting and Accrual Accounting.

While the former helps to report Income and expenses as they are incurred and earned; the latter notify them as they are paid and received.

Accounting Methods: Cash vs Accrual

Cash accounting is a method that is extremely simple and is majorly used by small-scale businesses. In this method, transactions get recorded when cash is received or spent. A sale gets recorded when the payment is received. And, the expense gets recorded when the invoice is cleared. Furthermore, this method is also used by individuals to manage personal finances.

As far as accrual accounting is concerned, it is based on the matching principle, which is aimed to match the revenue timing and recognition of expense. By matching costs with revenue, this method provides a precise picture of the real financial condition of a company.

Under this method, transactions get recorded as soon as they incur. This simply means that a purchase order gets recorded as revenue even if the funds are not transferred immediately. The same methodology is applied to finances.

Which One Should You Choose?

The importance of accrual accounting is more evident for large, complex organizations. Suppose there is a software company. It may take up a long-term project and might not receive the entire payment until the completion of the project.

If the cash accounting method is applied, the company will incur several expenses but will not recognize revenue until they receive cash from the customer. This way, the company’s financial game will not look substantial until they have received the entire payment.

However, if the same company took finances from a Bank, the cash accounting method will turn out to be the wrong choice as there are only expenses and no revenue as such. On the contrary, if the accrual accounting method is applied, the software company will recognize a specific percentage of costs and revenue corresponding to a part of the project that they completed.

This is widely called the percentage of completion method. However, the actual cash that is coming in will be shown on the cash flow statement of the company. This way, if there is a potential lender, he will get a complete picture of the revenue pipeline of that company.