A Business Owner's Guide to Accounting Methods
Tracking your revenues and earnings is one of the most important functions of operating your business. An accounting method is a way in which a company records those transactions for tax purposes. Every business has an accounting method that suits their financial needs and you should have one too. The difficulty lies in choosing the best accounting method for your business needs.
This article seeks to provide you with the proper foundation for your business’s accounting structure, by sharing the common accounting methods available, along with answering the most common questions that you may have as a business owner.
What are the accounting methods you should be paying attention to? Here is a list of the topics we will be covering:
- What is an Accounting Method?
- What is Schedule C?
- Cash Accounting Vs. Accrual Accounting.
- What is the Equity Accounting Method?
- Direct & Indirect Method of Accounting.
- Bad Debt Expense (Allowance Method Vs. Direct Write-off Method).
By the end of this article, you will know how to use these accounting methods, we will share a few examples at each, the advantages and disadvantages, and more. Talking to your accountant will be a whole lot easier by the time you're finished.
Now, let’s begin.
What Is An Accounting Method?
As we said earlier, an accounting method is a set of rules that businesses follow to record financial information. It is used for taxation purposes and reporting a company's revenues and expenses.
An Accounting Method, as defined by the financial-dictionary.thefreedictionary.com, is “The method under which income and expenses are determined for tax purposes.”
The IRS requires that companies have a set accounting method to show their financial records. This means that whatever method is used, they expect that companies will maintain it yearly (utilizing the same accounting method every year for consistency reasons for simpler checks). Of course, there are ways to change your accounting methodology, but each of them requires intensive work, following, in each state, different laws and procedures.
Although the main purpose of accounting is for tax purposes, it is strongly recommended that business owners use accounting records to make informed business decisions. Zoho.com puts it this way:
“You need to choose the method that offers the right financial reports for your business”.
With the right financial reports, you can have a bird’s eye view of where your business stands at any given time. That knowledge is invaluable in you making the best decisions to move forward.
You can read more about the matter in this zoho’s article here.
The first time you may have heard of an accounting method was in reference to a Schedule C.
What Is Schedule C?
Source: IRS Website
A Schedule C is a form used to report the income or loss from a business, as a sole proprietor. The form codes are form 1040 or 1040-SR. When a sole proprietor files their first income tax return they choose the accounting method that they will be using for their business. You can find this form on the IRS Website here, along with instructions on how to fill it.
When filling the form, three boxes are listed the accounting methods that you must pick from. Namely:
- The Cash Method.
- The Accrual Method.
Whichever accounting method you choose, it will be the same method utilized by your company every year. If you desire to change your accounting method then you ought to apply for approval from the IRS.
Now that we know what accounting methods are and what Schedule C is, let’s look at the two main accounting methods for recording revenues and expenses, and their differences.
Cash Accounting Vs. Accrual Accounting
Source: Snippet from double-entry-bookkeeping.com
What is the Cash Method of Accounting?
Cash Method Accounting is one of the simplest forms of accounting. When cash is either spent or received, you or your accountant records those transactions. This means that the recording process takes place when physical cash is actually transferred to one party from another. Therefore, the records become updated when paid, not when the sale took place.
Cash Method of Accounting, as defined by the financial-dictionary.thefreedictionary.com, is “A system of accounting that recognizes revenue and expenses in the order in which they are received or made.”
Let's look at a few examples to put things into perspective.
- Company A receives a bill for the building of office furniture. Using Cash Method Accounting that transaction becomes recorded when the company pays that bill.
- Company A receives a bill from Utility of $800 on September 18th,
- Company A pays the bill from Utility of $800 on November 3rd,
- The cash transaction of $800 is recorded on November 3rd, and not September 18th, since the Utility was paid in November.
- Company A sends a bill to the client for creating a business plan. Using the Cash Method Accounting the transaction becomes recorded when the client pays that bill.
- Company A sends a bill of $300 to Client B on January 28th,
- Client B pays the bill of $300 on March 5th,
- The cash transaction is recorded on March 5th and not on January 28th since Client B paid the bill in March.
Who Can Use The Cash Method of Accounting?
The Cash Method of Accounting is mainly used by persons new to businesses like small businesses, freelancers, and sole proprietors.
It is typically used by smaller business entities because it is easier to manage and to perform than the Accrual Accounting Method. The company records transactions only when payments are made available to them, in case of a sale, or when the payment has left their account, in case of a purchase. Another advantage is that it's easier to track one's cash flow using The Cash Method, giving business owners a better idea of what cash they have on hand.
Also, taxation rules work differently for this method. The company only pays taxes when it receives revenue and not when they issue the bill. This is very important for freelancers or new business owners that have slow-paying customers. As a result, companies using this method only file tax when they receive actual payment.
To understand this method better, check LoopHoleLewy.com, the Small Business Tax Center. It provides easy to understand examples and practical use cases. Be sure to check out their article on accounting methods.
What Is The Accrual Method of Accounting?
The Accrual Method of Accounting is when a business records transactions done at the time they actually take place. Accrual accounting is set apart from Cash Accounting as it records revenues and expenses at the point of the actual transaction instead of when cash is exchanged from one party to the other. Therefore, when the company receives a bill or a transaction is done in the form of a credit, the records are updated.
The Accrual Method of Accounting, as defined by the accountingcoach.com, “refers to adjustments that must be made before a company's financial statements are issued.”
Let's look at a few examples to put things into perspective.
- Company A receives an invoice for rent from their landlord. Using the Accrual Method transaction becomes recorded when the bill is received.
- Company A receives a rental bill of $1,000 on June 20th,
- Company A pays the rental bill of $1,000 on August 12th,
- The accrual transaction is recorded on June 20th, and not August 12th, even if it was paid for in August.
- Company A sends a bill to the client for website creation. Using the Accrual Method Accounting the transaction becomes recorded when the bill is sent out.
- Company A sends a bill to Client B of $600 on April 4th,
- Client B pays the bill of $600 on July 16th,
- The accrual transaction is recorded for April 4th, and not July 16th since Client B received the bill in April.
The same rule applies when paying taxes. When using the Accrual Method you pay taxes based on the accrual record, which is when the transaction took place, not when the transaction is settled.
- Company A sends a bill to Client B for website creation. Using the Accrual Method Accounting the taxes are paid for the bill which is sent out, even if payment hasn’t been made.
- Company A sends a bill to Client B of $600 on April 4th,
- Client B pays the bill of $600 on July 16th,
- The taxes are paid for the bill sent on April 4th, despite the Client paying the bill on July 16th.
Who Can Use The Accrual Method of Accounting?
The Accrual Method of Accounting is typically used by any business that operates on credit. Those companies use the Accrual Method since it shows the state of the income and expenses of the business at the time.
The US law demands that in a certain revenue bracket a company has to use this method. According to the IRS, businesses that exceed an annual sale of $25 million or more cannot use the Cash Method, including any combination of methods that includes the Cash Method, so if you’re aiming to operate in the millions then the Accrual Method is for you. You can find more information in this IRS Publication 538, page 9.
Businesses that stock inventory almost exclusively use an Accrual Method. The reason for that is that goods stored in inventory must be accounted for at the beginning and end of the tax year. If the Cash AccountingMethod is used then there would be large inconsistencies between the revenue and income reports and the inventory accounts.
If you desire to learn more about this accounting method and their uses, be sure to check out the article by Investopedia on Accrual Accounting Method.
What Is The Hybrid Method Of Accounting?
The Hybrid Method of Accounting is a combination of the Cash Accounting Method and the Accrual Accounting Method. A company can use the Hybrid Accounting Method to have the tax benefits from the Cash AccountingMethods but the accuracy of the Accrual Method.
According to the IRS Publication 538, page 8, the following restrictions apply for companies using the Hybrid Method:
- If an inventory is necessary to account for your income, you must use an Accrual Method for purchases and sales. Generally, you can use the Cash Method for all other items of income and expenses.
- If you use the Cash Method for reporting your income, you must use the Cash Method for reporting your expenses.
- If you use an Accrual Method for reporting your expenses, you must use an Accrual Method for figuring your income.
The key takeaway here is that companies income and expenses must be recorded using the same accounting method. If the company uses inventory to account for income then an Accrual Method shall be used. All other transactions can be recorded either way.
Whichever type of accounting method a business decides to use, it must be consistent every year.
What Are The Benefits Of Using Accrual Accounting Over The Cash Method?
There are several benefits of using an Accrual Method over the Cash Method:
- Accrual Accounting provides a practical snapshot of business income and expenses. The Cash AccountingMethod better reflects the cash flow, cash in, and cash out. The Cash Method doesn't depict the present expense or income that the company is experiencing. Whereas, the Accrual Accounting Method depicts such changes.
- It can depict complex transactions better than simple ones. If one has many transactions with varying clients, certain transaction payments coming into the account, and certain payments going out at different times, then the Cash Method may be quite difficult to keep up and record all these transactions. Waiting until the physical cash switches hand to record may affect the business owner’s ability to conduct well-informed decisions.
- It is required by the IRS once the company reaches a threshold of $25 million in annual revenue. Is your business planning to go big sooner or later? Then you can make it simple on yourself and switch while it is still simple.
- Accrual Accounting is the go-to method for inventory accounting. If your business is mainly dealing with purchasing and selling inventory, then this method will accurately depict your financial state.
Which Accounting Method Should I Use?
Ultimately, organizational structure and type of business determine the accounting method. Smaller businesses often use a Cash Method of Accounting whereas larger businesses use the Accrual Accounting Method.
If you are a small business and have slow-paying customers then Cash Accounting may be best for you. Especially when considering the tax policies, since you only pay when you receive the cash. If you are a bigger company, or intent to grow, then an Accrual Accounting Method would be ideal for future-proofing your company structure.
The Equity Accounting Method
Getting investors is a great business move, but when investors are in the picture the proper accounting methodology must also be brought in.
What Is The Equity Method of Accounting?
When investors hold between 20 and 50% of the voting rights or shares, both the investee and the investor use the Equity Method of Accounting. This method requires the investee and investor to record the profits or losses under the percentage of ownership. In this case, the term associate or affiliate refers to the investee. The investor exercises some form of influence over the investee but does not exercise complete control.
The Equity Method of Accounting, as defined by the accountingcoach.com, is “an accounting technique used by a company to record the profits earned through its investment in another company.”
If you desire to learn more about Equity Method of Accounting check out corporatefinanceinstitute.com, article on the Equity Method of Accounting.
What Increases The Investment Account Under The Equity Method of Accounting?
The Investment Account is the account that records the profit and losses of the investee in relation to the investor’s share in the company. This amount is in exact proportion to the investment amount.
A practical example of affecting the Investment Account is as follows:
- There are two companies, Blue Star Inc and Dwarf Star corp.
- Blue Star Inc. invests in Dwarf Star. Blue Star Inc. invested 40% in Dwarf Star Inc.for $200,000.
- It is now recorded under-investment in Associates and Affiliates of $200,000.
- Dwarf Star reports a net income of $50,000 and a dividend of $25,000 to shareholders.
- Blue Star, thus, received a dividend of $10,000 which is 40% of $25,000 and records that transaction as a reduction in the Investment Account since it would be a reduction of cash from the investee.
- Thereafter the investor will record an increase in the Investment Account of $20,000 since that is the net income received by the investee Dwarf Star Inc.
- Ending balance in Blue Star Inc. investment in Associates account will be $210,000, representing a $10,000 increase from the investment cost.
If you desire to learn more of the Investment Account you can visit tutorialspoint.com article on Financial Accounting - Investment Account.
Direct & Indirect Method of Accounting
The Direct and Indirect Accounting Methods in a business measure cash flow. It is measured for a specific time and is usually used to generate a Cash Flow Statement.
What Is The Direct Method of Accounting?
The Direct Method of Accounting is also known as the Income Statement method. The cash flow is measured when cash has been received and when cash payments have been met. The cash received is from customers and the cash outflow to suppliers. The Direct Method of Accounting uses actual cash from the company's operation to record into its Cash Flow Statement.
The Direct Method of Accounting provides a more detailed account of the cash flow of a business. The process is time-consuming since it requires to list all cash disbursements, which makes it less attractive to company owners. The Financial Accounting Standards Board (FASB) recommends companies use the Direct Method.
What Is The Indirect Method of Accounting?
The Indirect Method of Accounting is used to generate a Cash Flow Statement and uses the company’s Accrual Method records. This method starts with net income or net loss and then adds or deducts balances to arrive at the cash flow from operating activities. It is a trendy method because most companies use the Accrual Method, and the information can easily be gathered from the accrual accounts.
Under the Indirect Method, the information used comes from the Income Statement and the Balance Sheet, typical accounts found in the company's Chart of Accounts. Generally, the format used to present the Cash Flow Statement using Indirect Method is by presenting the cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
To learn more about the Direct and Indirect Method of accounting with examples and use cases, check out this course by lumenlearning.com.
Bad Debts Expense (Allowance Method Vs. Direct Write-off Method)
Let’s face it, sooner or later all companies find themselves in a situation where a client owes them for services and/or products and the client simply can’t pay. Well, in accounting, there is a method to record such expenses.
A Bad Debt, as defined by the investopedia.com, is an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible.
What Is A Bad Debt Expense?
A Bad Debt Expense is when a client or customer is unable to meet their financial obligation to pay you for goods and/or services rendered. Bad Debt Expense records such losses.
A Bad Debt Expense is one of the circumstances of doing business on a credit basis and should always be considered when extending credit to a customer. The other term used for this transaction is Uncollectible Accounts Expense.
There are two methods used to account for Bad Debt, these methods are the Direct Write-off Method and the Allowance Method.
What Is The Direct Write-off Method?
The Direct Write-off method is a method of accounting for Bad Debts. It involves recording a Bad Debt Expense only when the expense has become uncollectible. It will only record the actual losses from the transaction and will usually take place in a different period than when the initial transaction takes place.
An example of this is as follows:
- Company A sells a website creation service to Company B costing $500.
- On Sept 1st the service is provided to Company B.
- On Dec 1st, 2 months later, Company A recognizes that Company B is unable to pay for that service.
- Company A would then charge the Bad Debt Expense with an entry on Dec 1st with $500.
This method only records the Bad Debt Expense by increasing the debt but doesn’t mention the reduction in the recorded sales.
In the above example, the sale on Sept 1st of $500 is not reduced. This violates the Matching Principle which states that in the same reporting period the company must record revenue and expenses of any transaction that has taken place.
Hence Direct Write-off method is not acceptable for financial reporting purposes unless used for uncollectible amounts that are considered insignificant and wouldn’t affect the business.
What Is The Allowance Method?
The Allowance Method is a method of accounting for Bad Debts that involves setting aside or estimating an amount for Uncollectible Accounts, which expects to happen in the future and is performed on a timely basis.
This amount or reserve is estimated based on the risk of the client and is a percentage of the revenue received or anticipated to be received from the client. With the Allowance Method, the incomes and expenses are recorded beside each other, within the same period which keeps up with the accounting standard and allows individuals to have a more accurate reflection of the actual sales of the company.
Here is an example:
- Company A has been providing services to Client B for the past 3 years.
- Client B has a history of Bad Debt on its account.
- For the past 3 years, Client B has had Bad Debt Expenses on 7% of sales with Company A.
- So for a sales transaction of $50,000 from Company A to Client B.
- Company B would charge their Bad Debt Expense with an allowance of $3,500 which is 7% of $50,000 since that’s the percentage of bad debt owed to the company.
The Allowance Method, unlike the Direct Write-off method is the accepted standard for recording Bad Debts and provides an accurate picture of the state of a companies account receivables.
Learn more about Bad Debt accounting in this great resource by accountingtools.com.
Throughout this article, you learned the fundamentals of Accounting Methods. We looked at how an Accounting Method is a set of rules that businesses follow to record financial information. The importance of a Schedule C, which is a form a sole proprietor fills out when filing taxes. When a Sole Proprietor files their first income tax they choose the Accounting Method they will be using in their business.
We also described the main Accounting Methods - Cash and Accrual. Cash Method accounting is one of the simplest forms of accounting. When cash is either spent or received, this Accounting Method records those transactions. The Accrual Method of Accounting records transactions at the time they actually take place.
We covered information about the Equity Method of Accounting. The Equity Method of Accounting becomes applicable when an investor holds between 20 and 50% of the voting rights or shares of a company. We briefly described the Investment Account, which is the account that records the profit and losses of the investee.
Direct and Indirect Accounting Methods measure cash flow. It is measured for a period and is usually used to generate a Cash Flow Statement. The Indirect Method uses net income or net loss and then adds or deducts balances to arrive at the cash flow from operating activities. While the Direct method of Accounting records the actual cash from the company's operation to record its Cash Flow Statement.
Bad Debts Expense is also known as the Uncollectible Accounts Expense. Which is when a client or customer is unable to meet their financial obligation to pay a debt for goods and/or services. There are two ways to record such expenses, the Allowance Method and the Direct Write-off Method.
With this foundational knowledge, one can better structure their business and be able to make decisions in regards to the accounting aspects of their company.