Accounting Method

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What It Means

Accounting Method refers to the rules that govern how a company maintains financial records and prepares financial reports. The two most common methods for accounting are called Cash Method and Accrual Method.

• Cash Method - Under the Cash Method, companies recognize revenue and expenses only when money changes hands. Sales are recorded when a company receives payment from customers and expenses are recorded when a company pays its bills. This is the method most individuals use for their personal finances, so it is not surprising that it is also the preferred choice for most small businesses. Not all businesses, however, qualify to use the Cash Method. The IRS has established a strict set of qualification tests that determine whether a company may elect to use the Cash Method.

• Accrual Method - Under the Accrual Method, revenue is recognized when it is earned, whether or not the customer has paid, and expenses are recognized as they are incurred, not when the company pays a bill. The purpose of the Accrual Method is to match the timing of income and expenses throughout a tax year.

• Other Methods - There are a handful of Special Methods of accounting that affect income and expense for certain situations and types of companies, such as farms. To determine the applicability of these methods you should consult your Accountant.

Why It’s Important

Companies choose their Accounting Method with their first-year tax filing with the IRS and are generally expected to stick with the same accounting method year after year. The choice of Accounting Method can have a significant impact on a company's financials as well as their financial statements. There are some very good reasons why small businesses who can use the Cash Method choose to do so.

1. It is simpler and easier for business owners who may not have much accounting experience

2. It more closely reflects the flow of cash in and out of the business, which is critical for successful small business management

3. It helps avoid situations where tax payments become due before a company has actually received payment.

The primary advantage of the Accrual Method is that it provides better insight into the financial performance of a company because transactions involving related revenues and expenses will track more closely together in the company’s books. The Accrual Method accounts for the gaps between recognizing revenue or expenses and the actual exchange of cash using Asset and Liability accounts, such as Accounts Payable and Accounts Receivable.

Business owner’s contemplating a sale should expect potential Buyers to ask for financial records calculated under the Accrual Method, because it provides visibility into some important metrics, like how long it takes customers to pay. Fortunately, most accounting platforms make it easy to run reports calculated under either method, so depending on how a Seller maintains their company books, this might be a very easy piece of information to provide.

More Information

For the most up to date information on the latest IRS qualification requirements for the use of the Cash Method, visit the IRS website.

Related Terms

• Accounts Payable

• Accounts Receivable

• Acquisition

• Buyer

• Due Diligence

• Pro Forma

• Seller

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