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Accounting methods are the rules and procedures that you follow to report your revenues and expenses in your financial statements. Depending on your business's size, type, and objectives, there are various sorts of accounting methods, each of which has pros and cons.
The easiest and most uncomplicated accounting method is cash-basis accounting. Only when money is paid or received in cash should you record your income and expenses. For instance, you wouldn't record the income if you sold a consumer a product on credit until you were paid by the customer. In a similar vein, you don't record an expense for materials you purchase on credit from a vendor until you pay them. With this method, it's simple to monitor your cash flow and determine how much cash you have available at any one time.
Cash-basis accounting, however, also has certain disadvantages. You are unable to keep track of your inventory, loans, accounts receivable, accounts payable, or other liabilities. Also, because your revenues and expenses are not matched to the time period in which they are incurred, it does not provide you with an accurate picture of your company's performance. For instance, even though your real profitability did not change, your cash-basis income statement will show a smaller profit in the first month and a larger profit in the second month if you incur a large expense in one month but pay it in the next month.
Compared to cash-basis accounting, accrual accounting is the opposite. Regardless of when money is traded, it entails tracking your earnings and spending at the time they are made or incurred. As an illustration, even if a customer purchases a product from you on credit and you don't receive payment right away, you must still record the income at the moment of sale. The same is true if you purchase supplies on credit from a vendor; even if payment is not made right away, the expense is still recorded at the time of purchase. This will allow you to compare your income and expenses to the relevant time and determine how well your company is doing.
Yet, accrual accounting has certain disadvantages as well. Due to the need to maintain track of your inventory, accounts receivable, accounts payable, loans, and other liabilities, it necessitates more bookkeeping and record-keeping than cash-basis accounting. In order to make sure that your financial statements are accurate and comprehensive, it also necessitates more adjustments and reconciliations at the conclusion of each period. For instance, you must report depreciation expenses for fixed assets, bad debt expenses for questionable accounts receivable, prepaid expenses for advance payments, accruing expenses for overdue bills, etc.
The accounting method known as modified cash-basis is a combination of accrual and cash-basis accounting. Both accrual and cash-basis accounting principles are used when recording some transactions. As an illustration, you could use cash-basis accounting for revenues while employing accrual accounting for expenses. also the opposite. Alternatively, you can apply accrual standards to some types of revenues and expenses while using cash-basis rules for others. Your business needs and tastes will determine your decision.
Modified cash-basis accounting has the benefit of enabling you to adapt your accounting process to your company's needs and objectives. The amount of complexity and detail that works best for you can be chosen. You may strike a balance when reporting your financial performance between accuracy and simplicity.
Modified cash-basis accounting has the drawback that it might not adhere to Internal Revenue Service (IRS) or generally accepted accounting principles (GAAP) standards. Unless they are eligible for an exception based on their size or industry, enterprises must use accrual accounting for financial reporting purposes in accordance with GAAP. If a company's average yearly gross revenues over the previous three years were more than $25 million, the IRS mandates that it utilize accrual accounting for tax purposes, unless it qualifies for an exception based on its kind or structure.
Choosing the best accounting method for your business depends on several factors, such as:
- Your business size: Small businesses may prefer cash-basis or modified cash-basis accounting because they are simpler and easier to manage. Large businesses may prefer accrual or modified accrual accounting because they are more accurate and comprehensive.
- Your business type: Service businesses may prefer cash-basis or modified cash-basis accounting because they have fewer assets and liabilities to track. Manufacturing or retail businesses may prefer accrual or modified accrual accounting because they have more inventory and cost of goods sold to account for.
- Your business goals: Cash-basis or modified cash-basis accounting, which shows how much money is coming in and going out, may be preferred by businesses that wish to manage their cash flow. Accrual or modified accrual accounting, which shows how much revenue is made and how much expense is incurred, may be preferred by businesses that want to gauge their profitability.
- Your legal requirements: If required by GAAP or IRS regulations, businesses may have to adopt accrual or modified accrual accounting unless they are exempt due to their size or industry.
As you can see, selecting the right accounting method for your company does not have a one-size-fits-all answer. The optimal course of action for you must be determined after weighing the advantages and disadvantages of each choice.
