Selecting an Accounting Method

Selecting an Accounting Method

Deciding On an Accounting Method

Accounting is relevant in any type of business. Many new business owners fail to consider how they are going to handle their money.  Accounting will make or break your business.  A detailed and systematic accounting method is a must if you want to own a successful business.

What is accounting?

It is the process of identifying, measuring and conveying monetary and economic information.  This information affords the business owner vital information about his business.  Only through proper accounting practices can you know if you business is profitable or losing money.  Don’t confuse cash flow with profitability.  You can have cash in hand and still be running a business that is operating in the “red.”

Purpose of accounting

The primary purpose is to provide financial information about an enterprise showing its performance and condition to help interested individuals make informed decisions.

The users of this information may be grouped into:

Those with direct interests in the company which would include the following:

• Management
• Owners/stockholders
• Taxing authorities
• Suppliers and creditors
• Clients/Customers to which products and services are being offered
• Employees/Staff

Those with indirect interests in the enterprise including:

• Financial advisors and analysts
• Regulatory authorities
• Attorneys with regards to determination of legal provisions
• Labor unions in the formulation of wage and contract demands
• In stock exchanges

When you have an established business there is still a need for you to decide on what accounting method to use.

Description of Accounting Method

A method applied by any company or organization in keeping its records and books with the purpose of determining profit and taxable income. It encompasses all the method of accounting as well as accounting treatment of any item.

Deciding between cash basis and accrual basis of accounting is essential in the recording of business transactions and determination of income and revenue. So business enterprises still are in crucial position to choose between the two methods.

To help you out in deciding which to choose, here are some ideas of what these two methods are all about.

Cash basis-accounting

In this method, revenue is recorded in the books as cash received regardless when the service and/or product is earned. While expenses are recognized when it is paid rather than when it was actually incurred.

Advantages of using this type of method would include:

- It is easier to understand
- Implementation and utilization is simple
- Inexpensive

Disadvantages of cash method:

- Does not comply with revenue and matching principle. The revenue principle of recognition of revenue when earned and not when cash is received. While in matching principle, expenses are matched with its related revenue and not when it is paid.
- Inaccurate method of determining profit since it does not recognize receivable and payables. Difficulty of determination of profit and loss of a company since it does not take into account money owed and money due.

Accrual basis-accounting

In the accrual method of accounting, revenue is recognized when it is earned rather than when payment is collected. More so, expenses are recognized when it is incurred rather than when paid. Cash payments and receipts may be in the form of:

• Cash
• Electronic transfer
• Credit card
• Check
• And other means of payment

Thus in accrual basis, revenue is recorded in the year it is earned regardless of when received and expenses recorded when incurred regardless when paid.

Advantages of using this method:

- Provides a more accurate track of the performance of your company over the long term.
- Complements with revenue and matching principle
- Accurate measure of profit compared to cash basis of accounting.
- A much easier way of determining the overall financial condition of a company.

Disadvantage of Accrual accounting:

- More complex compared to cash basis accounting, poor job in tracing cash
- Implementation is more expensive
- Owing taxes on revenue even before actual payment received.

What to use?

For small businesses that are just starting it is recommended that you use cash basis of recording revenue and expenses for it is easier to comprehend and implement. But as the business grows, you may want to adapt the accrual method of accounting to have a more precise track of your revenues and expense.

While for all companies, from small retailers to manufacturers handling inventories, it is a requirement that they use accrual basis of accounting under the generally accepted accounting principles (GAAP).

When choosing an accrual basis of accounting, a company must use it consistently for all of its financial reporting and for credit purposes.