Comprehending Accounting Methods
Officially, you can find two varieties of accounting methods, which dictate how the company's transactions are recorded inside the company's monetary guides: cash-basis accounting and accrual accounting. The main element variation among the 2 types is how the company records dollars coming into and heading out of the business. In that straightforward difference lies a great deal of room for error — or manipulation. In fact, many from the major corporations involved in fiscal scandals have gotten in trouble because they played games with the nuts and bolts of their accounting method.
Cash-basis accounting
In cash-basis accounting, companies record expenses in financial accounts when the money is actually laid out, and they book revenue when they actually hold the cash in their hot little hands or, more likely, in a bank account. For example, if a painter completed a project on December 30, 2003,
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Smaller companies that haven't formally incorporated and most sole proprietors use cash-basis accounting because the system is easier for them to use on their own, meaning they don't have to hire a large accounting staff.
Accrual accounting
If a company uses accrual accounting, it documents revenue when the actual transaction is completed (such as the completion of work specified in a contract agreement among the business and its customer), not when it receives the dollars. That is, the company information revenue when it earns it, even if the customer hasn't paid yet. For example, a carpentry contractor who uses accrual accounting records the revenue earned when he completes the job, even if the customer hasn't paid the final bill yet.
Expenses are handled in the same way. The company records any expenses when they're incurred,
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All incorporated companies must use accrual accounting according to the generally accepted accounting principles (GAAP). If you're reading a corporation's financial reports, what you see is based on accrual accounting.
Why method matters
The accounting method a business uses can have a major impact on the total revenue the enterprise reports as well as on the expenses that it subtracts from the revenue to get the bottom line. Here's how:
Cash-basis accounting: Expenses and revenues aren't carefully matched on a month-to-month foundation. Expenses aren't recognized until the money is actually paid out, even if the expenses are incurred in previous months, and revenues earned in previous months aren't recognized until the cash is actually received. However, cash-basis accounting excels in tracking the actual dollars available.
Accrual accounting: Expenses and revenue are matched, providing a company with a better idea of how much it's spending to operate each month and how much profit it's making. Expenses are recorded (or accrued) from the month incurred,
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The way a organization records payment of payroll taxes, for example, differs with these two methods. In accrual accounting, each month a firm sets aside the amount it expects to pay toward its quarterly tax bills for employee taxes using an accrual (paper transaction in which no money changes hands, which is called an accrual). The entry goes into a tax liability account (an account for tracking tax payments that have been made or must still be made). If the organization incurs $1,000 of tax liabilities in March, that amount is entered from the tax liability account even if it hasn't yet paid out the dollars. That way, the expense is matched to the month it is incurred.
In money accounting, the business doesn't record the liability until it actually pays the government the funds. Although the company incurs tax expenses each month, the organization using funds accounting shows a higher profit during two months every quarter and possibly even shows a loss inside the third month when the taxes are paid.
To see how these two techniques can result in totally different fiscal statements, imagine that a carpenter contracts a job with a total cost to the customer of $2,000. The carpenter's expected expenses for the supplies, labor, and other necessities are $1,200, so his expected profit is $800. He contracts the work on December 23, 2004, and completes the job on December 31, 2004. But he isn't paid until January 3, 2005. The contractor takes no funds upfront and instead agrees to be paid in full at completion.
If he uses the cash-basis accounting method, because no cash changes hands, the carpenter doesn't have to report any revenues from this transaction in 2004. But say he lays out the funds for his expenses in 2004. In this case,
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If you're a small-business owner looking to manage your tax bill and you use cash-basis accounting, you can ask vendors to hold off payments until the beginning of the next year to reduce your net income, if you want to lower your tax payments for the year.
If the same carpenter uses accrual accounting, his bottom line is different. In this case, he books his expenses when they're actually incurred. He also records the income when he completes the job on December 31, 2004, even though he doesn't get the money payment until 2005. His net income is increased by this job, and so is his tax hit.
Office Professional 2010 Understanding Accounting
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