Accounting Method

Key Takeaways
* An accounting method determines when a business records revenues and expenses. The two primary methods are cash and accrual accounting.
* Cash accounting records transactions when cash is received or paid; accrual accounting records them when they are earned or incurred.
* GAAP and many large businesses require accrual accounting because it more accurately matches revenues and expenses.
* The IRS generally requires businesses with average annual gross receipts of $25 million or more (preceding three years) to use accrual accounting; changing methods requires IRS approval.
* Companies (but not individuals) may use certain hybrid methods if IRS rules are satisfied.

What is an accounting method?
An accounting method is the set of rules a taxpayer or business uses to report income and expenses. It affects timing of recognition on financial statements and influences tax reporting, financial analysis, and lending decisions.

Cash vs. Accrual Accounting
Cash accounting
* Records revenues when cash is received and expenses when cash is paid.
* Simple to maintain; commonly used by small businesses and for personal finances.
* Provides a clear view of cash on hand but can distort profitability when revenue and expenses span periods.

Accrual accounting
* Records revenues when earned and expenses when incurred, regardless of cash flow.
* Uses accounts receivable and accounts payable to reflect obligations and entitlements.
* Aligns with the matching principle (matching revenues with related expenses) and provides a fuller picture of financial performance and position.
* Required by Generally Accepted Accounting Principles (GAAP) for public companies and typically preferred by large or complex businesses.

Key regulatory rules and tax considerations
* IRS consistency requirement: Taxpayers must choose an accounting method that accurately reflects income and use it consistently from year to year.
* IRS threshold: Businesses with average annual gross receipts of $25 million or more for the preceding three years generally must use the accrual method.
* Method changes: Switching accounting methods usually requires IRS approval to prevent manipulation of taxable income.
* Hybrid methods: Corporations and businesses may use hybrid approaches (combining aspects of cash and accrual) if they meet IRS criteria; individuals typically cannot.

When to use each method
* Use cash accounting when:
– You run a small business with simple transactions.
– Cash flow monitoring is the primary concern.
– You qualify under IRS rules for the cash method.
* Use accrual accounting when:
– You need an accurate measure of profitability over reporting periods.
– Your business extends credit, carries inventory, or has long-term contracts.
– You are subject to GAAP, preparing audited financial statements, or meet the IRS revenue threshold.

Example: Construction company
A construction firm working on long-term projects may incur significant costs before receiving full payment. Under cash accounting, expenses show up immediately while revenue may not be recognized until payment arrives, understating ongoing performance. Under accrual accounting—often using the percentage-of-completion method—the company recognizes revenue and related expenses as work progresses, giving lenders and investors a clearer view of its financial position. Cash flow statements still reveal actual cash movements.

Practical steps and compliance
* Select the method that best reflects your business activities and ensures accurate tax reporting.
* Document the chosen method and apply it consistently.
* Consult an accountant or tax advisor before switching methods; obtain IRS approval if required.
* Maintain clear records (invoices, receipts, contracts) to support timing of recognition.

Conclusion
Choosing the right accounting method is essential for accurate financial reporting, tax compliance, and business decision-making. Cash accounting is simple and cash-focused, while accrual accounting provides a comprehensive view of performance by matching revenues with expenses. Regulatory rules favor accrual accounting for larger businesses and public companies, and changing methods requires careful planning and, in many cases, IRS approval.