MODULE 2
2.1 Accounting methods
Accounting methods refer to the set of rules a business follows to keep track of financial
transactions and financial records. Its main objective is to provide an accurate overview of an
organization’s expenses and profits.
2.1.1 Importance of Using the Right Account Method
Here are some of the reasons why choosing the right method are:
i. Determine financial health: Each accounting method offers various levels of perceived
profitability in the short-term and long-term. Some methods give a status of your business’s
current health based on current true income, while others provide a long-term overview of a
business’ finances.
ii. Taxation purposes: Based on company type, you may be required to report finances using a
specific accounting method.
iii. Financing purposes: The right accounting method can improve your chances when looking
for debt financing and when being evaluated by investors or other financial institutions.
iv. Growth forecasting: The right accounting method will make it easier for you to forecast the
future growth of your business based on your company’s size.
2.2 Types of Accounting Methods
An accounting method refers to the rules a company follows in reporting revenues and
expenses. The two primary methods of accounting are cash accounting (generally used by
individuals) and accrual accounting (generally used by companies); additionally the third
method is the Modified Cash-Basis Accounting method. Hence, the methods are;
i. Cash Accounting method
ii. Accrual Accounting method
iii. Modified Cash-Basis Accounting method
i. Cash Accounting method: Cash-basis accounting requires businesses to record cash,
expenses and income. Keep in mind income is recorded once received and expenses are paid.
Cash accounting is also called cash-basis accounting; and may be contrasted with accrual
accounting, which recognizes income at the time the revenue is earned and records expenses
when liabilities are incurred regardless of when cash is actually received or paid.
If you have a long-term project, you won’t be able to record transactions until it is paid.
Similarly, taxable income and expenses are reported in the year in which you get the
compensation or pay the expense. While this method gives an accurate overview of a business’
perceived income, it does not allow you to track loans, liabilities and inventory. It also does not
give an accurate representation of your business’s status because you won’t be able to see unpaid
transactions and expenses until the compensation is sent. Still, this method may be ideal for
small businesses that want an accurate overview of their financial situation.
Use With: Single-Entry Accounting: Cash-basis accounting is used alongside single-entry
accounting because they are both the simplest accounting methods. Incoming receipts and
outgoing expenses are only recorded once.
ii. Accrual Accounting method
Accrual accounting is a more complex accounting method that requires you to record incoming
revenue and expenses—even if payment has not been made. This means expenses are recorded
once the bill is received and income for a long-term contract is recorded when the deal is closed.
Unlike the straightforward cash-based accounting, accrual accounting also considers accounts
payable, liabilities, assets and inventory.
From a business perspective, this method allows a business to record all incoming revenue and
gives a better understanding of their profitability. It also makes it easy to create financial
forecasts and estimate budgets. Since all incoming revenue is recorded, this also makes it easier
for businesses to seek financing opportunities from banks and investors.
Use with: Double-Entry Accounting: When performing accrual accounting, a double-entry
accounting system is highly recommended. Each transaction is classified as a debit and credit to
different accounts which makes it more appropriate than a single-entry accounting method.
iii. Modified Cash-Basis Accounting method
The modified cash-basis accounting method is a combination of cash and accrual accounting. All
transactions and payments related to income and expenses are recorded once it occurs. Instead of
choosing one accounting method, this type lets businesses record short and long-term
transactions and gets the best of both worlds.
Cash-basis accounting lets businesses use a mix of accounts such as cash, liabilities, assets and
accounts payable.
Use with: Double-Entry Accounting: Much like accrual accounting, modified cash-basis
accounting is used with double-entry accounting.
2.2.1 Example of Cash Accounting
Under the cash accounting method, say Company A receives $10,000 from the sale of 10
computers sold to Company B on November 2, and records the sale as having occurred on
November 2. The fact that Company B in fact placed the order for the computers back on
October 5 is deemed irrelevant, because it did not pay for them until they were physically
delivered on November 2. Under accrual accounting, by contrast, Company A would have
recorded the $10,000 sale on October 5, even though no cash had yet changed hands. Similarly,
under cash accounting companies record expenses when they actually pay them, not when they
incur them. If Company C hires Company D for pest control on January 15, but does not pay the
invoice for the service completed until February 15, the expense would not be recognized until
February 15 under cash accounting. Under accrual accounting, however, the expense would be
recorded in the books on January 15 when it was initiated.
Example of cash basis accounting entry for monthly income statement is given below:
2.3 Advantages of cash accounting and Limitations
2,3.1 Advantages: Cash accounting benefits are as below.
i. Simple to implement: Cash accounting is easy and no training is required to use the method
from day 1 of running your business. It isn’t time-consuming and complicated either, so it is easy
to get other people on board to understand the process when compared to accrual accounting.
ii. Accurate cash flow insight: It shows the cash flow of the business at the moment. It doesn’t
factor in the past or the future but shows how much cash is available in a business at any given
time. For start-ups and small businesses, this can be an excellent way to know how much cash
they have at any time.
iii. Simplifies tax returns: Cash accounting makes tax returns easy for some MSMEs. Let us
say a client owes you money. As they have not paid yet, you have a lower tax burden for the
current financial year because you won’t account for it unless the cash enters your business. This
is beneficial for large payments.
2.3.2: Limitations of Cash Accounting
i. A main drawback of cash accounting is that it may not provide an accurate picture of the
liabilities that have been incurred (i.e. accrued) but not yet paid for, so that the business might
appear to be better off than it really is. On the other hand, cash accounting also means that a
business that has just completed a large job for which it is awaiting payment may appear to be
less successful than it really is because it has expended the materials and labor for the job but not
yet collected payment. Therefore, cash accounting can both overstate or understate the condition
of the business if collections or payments happen to be particularly high or low in one period
versus another.
ii. There are also some potentially negative tax consequences for businesses that adopt the cash
accounting method. In general, businesses can only deduct expenses that are recognized within
the current tax year.
iii. Inflow and outflow not properly captures. If a company incurs expenses in December 2019,
but does not make payments against the expenses until January 2020, it would not be able to
claim a deduction for the fiscal year ended 2019, which could significantly affect the business'
bottom line. Likewise, a company that receives payment from a client in 2020 for services
rendered in 2019 will only be allowed to include the revenue in its financial statements for 2020.
2.4 Cash Basis Accounting Vs Accrual Basis Accounting
Some of the differences between Cash and Accrual basis accounting
Cash Basis Accounting Accrual Basis Accounting
The simple system that keeps a
Complicated method.
record of business cash flow
Apt for small business, sole
Suitable for businesses that don’t get paid right at
proprietorship firm that mostly
the moment.
deals with transactions in cash.
Gives a clear picture of the correct financial
Gives a clear picture of the amount
position of a business;
of cash in hand and the bank
Cash Basis Accounting Accrual Basis Accounting
account;
It doesn’t reflect the money that is
It records money owed to you and the money you
owed to you or money you owe to
owe to others.
others.
2.5 Choosing the Best Accounting Method
Each accounting method comes with pros and cons. The method you choose will impact how
taxation is reported and your overview of your business’ financial situation.
If you’re a large and complex business, accrual accounting will give you a better understanding
of your business’s revenue. For example, a marketing company may be paid periodically based
on the percentage of work performed or compensation could wait until the entire project is
completed. Financial institutions and investors may view this accounting method more favorably
because it gives a better overview of its revenue and expenses in the long-term. Cash accounting
method is ideal for small businesses which prefer a straightforward way to measure income and
expenses. However, revenue won’t appear on the ledger until the payment is received.
Nevertheless, businesses looking to combine the two methods can opt for modified cash-basis
accounting. This allows them to view short-term cash transactions and long-term financial
transactions related to their business.
Bottom Line When choosing an accounting method, be sure to educate yourself on its
implications. The ideal method should provide you with an understanding of your business’
financial health and transactions. To help make the process easier, businesses often choose to use
accounting software.
