Section 2: An Overview of Accounting Methods and Statements

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Accounting methods are the systems businesses employ to report income and expenses. In the United States, the Internal Revenue Service (IRS) recognizes two primary accounting methods: cash accounting and accrual accounting. The majority of small businesses, and individuals, typically use the cash accounting method, while larger enterprises with annual sales exceeding $5 million are mandated by the IRS to adopt the accrual accounting method. This requirement is due to the accrual method's ability to provide a more accurate financial picture for substantial businesses. These accounting methods are essential when preparing financial statements, which offer valuable insights into a company's financial health, cash flow, sales, expenses, and other critical data over specific periods.

Cash Accounting Method

The cash basis of accounting is considered the simpler of the two methods. Under this approach, revenues and expenses are recorded only when cash is actually received or paid out, rather than when they are incurred. This simplicity makes it particularly suitable for small businesses and individuals who do not deal with large volumes of revenue or inventory. In personal finance, people often rely on the cash method by comparing their current cash holdings against outstanding debts without necessarily forecasting future transactions.

Despite its ease of use, the IRS does not favor the cash accounting method for larger companies due to its susceptibility to manipulation. For instance, a company might defer cashing a received check until the next fiscal year to lower its current taxable income or prepay expenses to increase deductions for the current year. Such practices, though unethical and prohibited by the IRS, can be challenging to detect.

However, not all delayed reporting is unethical. Seasonal sales spikes, such as those during the holiday season, may result in companies recognizing sales in the following fiscal year if the cash receipts from credit card payments and checks are not processed in time for the current year's financial reports.

Given the potential for financial misrepresentation, there are stringent regulations on who can use the cash accounting method. Specifically, tax shelters and C corporations are barred from utilizing this method to ensure accurate and ethical financial reporting.

Entities with gross receipts under $25,000,000 over the past three tax years may utilize this method. Additionally, businesses that derive at least 95% of their revenue from personal services can also opt for the cash method.

How to Implement the Cash Accounting Method

The two primary financial statements for businesses employing the cash accounting method are the income statement and the balance sheet. The income statement is typically generated on a monthly basis, capturing all activities within that accounting period. For instance, if a graphic designer completes a website project for a client at the end of June, they would record the resources used and time spent in June. However, if the client pays in August, the payment would not be recorded until that month.

In contrast, the balance sheet for a company using the cash method will not display accounts payable or accounts receivable, as it does not account for future revenues or expenditures. It also omits inventory information and work completed during the current period unless the customer makes payment within the same period.

When preparing a cash basis income statement, it is crucial to differentiate it from an accrual basis statement due to the significant differences in preparation and interpretation. Most companies using the cash method adjust their statement headings accordingly. For example, they might list their company name, followed by "Cash Basis Income Statement," and then indicate the period, such as ‘for the month ended (date)’. Additionally, the results of the income statement should be labeled as ‘cash basis net income’ instead of just ‘net income’.
The reason behind this is that companies using cash basis accounting can experience significant fluctuations in net income from month to month. To address this, we will focus on the accrual basis system of accounting. Unlike cash basis accounting, accrual basis accounting is more closely regulated, reducing the chances of misinterpretation. In some cases, companies that use cash basis accounting may create internal reports using accrual basis accounting to make better-informed decisions about their business, especially when dealing with service contracts or prepaid services.

To make the information relevant to accrual basis accounting, adjustments need to be made for both revenue and expenses. For the revenue account, the following adjustments should be considered:

  • Subtract receivables from customers who have already paid their bills.
  • Subtract cash deposits for services or goods that have not yet been provided.
  • Add billed bills for work done in the current period.
  • Add products/services that have been earned but not yet paid for.

In terms of expenses, the following adjustments should be made for accrual basis accounting:

  • Subtract payments for expenses from previous periods.
  • Subtract deposits for expenses that have not yet been paid.
  • Add accumulated expenses that have not yet been invoiced by suppliers.
  • Add supplier invoices for the current period.
  • Add amortization, depreciation expense, and other non-cash expenses.

When a cash basis company undergoes an audit, it is often required to prepare their statements using accrual basis accounting. Auditors will not certify income statements that have been prepared according to cash accounting.

Accrual Accounting Method

The accrual method of accounting recognizes income and expenses when they are earned and incurred, rather than when debts are paid. However, one of the challenges of the accrual method is the need for estimates. Not all customers may pay their debts on time or in full, leading to the recognition of bad debt expenses. Despite this challenge, accrual accounting provides a better understanding of a company's financial performance for stockholders, investors, and creditors. It is particularly beneficial for companies with lengthy contracts, as the cash method may not provide a clear picture.

Let's take a construction company as an example. Typically, construction companies receive partial payments upfront to cover labor and material costs. With accrual accounting, instead of waiting to list additional revenue, the company would record the percentage of the project completed at the time of the statement, including income from the estimated payment for that portion of the project and expenses from estimated materials and labor costs. This approach provides an accurate reflection of cash inflows and outflows throughout the project.

Using the cash method of accounting, the construction company might recognize revenue only when the project is scheduled. As a result, their incoming revenue would appear significantly lower during the months they are working on the project. This could make it challenging to attract investors or secure loans because it would appear as though the company has no revenue coming in.