Accounting Method

Accounting method refers to the rules a company follows in reporting revenues and expenses. Two primary methods are accrual accounting and cash accounting. Cash accounting reports revenue and expenses as they are received and paid; accrual accounting reports them as they are earned and incurred.

Cash accounting is an accounting method that is relatively simple and is commonly used by small businesses. If a business generates more than $5 million in annual sales, however, it must use the accrual method, according to Internal Revenue Service rules.

Accrual accounting is based on the matching principle, which is intended to match the timing of revenue and expense recognition. By matching revenues with expenses, the accrual method is intended to give a more accurate picture of a company's true financial condition.

The value of accrual accounting becomes more evident for large, complex businesses. A construction company, for example, may undertake a long-term project and may not receive complete cash payments until the project is complete. Under cash accounting rules, the company would incur many expenses but would not recognize revenue until cash was received from the customer. Under accrual accounting, the company would recognize a percentage of revenue and expenses corresponding to the portion of the project that was complete. This is known as the percentage of completion method. How much actual cash coming into the company, however, would be evident on the cash flow statement.

The Internal Revenue Service requires taxpayers to choose an accounting method that accurately reflects their income and to be consistent in their choice of accounting method from year to year. IRS approval is required to change methods. Companies may use a hybrid of the two methods, which is allowable under IRS rules if specified requirements are met.