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An accounting method is the way in which a business keeps track of income and expenses. The two main types of accounting are the accrual method and the cash method. Each method has its own benefits and drawbacks. A business can use either or both accounting methods. For example, a company sometimes uses the accrual method for shareholder reports and the cash method for tax purposes.
The cash accounting method is typically the most straightforward. Payments received within a certain time period are considered income. Amounts paid out during that same time period are considered expenses. No matter what is expected to come in or be paid out, the bottom line is what is transferred in and out of the business. The cash accounting method is typically a good way for a business to keep track of its costs and earnings from month to month. It is generally useful for keeping accounts balanced, but it usually does not give an accurate picture of the business as a whole.
Accrual accounting reports income and expenses on the basis of what is expected. Income is calculated by the amount of money the business invoices, and expenses are calculated by how much the business owes. Many financial experts say the accrual method of accounting gives a clearer picture of the business overall. By demonstrating how much a business owes and is owed each month, the business owner or potential investor can usually interpret the financial health of the company.
The cash accounting method is usually more suited to small businesses, such as a one-man gardening service, and typically less expensive and easier to implement. Accrual accounting is generally better suited to larger businesses, as it is usually more expensive and more difficult to implement. In the accrual method, expected revenues are taken into account along with income. Expenses are not just the bills being paid out, but also the business's anticipated debts. In this way, a business with a long sales delivery lead time does not appear to have months of no income and large expenses and then a period of large revenues and no expenses.
A less well-known method is the equity method of accounting. The equity accounting method is generally used when the shareholder of a company owns at least 20% of the distributed stock. By claiming the perceived value of the stock rather than the actual purchase price of the stock, the shareholder can claim either a rise or drop in income within a given tax year. This makes it appear as if the shareholder has more assets on paper than in reality, but the equity accounting method is typically a legitimate way of recording stock value advocated by many financial advisers and tax accountants.
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