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Accounting method is a key financial term. Find out what it means.
An accounting method is the set of guidelines and rules businesses use to keep financial records and prepare financial reports for the purpose of taxation.
The accounting method helps in reporting income and expenses for the purpose of taxation, as well as decision-making by the management of a business. Taxpayers are required by the IRS to have an accurate method of showing their income and expenses. They are also obliged to ensure consistency in their accounting method of choice every year. The selection of the accounting method is usually based on tax minimization and regulation strategies.
There are two primary accounting methods used in record keeping: accrual basis and cash basis. Under the cash basis, expenses and incomes are recognized according to real-time cash flow. Income is recorded once the funds are received, as opposed to when they are earned. Likewise, expenses are recorded when they are paid, and not when they are incurred. This method allows for deferment of taxable income, which can be achieved through delayed billing that ensures payment does not come in the current year. Payments can also be accelerated by immediately paying bills that are received before the due date.
Companies that use the accrual basis of accounting recognize income and expenses as soon as they are earned or incurred, even if the cash associated with the transactions has not been transferred. In this basis, revenue is recorded when earned, even before it has been received. Likewise, expenses are recorded when incurred, regardless of when payments are made.
Company A has an annual rent of $12,000. The company has a policy of paying this amount at the beginning of the year. If the firm records the transaction on a cash basis, the rent expense will be recorded in January as $12,000. On the other hand, if the firm uses the accrual basis, the account entry for rent in January will be $1,000 ($12,000 divided by 12 months).