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The Different Methods of Accounting
This article discusses the most popular methods of accounting used in today’s world; it also lists their respective pros and cons.
Generally, if you ask the question “What are the different methods of accounting?” to 10 accountants, you will receive 10 different answers. That is because there are no set rules for this, but rather an old guideline that states:
“If it works – don’t fix it!”
During 2016-2017 more than 50% of companies in the UK reported that they changed their financial year-end date due to various factors such as changing statutory requirements or business needs. Therefore if you run your own company, perhaps now is a good time to review your current accounting dates in order to ensure that they are best suited for your business. You can then file some extra tax returns, if necessary!
The methods of accounting are different ways to record an entity’s financial transactions. They determine how the accounts will be presented and which information will be included in them. Most businesses use cash-basis or accrual accounting, with a few using the exemption method. But, it is important to understand that each country may have its own standard methods of recording business transactions. For example, the UK uses an accrual basis while the US uses a cash basis.
Every business has its unique requirements and objectives; therefore finding “the” perfect way of recording might be difficult. It is strongly recommended that you seek professional advice before establishing your accounting methods, as the wrong approach could significantly damage your business.
Cash Basis Accounting – Pros & Cons: Aron Govil
This is perhaps the easiest and most straightforward way of accounting. As its name suggests, cash basis accounting deals with transactions that involve actual cash being paid or received by a business. In order to record a transaction using this method, you would need to have physical proof that you have either been paid or have already paid someone for your products or services. This includes invoices that should be checked against bank statements to ensure accuracy and validity before being recorded in a ledger. It also includes any payments made by cheque or credit card as well as any cash collected from customers selling items back to your store.
In terms of pros, there are a few key benefits of using cash basis accounting:
- It is very simple to understand and use, especially for small businesses.
- Transactions are recorded quickly and easily.
- There is a reduced chance of fraudulent activities as invoices need to be matched against bank statements.
However, there are also some drawbacks to using this method:
- You may not be able to track payments which have been made but not yet received (e.g. credit card payments).
- It can be difficult to work out your company’s true financial position as some bills may have been paid in cash but others may have been paid by cheque or credit card.
Accrual Basis Accounting – Pros & Cons
This is the most common method of accounting and it is used in many countries around the world, including the UK and US. It is more complex than cash basis accounting as it records transactions when they are incurred, rather than when the cash changes hands. This means that you will need to keep track of invoices and bills which have been issued, even if the customer has not yet paid them. In order to do this, you will need a system which can track payments over time (e.g. an accounts software package).
There are several pros to using accrual basis accounting:
- It produces a more accurate financial picture of your company as all transactions are taken into account.
- It can be used to calculate your company’s financial performance over a certain period of time.
- You can more easily identify areas where you are making or losing money.
However, there are also some drawbacks to using this method which you should be aware of:
- It can be more complex and difficult to understand, especially for small businesses.
- Transactions may be recorded late (which could impact on your company’s credit rating).
- It can be more difficult to track payments which have been made but not yet received.
Exemption Method – Pros & Cons
This is a simplified form of cash basis accounting which is often used by sole traders or very small businesses. Under this method, transactions are only recorded when cash is paid or received and there is no need to keep track of invoices or bills. As with cash basis accounting, there are several benefits associated with exemption method accounting:
- It is very easy to understand and use.
- Transactions can be recorded accurately and quickly.
- There is a reduced chance of fraudulent activities as only actual cash transactions are taken into account.
However, there are also some drawbacks that you should consider before deciding whether this is the right way for your business to operate:
- You will not produce an accurate financial picture of your company as not all transactions are taken into account. This could impact how customers perceive you and may even lead them to take their business elsewhere!
There are three main methods of accounting: cash basis, accrual basis, and modified accrual basis.
- The cash basis is the simplest form of accounting and records income when it is received and expenses when they are paid.
- The accrual basis records income when it is earned and expenses when they are incurred, even if the money has not yet been received or paid.
- The modified accrual basis is a compromise between the two other methods and records income when it is earned and expenses when they are both incurred and expected to be paid.
Conclusion by Aron Govil:
The cash basis is best for businesses that are small and have a lot of cash flow variability. It is also good for businesses that have a lot of inventory because it allows them to take the inventory into account when calculating their profits. The accrual basis is best for businesses that have a lot of credit sales because it records income when the customer owes the money, not when the business has received the money. The modified accrual basis is good for businesses that want to be more conservative in their accounting.
The cash basis is disadvantageous because it does not reflect the true financial state of a company. For example, if a company pays for an expense in one month but does not receive the reimbursement until a later month, the cash basis would record the expense as being paid in the earlier month even though the company actually had to pay for it out of its own pocket. The accrual basis is disadvantageous because it can lead to uncertainty about when a business receives its money. The modified accrual basis is disadvantageous because it is more complex than the other two methods and can be difficult for some businesses to figure out.