Accounting Methods – Definition and Types

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Tally Solutions | Dec-03-2019

Accounting Methods - Definition

An accounting method is defined as a means to record when income is received and expenses are paid so that profit can be determined for a specific time period, referred to as the accounting period.

Following the accounting methods, a business measures its own success and by which the tax authorities can determine taxable income. But in most of the cases, the tax law restricts the choice of accounting methods and accounting periods for specific business entities.

Why choose an accounting method?

A basic requirement of any accounting method is that it must accurately reflect income. Cash accounting is based on cash values received and paid. It is a simpler method and usually followed by few micro-businesses.

Accrual accounting, along with the matching principle, is based on earned revenues and incurred expenses. It clearly reflects business performance, making it more reliable and widely accepted by users.

Can an Accounting Method once followed be changed?

Once an accounting method is chosen, a business can only change it with the consent of the tax authorities. The taxpayer must request the change using the required form and such application for change in accounting method may mention the tax period for which the change is proposed to be applied.

Type of Accounting Methods

The two primary methods of accounting that differ in when income and expenses are recognized are as follows

  • Cash Accounting Method
  • Accrual Accounting method

Cash Accounting Method

Under the cash accounting method, transactions are recorded only when money changes hands. Revenues are recognized when they are received, while expenses are recognized when paid for. This is also called as receipts and disbursement method of accounting.

Thereby, the cash-based method of accounting is the easiest one to implement and is most commonly used by sole proprietorships and small businesses.

For example, ABC Inc. sold garments worth Rs. 10,000/-. 40% on cash basis and remaining on credit basis. ABC Inc. maintains its accounts under the cash method.

On following the cash-based accounting method, ABC Inc. would recognize revenue to the extent of Rs. 4,000/- (i.e., 10,000*40%) only.

And similarly, any commissions or other expenses, even if directly related to this sale, would be recorded only when ABC Inc. makes their payment.

Accrual based Method of accounting

Under the accrual-based method of accounting, gross income must be reported when it is earned, regardless of when the income is collected, because the entity has a right to receive it.

Let’s consider the example of ABC Inc. and see the difference if it maintains its accounts under the accrual method. On selling garments worth Rs. 10,000, ABC Inc. would record sales revenue of Rs.10,000, regardless of whether it is a cash or credit sale.

Following the matching principle, any expenses incurred to gain the Rs.10,000 revenue would also be recorded in the same period.

The following are two tests which determine if the income has been received or an expense incurred: -

  • All Events Test
  • Economic Performance Test.

All events test

The test of satisfying all events occurs when the amount of the income or expense is ascertainable with reasonable certainty and the business has the legal right to receive the income or the legal obligation to pay the expense.

Performance test

The performance test determines whether everything has occurred to earn the income or to be liable for the expense. So, for instance, the income is earned when the amount is known with reasonable certainty and when everything occurred that was promised in exchange for the income. The test of performance includes completing services for the customer or transferring the title of the property to the buyer.

However, if there is a dispute as to the payment, then the income does not have to be reported until it is actually received since the amount of the receipts cannot be determined with reasonable accuracy.

Likewise, expenses are reported when they are incurred rather than when they are paid. However, there is an exception for recurring items, which are expenses paid for specific types of items regularly, which allows the business to deduct the expenses when accrued, even though economic performance has not been completed.

The third Accounting Method - Hybrid

The hybrid method of accounting is primitively a blend between the cash and accrual methods but also incorporates other special methods of accounting. The accounting method is permissible for internal accounting and tax purposes.

This method of accounting incorporates the cash and accrual methods of accounting and is acceptable for internal accounting as well as tax purposes. However, the taxation laws related to specific entities have special requirements relating to the use of the hybrid method which focuses on line items related to inventory, income, and expenses. The hybrid method must be applied consistently in order to pass the scrutiny conducted by tax officials and be acceptable for internal accounting purposes.

Accounting Methods - Interesting Facts around the globe

Indonesia

In Indonesia, financial statements are based on Accounting Standards determined by IAI and Bapepam regulations in the accounting field.

Financial statements must be prepared using the accrual accounting basis. Accounting information systems range from paper-based manual systems to sophisticated, distributed internet-based systems. In Indonesia, many businesses and SOEs use accounting packages.

India

Australia, Canada, Colombia, United States and France are some of the countries that have incorporated the accounting system on the accrual basis, while countries like Indonesia, Israel and Finland follow a combination of both cash and accrual basis of accounting.

In India, businesses follow the standards determined by Indian Accounting Standards. Uniform accounting principles assist in the comparison of the financial statement of entities. If accounting principles followed are same, then reader of financial statements can compare financial results of two entities.

In India, the accounting principle states that the accounting transactions should be recorded in the accounting periods when they actually occur, rather than in the periods when there are cash flows associated with them.

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