Methods of Accounting…1,2,3

There are three methods an organization can use to account for their daily transactions: pure cash basis method, accrual method and modified accrual method. The major difference between these methods is how an organization records its inflow (receipts) and outflow(disbursements) of cash. Let’s define the pure cash basis method.

The pure cash basis method of accounting only recognizes income or expense when cash is received or paid. Basically, this means that an organization will not record an expense when a service is performed, or invoice is received, but rather when payment for that service or invoice occurs. Similarly they will not record revenue when a service is preformed or a sale is made, but rather when payment is received. This is the most basic method of accounting and may be appropriate for very small organizations.

However, because the cash basis method of accounting does not match income to expense, it does not provide the most accurate information about the financial position of an organization. For this reason many companies choose, and some are required, to use the accrual method of accounting. What is the accrual basis of accounting?

The accrual method of accounting is more complex than the pure cash basis of accounting and involves recognizing income and expense when you have the right to receive the income or become liable for the expense whether or not cash is received or paid immediately after. Because income and expense are recognized before cash is received or paid, the accrual method of accounting involves estimating revenue and expense initially and then adjusting them if the actual cash received or paid differs from the estimate. The accrual method of accounting allows revenue to be matched to the resulting expense within the year and thus levels out net income. This can be useful to avoid peaks in income that result in higher taxes. It also gives a clearer and more accurate picture of how an organization is really doing.

The third method of accounting is classified as the modified accrual accounting. This is basically a mixture of the first two accounting methods, in which the cash basis of accounting is used for certain transactions within the organization and the accrual method is used for others. This can be done for a variety of reasons including legal requirements.

What method does your organization use? Look at the balance sheet and determine if accounts receivable or accounts payable have been listed. Is cash your only asset? If so, your organization is probably using the “cash basis” of accounting.