Choosing an Accounting Method for Your Business
9 of 12 in Series: The Essentials of Accounting Basics
Different businesses make different accounting decisions. Some businesses choose conservative accounting methods while others choose liberal accounting methods. Accounting is more than just reading the facts or interpreting the financial outcomes of business transactions. Accounting also requires accountants to choose between alternative accounting methods.
Similar to the conservative states and liberal states addressed in politics, accounting has:
Conservative accounting methods: These accounting methods delay the recording of revenue and accelerate the recording of expenses. Profit is reported slowly.
Liberal accounting methods: These accounting methods accelerate the recording of revenue and delay the recording of expenses. Profit is reported quickly.
In general terms, conservative accounting methods are pessimistic, and liberal methods are optimistic. The choice of accounting methods also affects the values reported for assets, liabilities, and owners’ equities in the balance sheet.
Accounting methods must stay within the boundaries of Generally Accepted Accounting Principles (GAAP). A business can’t conjure up accounting methods out of thin air. GAAP isn’t a straitjacket; it leaves plenty of wiggle room, but the one fundamental constraint is that a business must stick with its accounting method when it makes a choice.
Consistency is the rule; the same accounting methods must be used year after year. The Internal Revenue Service (IRS) allows businesses to change their accounting methods once in a while, but the justification has to be persuasive.
A new business with no accounting history has to make accounting decisions such as the following, for the first time:
If the business sells products, it has to select which cost of goods sold expense method to use.
If the business owns fixed assets, it has to select which depreciation method to use.
If the business makes sales on credit, it has to decide which bad debts expense method to use.
The choices of accounting methods for these three expenses — cost of goods sold, depreciation, and bad debts — can make a sizable difference in the amount of profit or loss recorded for the year. Choosing conservative accounting methods for these three expenses can cause profit for the year to be lower by a relatively large percent compared with using liberal accounting methods for the expenses.