Accounting method

Accounting method refers to the set of rules and procedures that an organization uses to record, recognize and report financial transactions in its accounting records ^[1]. The choice of accounting method affects when revenues and expenses are recognized, how assets are valued, and how financial information is presented to stakeholders. Accounting methods must comply with applicable accounting standards and tax regulations while providing a faithful representation of the organization's economic activities.

Historical development

The development of standardized accounting methods parallels the evolution of business practices and capital markets. Early commercial enterprises used simple cash-based records that tracked money received and paid without regard to when underlying transactions occurred ^[2]. As businesses grew larger and more complex the limitations of cash accounting became apparent particularly for enterprises with significant credit transactions and long-term investments.

The development of double-entry bookkeeping in medieval Italy provided the foundation for more sophisticated accounting methods. Luca Pacioli's 1494 treatise on bookkeeping described techniques for recording transactions that affected multiple accounts and established principles that remain relevant today. The industrial revolution created demand for accounting methods that could handle the complexity of manufacturing enterprises including the allocation of costs to product and the depreciation of long-lived assets.

The establishment of professional accounting bodies in the nineteenth and twentieth centuries led to efforts to standardize accounting methods. In the United States the American Institute of Certified Public Accountants began developing accounting principles in the 1930s following the stock market crash which revealed widespread inconsistencies in financial reporting ^[3]. The Financial Accounting Standards Board established in 1973 assumed responsibility for setting generally accepted accounting principles (GAAP) which define permissible accounting methods for public companies.

International efforts to harmonize accounting methods began with the formation of the International Accounting Standards Committee in 1973 which was succeeded by the International Accounting Standards Board in 2001. The resulting International Financial Reporting Standards (IFRS) are now used in over 140 countries creating greater comparability of financial statements across national boundaries though significant differences with GAAP persist in certain areas.

Cash versus accrual accounting

The most fundamental choice of accounting method involves the basis for recognizing revenues and expenses ^[4].

Cash basis accounting

Under cash basis accounting revenues are recognized when cash is received and expenses are recognized when cash is paid regardless of when the underlying economic events occur. A sale made on credit is not recorded as revenue until the customer pays and an expense incurred but not yet paid is not recorded until payment is made. This method provides a straightforward view of cash flows but may not accurately reflect the economic results of business activities.

Cash basis accounting is simple to implement and understand making it popular among small businesses with straightforward transactions. It provides clear information about cash availability which is important for businesses that must manage liquidity carefully. For tax purposes cash basis accounting may defer tax on income not yet collected.

However cash basis accounting has significant limitations. It does not match revenues with the expenses incurred to generate them which can distort reported results from period to period. A business might appear profitable in a period when it collects payment for past sales while incurring significant expenses that will only appear in future periods when paid. Financial statements prepared on a cash basis do not conform to generally accepted accounting principles for most businesses.

Accrual basis accounting

Accrual basis accounting recognizes revenues when earned and expenses when incurred regardless of when cash changes hands ^[5]. Revenue is earned when goods are delivered or services are performed and the customer has an obligation to pay. Expenses are incurred when the organization receives goods or services and has an obligation to pay. This approach provides a more accurate picture of economic performance by matching revenues with related expenses in the same period.

Under generally accepted accounting principles and international financial reporting standards accrual basis accounting is required for most businesses. Public companies and larger private companies must use accrual accounting for financial reporting purposes. In the United States the Internal Revenue Service requires businesses with more than twenty-five million dollars in average annual revenue to use accrual accounting for tax purposes.

The accrual method provides more relevant information for decision making by showing economic results when activities occur rather than when cash moves. However it requires more complex record-keeping including tracking receivables, payables, prepaid items and accrued expenses. Estimates and judgments are often required which introduces subjectivity into the financial statements.

Modified cash basis

The modified cash basis or hybrid method combines elements of both cash and accrual accounting ^[6]. Short-term items such as revenues and most expenses are recorded on a cash basis while long-term items such as fixed assets and loans are recorded on an accrual basis including depreciation. This approach provides some of the simplicity of cash accounting while capturing the economic substance of significant long-term transactions.

The modified cash basis is not permitted under GAAP or IFRS but may be acceptable for smaller businesses, internal reporting purposes and certain tax situations. It represents a practical compromise for organizations that want better information than pure cash accounting provides without the full complexity of accrual accounting.

Inventory valuation methods

Organizations that maintain inventory must select methods for determining the cost of inventory sold and the value of inventory remaining on hand ^[7].

First-in first-out

The first-in first-out (FIFO) method assumes that the oldest inventory items are sold first. The cost of goods sold reflects the cost of items acquired earliest while ending inventory reflects the cost of more recent purchases. During periods of rising prices FIFO results in lower cost of goods sold and higher reported income compared to other methods. The ending inventory on the balance sheet approximates current replacement cost.

FIFO is permitted under both GAAP and IFRS and is widely used because it often corresponds to the actual physical flow of goods. It provides a balance sheet value that reflects relatively current costs which may be more useful for assessing financial position.

Last-in first-out

The last-in first-out (LIFO) method assumes that the most recently acquired inventory is sold first. Cost of goods sold reflects current acquisition costs while ending inventory may contain very old costs that do not reflect current values. During periods of rising prices LIFO results in higher cost of goods sold and lower reported income compared to FIFO. The tax benefit from lower income has made LIFO popular among American companies.

LIFO is permitted under United States GAAP but is prohibited under IFRS ^[8]. The International Accounting Standards Board eliminated LIFO because it does not typically reflect the actual physical flow of inventory and can result in balance sheet values that bear little relationship to current costs. Companies that use LIFO for tax purposes must also use it for financial reporting purposes under the tax conformity requirement.

Weighted average cost

The weighted average cost method calculates the average cost of all inventory items available for sale during the period. This average cost is used for both cost of goods sold and ending inventory. The method smooths out price fluctuations and is straightforward to apply especially for fungible goods where tracking specific lots is impractical.

Weighted average cost is permitted under both GAAP and IFRS and is appropriate when inventory items are interchangeable and it is not possible or practical to track the cost of specific units.

Specific identification

The specific identification method tracks the actual cost of each individual inventory item. When an item is sold its actual cost is recorded as cost of goods sold. This method is appropriate for unique high-value items such as automobiles, jewelry or artwork where each item can be distinctly identified and tracked.

Specific identification provides the most accurate matching of costs with revenues but is practical only when inventory items are distinguishable and relatively few in number.

Depreciation methods

Long-lived tangible assets lose value over time through use, obsolescence and physical deterioration. Depreciation methods allocate the cost of these assets to expense over their useful lives ^[9].

Straight-line depreciation

Straight-line depreciation allocates the depreciable cost of an asset equally over its useful life. Annual depreciation expense equals the cost minus salvage value divided by the number of years of useful life. This method is simple to calculate and apply and results in consistent expense recognition from period to period.

Straight-line depreciation is the most commonly used method and is appropriate when the asset provides relatively constant benefits throughout its life. It is permitted under both GAAP and IFRS and is widely used for financial reporting purposes.

Declining balance depreciation

Declining balance methods including double declining balance allocate higher depreciation expense in early years and lower expense in later years. Depreciation is calculated as a percentage of the remaining book value rather than the original cost. These methods result in accelerated expense recognition and may better reflect the pattern of economic benefits for assets that are most productive when new.

Accelerated depreciation methods reduce reported income in early years and increase it in later years compared to straight-line. They may be advantageous for tax purposes when permitted and may better match expenses with revenues for assets whose productivity declines over time.

Units of production depreciation

The units of production method bases depreciation on actual usage rather than time. Total depreciable cost is allocated based on the number of units produced, miles driven, hours operated or other measure of activity. This method matches depreciation expense directly with the benefit received from the asset.

Units of production depreciation is appropriate when asset consumption varies significantly from period to period and when usage can be readily measured. It provides better matching than time-based methods for assets whose useful life depends primarily on physical use rather than technological obsolescence.

Changing accounting methods

Organizations may change accounting methods when a different method would provide more relevant and reliable information or when required by changes in accounting standards ^[10]. However changes must be made carefully to maintain consistency and comparability of financial statements.

Financial reporting requirements

Under GAAP and IFRS voluntary changes in accounting method are generally applied retrospectively meaning that prior period financial statements are restated as if the new method had always been used. This maintains comparability across periods but requires significant effort to recalculate prior period amounts. Some changes are applied prospectively affecting only current and future periods when retrospective application is impracticable.

Accounting standards require disclosure of accounting method changes including the nature and reason for the change, the method of applying the change and the effect on reported amounts. Stakeholders must be able to understand how changes affect the comparability of financial information.

Tax requirements

In the United States changes in accounting methods for tax purposes generally require approval from the Internal Revenue Service through Form 3115 Application for Change in Accounting Method ^[11]. Some changes qualify for automatic approval while others require advance consent through a more detailed review process.

The requirement for approval helps ensure that accounting method changes are not used to manipulate taxable income. Changes that shift income between periods must be accounted for through a section 481(a) adjustment that prevents items from being duplicated or omitted as a result of the change.

Advantages of appropriate accounting methods

Selecting appropriate accounting methods provides several benefits ^[12]:

• Faithful representation of economic transactions and events
• Comparability of financial information across periods and with other organizations
• Relevance for stakeholder decision making
• Compliance with applicable accounting standards and regulations
• Consistency between financial reporting and tax reporting where required
• Appropriate matching of revenues with related expenses
• Clear communication of the organization's financial position and results

Limitations of accounting methods

Accounting methods also have inherent limitations ^[13]:

• Require judgments and estimates that introduce subjectivity
• May not capture all economically significant information
• Differences between methods can make comparisons difficult
• Complexity increases costs of record-keeping and reporting
• Changes in methods can affect comparability across periods
• Methods permitted for tax may differ from those required for financial reporting
• Some methods may be manipulated to achieve desired results

Accounting method — recommended articles

Financial management — Standard — Documentation — Decision making — Quality control — Management — Organization — Planning — Stakeholder

References

• Kieso D.E., Weygandt J.J., Warfield T.D. (2022), Intermediate Accounting, John Wiley & Sons, 18th edition.
• Horngren C.T., Sundem G.L., Elliott J.A. (2021), Introduction to Financial Accounting, Pearson, 13th edition.
• FASB Accounting Standards Codification.
• IFRS Foundation (2023), International Financial Reporting Standards.
• Internal Revenue Service (2022), Publication 538 Accounting Periods and Methods.

Footnotes

1. Kieso D.E. et al. (2022), p. 45
2. Horngren C.T. et al. (2021), pp. 8-15
3. Kieso D.E. et al. (2022), pp. 5-10
4. IRS Publication 538, pp. 8-10
5. Kieso D.E. et al. (2022), pp. 98-105
6. IRS Publication 538, p. 11
7. Kieso D.E. et al. (2022), pp. 425-445
8. IFRS Foundation (2023), IAS 2
9. Kieso D.E. et al. (2022), pp. 578-595
10. FASB ASC Topic 250
11. IRS Publication 538, pp. 15-18
12. Kieso D.E. et al. (2022), pp. 48-50
13. Horngren C.T. et al. (2021), pp. 18-20

Author: Sławomir Wawak