Accounting Methods: Definition, Types, and Example

ByObeydul Haque Reading Time: 6 minutes

Accounting is often described as the language of business, a system that records, analyzes, and communicates financial information to stakeholders. At the heart of this system lie accounting methods—structured approaches that determine how financial transactions are recorded and reported. These methods are critical for ensuring consistency, transparency, and compliance with regulatory standards. This article explores the definition of accounting methods, the primary types used in practice, and practical examples to illustrate their application.

What Are Accounting Methods?

Accounting methods refer to the rules, principles, and procedures a business or individual follows to record and report financial transactions. These methods dictate when and how income, expenses, assets, and liabilities are recognized in financial statements. The choice of an accounting method impacts a company’s reported profitability, tax obligations, and overall financial health, making it a pivotal decision for businesses of all sizes.

Accounting methods are governed by standards such as the Generally Accepted Accounting Principles (GAAP) in the United States or the International Financial Reporting Standards (IFRS) globally. While these standards provide a framework, they allow flexibility in choosing specific methods based on a business’s size, industry, and operational needs. The two primary categories of accounting methods are cash-basis accounting and accrual-basis accounting, with hybrid approaches and specialized methods also in use.

Types of Accounting Methods

There are several accounting methods, each with distinct characteristics and applications. Below, we delve into the most common types: cash-basis accounting, accrual-basis accounting, modified cash-basis accounting, and other specialized methods.

1. Cash-Basis Accounting

Cash-basis accounting is the simplest and most straightforward method. Under this approach, revenues and expenses are recorded only when cash changes hands—when payment is received or made. This method does not recognize accounts receivable or payable, focusing solely on actual cash flow.

  • Key Features:
    • Revenue is recorded when cash is received from customers.
    • Expenses are recorded when cash is paid to suppliers or vendors.
    • No recognition of credit transactions until settled in cash.
  • Advantages:
    • Easy to implement and understand, making it ideal for small businesses or sole proprietors.
    • Provides a clear picture of cash availability.
    • Simplifies tax reporting for businesses with minimal credit transactions.
  • Disadvantages:
    • Does not reflect the full financial picture, as it ignores obligations or earnings not yet settled in cash.
    • Not compliant with GAAP or IFRS, limiting its use for larger businesses or those seeking investors.
  • Who Uses It?
    • Small businesses, freelancers, and individuals with simple financial structures often adopt cash-basis accounting.
2. Accrual-Basis Accounting

Accrual-basis accounting takes a more comprehensive approach by recording revenues and expenses when they are earned or incurred, regardless of when payment occurs. This method aligns with the matching principle, which states that revenues and related expenses should be reported in the same period to accurately reflect profitability.

  • Key Features:
    • Revenue is recognized when a sale is made or a service is performed, even if payment is deferred (e.g., accounts receivable).
    • Expenses are recorded when they are incurred, such as when goods are received, even if payment is pending (e.g., accounts payable).
    • Requires adjusting entries for prepaid expenses, accrued revenues, and depreciation.
  • Advantages:
    • Provides a more accurate representation of a company’s financial position and performance over time.
    • Compliant with GAAP and IFRS, making it suitable for publicly traded companies and larger organizations.
    • Facilitates better long-term planning and analysis.
  • Disadvantages:
    • More complex and time-consuming due to the need for tracking receivables, payables, and adjustments.
    • May not reflect immediate cash flow, which can be a drawback for cash-strapped businesses.
  • Who Uses It?
    • Medium to large businesses, corporations, and entities required to follow GAAP or IFRS typically use accrual-basis accounting.
3. Modified Cash-Basis Accounting

Modified cash-basis accounting, also known as the hybrid method, combines elements of both cash-basis and accrual-basis accounting. This approach allows businesses to tailor their accounting practices to their specific needs, recording some transactions on a cash basis and others on an accrual basis.

  • Key Features:
    • Short-term transactions (e.g., daily operating expenses) are recorded when cash changes hands, similar to cash-basis accounting.
    • Long-term items (e.g., fixed assets, depreciation, or large receivables) are recorded using accrual principles.
    • Offers flexibility in tracking cash flow and financial obligations.
  • Advantages:
    • Balances simplicity with a more accurate financial overview.
    • Useful for businesses transitioning from cash-basis to accrual-basis accounting.
    • Provides insight into both cash flow and long-term financial commitments.
  • Disadvantages:
    • Lacks uniformity, as the method varies by business, potentially complicating audits or comparisons.
    • May not fully comply with GAAP or IFRS unless carefully structured.
  • Who Uses It?
    • Small to medium-sized businesses seeking a middle ground between cash and accrual methods often adopt this approach.
4. Specialized Accounting Methods

In addition to the primary methods, certain industries or situations require specialized accounting approaches. These include:

  • Percentage of Completion Method:
    • Used in long-term projects (e.g., construction), where revenue and expenses are recognized based on the project’s progress.
    • Ensures income is reported proportionally as work is completed.
  • Completed Contract Method:
    • Also used for long-term projects, but revenue and expenses are recorded only when the project is fully completed.
    • Common in industries with significant uncertainty, such as custom manufacturing.
  • Installment Method:
    • Applied when payments are received in installments over time (e.g., real estate sales), recognizing revenue as payments are collected.
  • Cost Accounting:
    • Focuses on tracking production costs, often used in manufacturing to allocate expenses to goods produced.

These specialized methods cater to unique operational or regulatory requirements, ensuring financial reporting aligns with the nature of the business.

Examples of Accounting Methods in Practice

To illustrate how these methods work, let’s explore a few practical examples across different scenarios.

Example 1: Cash-Basis Accounting

Imagine a freelance graphic designer, Sarah, who completes a $1,000 project for a client in December 2024 but doesn’t receive payment until January 2025. Under cash-basis accounting:

  • Sarah records $0 in revenue for December 2024 because no cash was received.
  • In January 2025, when the client pays, Sarah records $1,000 as revenue. Similarly, if Sarah pays $200 for software in December 2024, she records the expense immediately, as cash has left her account. This method keeps her records simple but doesn’t reflect the work completed in December.
Example 2: Accrual-Basis Accounting

Now consider a small manufacturing company, Apex Widgets, which sells $10,000 worth of goods to a retailer in March 2025, with payment due in April 2025. Under accrual-basis accounting:

  • Apex records $10,000 in revenue in March 2025, when the sale is made, increasing accounts receivable.
  • In April 2025, when the retailer pays, Apex reduces accounts receivable and increases cash, with no additional revenue recorded. On the expense side, if Apex receives $5,000 in raw materials in March but pays in April, it records a $5,000 expense in March (accounts payable) and settles the liability in April. This method shows Apex’s financial activity more accurately for March.
Example 3: Modified Cash-Basis Accounting

A local bakery, SweetRise, uses a modified cash-basis approach. In June 2025, it pays $300 in cash for daily supplies and records the expense immediately (cash basis). However, it also buys a $12,000 oven with a five-year lifespan, paying in cash. Instead of expensing the full $12,000 upfront, SweetRise records the oven as an asset and depreciates it over five years ($2,400 per year) using accrual principles. This hybrid method tracks cash flow for daily operations while accounting for long-term investments.

Example 4: Percentage of Completion Method

A construction firm, BuildCorp, undertakes a $1 million project expected to take two years, starting in January 2025. By December 2025, the project is 40% complete. Using the percentage of completion method:

  • BuildCorp recognizes $400,000 in revenue ($1 million × 40%) and the corresponding expenses (e.g., $300,000 in labor and materials) in 2025.
  • The remaining revenue and costs are recorded as the project progresses. This method ensures income is reported steadily rather than all at once.

Choosing the Right Accounting Method

Selecting an accounting method depends on several factors:

  • Business Size: Small businesses may prefer cash-basis for simplicity, while larger firms opt for accrual-basis to meet reporting standards.
  • Industry: Construction or manufacturing may require specialized methods like percentage of completion.
  • Tax Requirements: Some jurisdictions allow cash-basis for tax reporting, while others mandate accrual-basis for certain entities.
  • Financial Goals: Businesses seeking investors or loans often adopt accrual-basis to present a robust financial picture.

The U.S. Internal Revenue Service (IRS), for instance, allows businesses with average annual gross receipts of $25 million or less (as of 2025) to use cash-basis accounting, while larger entities must typically use accrual-basis to comply with GAAP.

Conclusion

Accounting methods are the backbone of financial reporting, shaping how businesses track and communicate their economic activities. From the simplicity of cash-basis accounting to the precision of accrual-basis and the flexibility of hybrid approaches, each method serves a distinct purpose. Specialized methods further cater to unique industry needs, ensuring relevance and accuracy. By understanding these methods and their applications—illustrated through examples like Sarah’s freelance work or BuildCorp’s construction project—business owners and stakeholders can make informed decisions that align with their operational and regulatory requirements. Ultimately, the choice of an accounting method is not just a technical decision but a strategic one, influencing financial transparency, tax planning, and long-term success.

I (plan to) write about business, finance, SEO, WordPress, and whatever else interests me. You might find those interesting too. For now, find me on Twitter/ X.