Legal Definitions - accounting method

An accounting method refers to the specific set of rules and practices a business or individual uses to record and report their income and expenses for financial statements and tax purposes. Different methods determine when revenue is recognized and when costs are accounted for, significantly impacting a company's financial picture in any given period.

• Accrual Accounting Method

  This method records income when it is earned and expenses when they are incurred, regardless of when the actual cash changes hands. It provides a more accurate picture of a company's financial performance over a period.

  • Example 1: A marketing agency completes a project for a client in December but doesn't receive payment until January of the following year. Under the accrual method, the agency would record the income in December when the service was rendered, even though the cash wasn't received yet.

    Explanation: The income is recognized when the service is performed and the right to receive payment is established, not when the payment itself arrives.

  • Example 2: A manufacturing company receives a bill for raw materials delivered in March, but the payment isn't due until April. Using the accrual method, the company records the expense for the materials in March when they were received and used, reflecting the liability incurred.

    Explanation: The expense is recognized when the obligation to pay arises (materials received), not when the cash is disbursed.

• Capitalization Accounting Method

  This method involves determining the present value of an asset by estimating its future financial benefits (like income or cost savings) and then discounting those future benefits back to today's value using an appropriate rate. It helps in making investment decisions or valuing long-term assets.

  • Example 1: An investor is considering buying a commercial office building. They use the capitalization method to estimate the building's value by projecting the rental income it will generate over the next 20 years and then calculating what that future income stream is worth in today's dollars.

    Explanation: The building's present value is determined by its potential to produce future income, discounted to reflect the time value of money.

  • Example 2: A pharmaceutical company assesses the value of a new drug patent. They project the sales and profits the drug is expected to generate over its patent life and then use the capitalization method to determine the patent's current worth based on those future earnings.

    Explanation: The patent's value is derived from its anticipated future economic benefits, brought back to a current valuation.

• Cash-Basis Accounting Method

  This method recognizes income only when cash is actually received and records expenses only when cash is actually paid out. It is simpler than the accrual method and often used by small businesses or individuals.

  • Example 1: A freelance writer completes an article in October but doesn't receive payment from the client until November. Under the cash-basis method, the writer would record the income in November when the payment is deposited into their bank account.

    Explanation: Income is recognized only when the cash is physically received.

  • Example 2: A small consulting firm receives an electricity bill in January for December's usage but pays it in February. Using the cash-basis method, the firm records the electricity expense in February when the payment is made, not in January when the bill was received or December when the electricity was used.

    Explanation: The expense is recognized only when the cash is actually paid out.

• Completed-Contract Accounting Method

  This method is used for long-term projects, where all income and expenses related to a contract are recognized only in the tax year the entire contract is finished and accepted. This defers the recognition of profit or loss until the project's conclusion.

  • Example 1: A company builds a custom bridge that takes three years to complete. Under the completed-contract method, the company would not report any profit or loss from the bridge project until the third year, when the bridge is fully constructed and handed over to the client.

    Explanation: All revenue and costs are accumulated and recognized at the point of final completion, not incrementally during construction.

  • Example 2: A specialized engineering firm is contracted to design and construct a unique industrial facility over a two-year period. They will only recognize the total revenue and expenses, and thus the profit or loss, from this project in the year the facility is fully operational and accepted by the client.

    Explanation: The financial outcome of the entire project is reported in the year the contract's terms are fully satisfied.

• Cost Accounting Method

  This method involves recording the value of assets, such as inventory or equipment, at their original purchase price. This historical cost is generally used for financial reporting unless specific accounting standards require revaluation.

  • Example 1: A manufacturing company buys a new machine for $100,000. Under the cost accounting method, the machine is recorded on the company's books at $100,000, even if its market value changes over time.

    Explanation: The asset's value is based on its initial acquisition cost.

  • Example 2: A retail store purchases a batch of new clothing inventory for $5,000. This inventory is recorded at $5,000 on their balance sheet, reflecting the actual cost incurred to acquire it.

    Explanation: The inventory is valued at the price paid to obtain it.

• Direct Charge-Off Accounting Method

  This method for bad debts allows a business to deduct an uncollectible amount (money owed to them that won't be paid) as an expense only when it is determined that the specific debt is partially or completely worthless. This is in contrast to estimating bad debts in advance.

  • Example 1: A small business extends credit to a customer who later declares bankruptcy, making it impossible to collect the outstanding invoice of $500. Using the direct charge-off method, the business would record a $500 bad debt expense in the year the bankruptcy is finalized and the debt is deemed uncollectible.

    Explanation: The expense is recognized only when a specific debt is definitively identified as worthless.

  • Example 2: A medical clinic has an unpaid patient bill from two years ago. After repeated collection attempts and confirmation that the patient has moved without a forwarding address, the clinic decides the debt is uncollectible. They then "charge off" the specific bill as a bad debt expense in their accounting records.

    Explanation: The loss is recorded only when the specific account is confirmed to be unrecoverable.

• Equity Accounting Method

  This method is used when an investor holds a significant ownership stake (typically 20-50%) in another company, giving them influence over its operations. The investment's value on the investor's books is adjusted to reflect their share of the investee company's profits or losses and is reduced by any dividends received.

  • Example 1: Company A owns 30% of Company B. If Company B reports a net profit of $1 million, Company A would increase the value of its investment in Company B on its own balance sheet by $300,000 (30% of $1 million). If Company B then pays out $200,000 in dividends, Company A would reduce its investment value by $60,000 (30% of $200,000).

    Explanation: The investor's share of the investee's earnings increases the investment's value, while dividends received reduce it.

  • Example 2: A venture capital firm has a 25% stake in a growing tech startup. Each quarter, the firm adjusts the book value of its investment based on the startup's reported profits or losses, ensuring its financial statements reflect the underlying performance of the company it influences.

    Explanation: The investment's value is dynamically updated to reflect the proportional share of the investee's financial results.

• Fair-Value Accounting Method

  This method values assets and liabilities on a company's balance sheet at their current market price or estimated actual worth, rather than their historical cost. This provides a more up-to-date picture of a company's financial position.

  • Example 1: A real estate investment trust (REIT) owns a portfolio of commercial properties. Under fair-value accounting, they would periodically re-appraise these properties and update their value on the balance sheet to reflect current market conditions, even if they haven't been sold.

    Explanation: The assets are reported at their current market value, not their original purchase price.

  • Example 2: A financial institution holds a large portfolio of publicly traded stocks. Using fair-value accounting, these stocks are valued daily at their closing market prices, reflecting their current worth.

    Explanation: The value of the assets is adjusted to reflect what they could be sold for in the current market.

• Installment Accounting Method

  This method allows a taxpayer to spread out the recognition of profit from the sale of property over the period in which payments are received. The profit recognized with each payment is proportional to the gross profit percentage of the original sale.

  • Example 1: An individual sells a piece of investment land for $200,000, with a cost basis of $100,000, resulting in a $100,000 profit (50% gross profit margin). The buyer agrees to pay $50,000 per year for four years. Using the installment method, the seller would recognize $25,000 (50% of $50,000) of profit each year as they receive the payments.

    Explanation: The gain on the sale is recognized gradually as the payments are collected, proportional to the profit margin.

  • Example 2: A business sells a high-value piece of machinery for $10,000, which cost them $6,000, resulting in a $4,000 profit (40% gross profit margin). The buyer pays in five monthly installments of $2,000. The business would recognize $800 (40% of $2,000) of profit with each monthly payment.

    Explanation: The profit is spread across the payment period, aligning income recognition with cash inflow.

• Percentage-of-Completion Method

  This method recognizes revenue and expenses for long-term contracts gradually as the work progresses, based on the estimated percentage of the contract that has been completed. This provides a more consistent view of a company's performance over the life of a long project.

  • Example 1: A construction company is building a large office complex over four years. At the end of the first year, engineers estimate the project is 25% complete. Under the percentage-of-completion method, the company would recognize 25% of the total estimated revenue and expenses for the project in that first year.

    Explanation: Revenue and costs are recognized incrementally as the work on the long-term contract progresses.

  • Example 2: A software development firm is creating a custom enterprise system for a client, a project expected to take 18 months. As they hit specific milestones and complete defined portions of the work, they recognize a corresponding percentage of the total contract revenue and associated costs.

    Explanation: The financial results of the project are reported over its duration, reflecting the progress made.

• Physical-Inventory Accounting Method

  This method involves physically counting all items of inventory on hand at the close of an accounting period (e.g., end of the year) to determine the quantity and value of goods available for sale. This count is then used to calculate the cost of goods sold and the ending inventory value.

  • Example 1: A small bookstore closes for a day at the end of its fiscal year. Employees manually count every book on the shelves, in storage, and in transit to determine the exact number of units and their total value for financial reporting.

    Explanation: The inventory value is determined by a direct, manual count of all physical items.

  • Example 2: A hardware store conducts an annual physical inventory count. They go through every aisle, counting each type of screw, tool, and paint can to ensure their recorded inventory matches what is actually present.

    Explanation: The method relies on a literal count of all goods to establish inventory figures.

• Purchase Accounting Method

  This method is used when one company acquires another. The acquiring company records the acquired firm's identifiable assets and liabilities at their fair market value on its own books. If the purchase price exceeds the fair value of these identifiable net assets, the excess amount is recorded as "goodwill."

  • Example 1: Tech Giant X acquires Startup Y for $500 million. Startup Y's identifiable assets (like patents, equipment, and cash) are valued at $300 million. Under purchase accounting, Tech Giant X records these assets at $300 million and records the remaining $200 million as "goodwill" on its balance sheet, representing the value of Startup Y's brand reputation, customer base, and future growth potential.

    Explanation: The acquired company's assets are revalued to their current market worth, and any premium paid above that is recognized as goodwill.

  • Example 2: A large food conglomerate buys a smaller organic snack brand. The conglomerate records the snack brand's recipes, trademarks, and production facilities at their current fair market value. The additional amount paid for the brand's established customer loyalty and market presence, beyond the value of its tangible assets, is accounted for as goodwill.

    Explanation: The acquisition records the fair value of specific assets and attributes any additional cost to intangible assets like brand value.