You may think that two businesses that are identical in every financial respect and have identical transactions during the year would report identical financial statements. You’d be wrong. The two businesses would have identical financial statements only if they made identical accounting choices, and that’s very unlikely. Different businesses make different accounting decisions. 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 rough 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).
Where and When To Start?
A new business with no accounting history has to make its accounting decisions for the first time. If the business sells products, it has to select which cost of goods sold expense method to use. If it owns fixed assets, it has to select which depreciation method to use. If it makes sales on credit, it has to decide which bad debts expense method to use. These are three of the many accounting decisions a business has to make.
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 cost and expenses can cause profit for the year to be lower by a relatively large percent compared with using liberal accounting methods for the expenses. For better page load reason, I would break this Choosing [Basic] Accounting Methods into three posts in serial, they are: Cost of Goods Sold Methods [for Unique OR Fungible Products], Depreciation Methods, and Choosing Bad Debt Methods. By reading all of the posts, among the available choices, you should be able to judge, which methods are considered as a conservative accounting methods and which are liberal methods. Enjoy!