What is Cash Basis Accounting?Cash basis accounting is an accounting system that recognizes and records income and expenses as they are paid in cash. GAAP dictates that businesses cannot use the cash basis of accounting. Instead, businesses must use the accrual basis of accounting that recognizes revenues and expenses when they are earned or occur. The cash basis of accounting recognizes revenues when cash is received, and expenses when they are paid. This method does not recognize accounts receivable or accounts payable. Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is no need to track receivables or payables. The cash method is also beneficial in terms of tracking how much cash the business actually has at any given time; you can look at your bank balance and understand the exact resources at your disposal. Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t taxed until it’s in the bank.
What Does Cash Basis Accounting Mean?The cash basis of accounting is the practice of recording revenue when cash has been received, and recording expenses when cash has been paid out. The cash basis is commonly used by individuals and small businesses (especially those with no inventory), since it involves the simplest accounting. An alternative method for recording transactions is the accrual basis of accounting, under which revenue is recorded when earned and expenses are recorded when liabilities are incurred or assets consumed, irrespective of any inflows or outflows of cash. The accrual basis is most commonly used by larger businesses. A start-up company will frequently begin keeping its books under the cash basis, and then switch to the accrual basis when it has grown to a sufficient size. Accounting software can be configured to work under either the cash basis or the accrual basis of accounting, usually by setting a flag in a setup table.
ExampleAssume a company starts only one bank account and all the cash receipts from the year are deposited in the account. In other words, all the revenue that the company collects is deposited in one single account. Additionally, all the expenses are paid out of this one account. At the end of the year, the balance of the bank account less than the beginning balance would be the cash basis net income for the company for the year. As you can see, this is a much more simplified accounting system than the accrual accounting system. The cash basis of accounting does not recognize any accrued revenues or expenses because they were not paid in cash during the period. GAAP does not allow companies to use the cash basis of accounting because it violates the matching principle, time period principle, and doesn’t reflect the actual company performance or financial status. Companies are allowed to use the cash basis for internal purposes. Some smaller companies are also allowed to file tax returns on the cash basis.
Advantages of the Cash Basis of Accounting
The cash basis of accounting has the following advantages:
- Taxation. The method is commonly used to record financial results for tax purposes, since a business can accelerate some payments in order to reduce its taxable profits, thereby deferring its tax liability.
- Ease of use. A person requires a reduced knowledge of accounting to keep records under the cash basis. Several accounting software packages are designed for the cash basis of accounting, to make them easier to use.
Disadvantages of the Cash Basis of Accounting
The cash basis of accounting also suffers from a number of problems, as outlined below:
Accuracy. The cash basis of accounting yields less accurate results than the accrual basis of accounting, since the timing of cash flows do not necessarily reflect the proper timing of changes in the financial condition of a business. For example, if a contract with a customer does not allow a business to issue an invoice until the end of a project, the company will be unable to report any revenue until the invoice has been issued and cash received.
Manipulation. A business can alter its reported results by not cashing received checks or altering the payment timing for its liabilities. This is commonly used to defer the recognition of taxable income to a later reporting period.
Lending. Lenders do not feel that the cash basis generates overly accurate financial statements, and so may refuse to lend money to a business reporting under the cash basis. However, this may not be the case for a small business that cannot afford the services of a CPA to prepare its books.
Audited financial statements. Auditors will not approve financial statements that were compiled under the cash basis of accounting, so a business will need to convert to the accrual basis if it wants to have audited financial statements.
Management reporting. Since the results of cash basis financial statements can be inaccurate, management reports should not be issued that are based upon it.
In short, the numerous problems with the cash basis of accounting usually cause businesses to abandon it after they move beyond their initial startup phases.
What Is the Difference Between Cash and Accrual Accounting?While the cash basis accounting recognizes revenues and expenses only when cash is collected or disbursed, the accrual basis of accounting recognizes revenues and expenses when they occur or when they are earned. In the accrual method of accounting, account receivable and account payable are used to track amounts due from customers on credit sales and the amount your business owes to the vendor on a credit purchase. The choice of the accounting system has a major impact on the operations. Listed below are some of the key differences between cash and accrual accounting.
|Basis||Cash Basis of Accounting||Accrual Basis of Accounting|
|Ease of use||Simple, straightforward and easy to use||An intricate but widely used system|
|Meaning||Revenues and expenses are recorded when cash is exchanged||Revenues and expense are recorded at the point of purchase or sale|
|Credit accounts||There is no record of accounts receivable and accounts payable. The system might overstate the health of a company that is cash-rich||Includes accounts receivables and payables and as a result is a more accurate picture of the profitability of a company|
|Net income||The net income is based on the cash received and cash disbursements rather than revenues earned, and expense incurred||The net income is based on the revenues earned and expenses incurred in the accounting period|
|Balance Sheet||The balance sheet omits certain assets and liabilities.||As far as reporting of assets, liabilities and stockholders’ equity is concerned, the balance sheet is complete|
|Accounting Standards||Violates the matching principle of GAAP||Required by GAAP and IFRS|
|Used by||Best suited for small service-based businesses, individuals, non-profit organizations etc.||Used by all the public companies and other organizations that must file audited financial statements|
How to Choose between Cash Basis and Accrual Accounting
The accounting system you choose ultimately depends on your preferences and, in some cases, stipulations from the Internal Revenue Service (IRS). Knowing what to consider can help you make a more strategic decision. Here are some ways to choose between cash basis and accrual accounting:
1. Consider the IRS requirements
While most small businesses can choose between the cash basis and accrual accounting methods, the IRS does have some stipulations. For example, if a company has over $25 million in average annual gross receipts from sales for the last three tax years, they need to follow the accrual method.
2. Think of the long term
Even if your company isn’t currently making over $25 million in gross annual sales, consider the long term. If you anticipate it growing to this extent, the accrual method may make more sense for your company financially.
3. Determine the importance you place on accuracy
Consider how important it is for you to have a full picture of your organization’s financial health. While the cash basis method comes with many benefits, it may overstate your company’s health because it doesn’t factor everything in. Since an accrual method includes both accounts receivables and payables, it gives you a more accurate idea of your company’s profitability—especially in the long term.
Who Uses Cash Basis Accounting?Cash basis accounting can be adequate and preferred by some small businesses, government agencies, non-profit organizations, community association and small service businesses that do not deal with inventory. Businesses that do not sell or buy on credit can use the cash basis of accounting for evaluating their financial performance. Here are some common reasons why businesses may use cash basis accounting.
- The business uses simple single-entry accounting rather than double-entry accounting
- The company operates as a sole proprietorship or partnership. It does not publish financial statements like public companies for audit
- At the time of sale, the customer pays by cash, wire transfer, check or credit/debit card
- The business does not deliver goods and services on credit
- There are few financial transactions each day
- The business has only a few employees
- The business has no inventory to be tracked or valued such as service businesses