Cash basis of accounting definition
/What is the Cash Basis of Accounting?
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.
Example of Cash Basis Accounting
Grouch Electronics installs home theater systems. The owner, Bubba, completes a major install for a rich client in February. He bills the client $25,000, but is not paid until June, because the client turns out not to be so rich. He cashes the client’s check in June, and records $25,000 of revenue in his accounting records at that time. He does not record the $25,000 in February, when he completed the work, because he operates under the cash basis of accounting.
Advantages of the Cash Basis of Accounting
The cash basis of accounting has the following advantages:
Simplicity. The cash basis is straightforward and easy to implement, making it ideal for small businesses and sole proprietors. It does not require tracking accounts receivable or payable, reducing the complexity of bookkeeping.
Cash flow focus. This method provides a clear picture of actual cash on hand, helping businesses manage liquidity effectively. Since transactions are recorded only when cash is received or paid, it simplifies cash flow monitoring and decision-making.
Lower costs. Cash basis accounting typically involves less administrative work and fewer accounting fees compared to accrual accounting. The simplified approach reduces the need for complex financial systems and professional accounting services.
Tax timing flexibility. Small businesses can potentially defer income tax liability by managing the timing of cash receipts and payments. By controlling when revenue is received and expenses are paid, they can influence taxable income for a given year.
Compliance for small businesses. Many tax authorities allow cash basis accounting for small businesses under a certain revenue threshold. This compliance option makes it easier for small entities to meet reporting requirements without adopting more complex accrual methods.
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.
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.
Cash Basis of Accounting FAQs
How does the cash basis of accounting differ from accrual accounting in measuring performance?
Cash-basis accounting measures performance based on cash received and paid during a period, so results can shift with payment timing. Accrual accounting records revenues when earned and expenses when incurred, providing a more complete measure of economic performance by matching related revenues and costs together.
How does cash-basis accounting treat accounts receivable and accounts payable?
Cash-basis accounting does not recognize accounts receivable or accounts payable when amounts are earned or incurred. Revenue is recorded only when cash is collected, and expenses are recorded only when cash is paid. Consequently, unpaid customer balances and unpaid vendor obligations do not appear as recognized operating amounts in the accounts.
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