What is the Cash Basis of Accounting?
One of the simplest forms of accounting is called cash-basis accounting. In this method, you record income when it is physically received and expenses when you physically pay them. A business only uses cash accounts, which means nothing is recorded in accounts payable, accounts receivable, or any long-term liability accounts. Single-entry bookkeeping is how you record these transactions.
Who Uses the Cash Basis of Accounting?
Unlike the accrual basis of accounting, the cash method is not part of the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS). It is only used by public companies that meet a sales test. In this case, the cash method of accounting is mostly for tax purposes. This includes partnerships, sole proprietors, S corporations, and regular companies.
How is Cash-basis Accounting Calculated?
Cash-basis differs greatly from accrual basis accounting in that you cannot record any expense you have been billed for until it is paid. In this accounting system, you subtract your total cash-basis expenses from your cash-basis income. The result is a net income and a balance sheet based on your actual cash flow and not obligations to pay or be paid.
When a business uses the cash method, they may not write off inventory items as soon as they’re paid. To paint a more accurate picture, they may use a method of accounting for inventories that will either treat them as non-incidental supplies and materials or follows the way their financial statements treat inventory.
Pros and Cons of a Cash Basis System
Much like the accrual method of accounting, the cash-basis system has advantages and disadvantages.
For a small business owner, cash-basis accounting has a number of pros over the accrual or modified cash basis methods.
Ease of Use
Since cash-basis is so simple, it’s easy to learn, implement, and maintain for business owners. Recording cash transactions like this is also more cost-efficient. This form of financial accounting takes less time, labor, and resources.
The learning curve for cash-basis accounting is much lower than the accrual method. There are fewer bank accounts to monitor and much less information to track during an accounting period. A business doesn’t have to plan as much or go into specifics with cash accounting. What you see is what you get. It’s very cut and dry.
Exists in the Now
Cash-basis accounting allows a business to actually see how much cash they have on hand. You are only dealing with concrete funds that go in and out. There is no need to factor in future expenses or income into your books until cash actually exchanges hands.
Many companies use the cash-basis method for income tax. Some businesses may benefit because you only record income and expenses when cash is exchanged, which means you control the timing of transactions. By doing this, you can speed up expenses and slow down revenue. This allows you to legally decrease income to lower your tax liability.
Despite the various benefits, there are a few cons to using the cash-basis method of accounting. Consider some of these disadvantages before making a decision:
With the cash-basis method of accounting, a business has a limited look at its income and expenses. It does not show your liabilities which makes it hard to determine a company’s profitability. You may think you have more money than you do.
Likewise, the cash method does not demonstrate your customer’s liabilities to the business or any debts owed. This can result in forgetting about unpaid debts and losing track of valuable assets.
Since cash-basis is just a snapshot of your business’ finances, you may not have a clear picture of what’s ahead for the long-term. This could impact a variety of things like decision making, new hires, and company growth.
Not all businesses are allowed to use the cash-based method of accounting. You cannot use it if:
- You sell any products or services on credit
- Need inventory to account for income
- Have gross receipts that are higher than the IRS requirements
When you offer credit to customers, a business must use the accrual method of accounting. That’s because the very definition of credit is that you don’t pay right away. In this case, you must record transactions when they take place. This helps to keep track of who has what credit.
The IRS also has restrictions set on what types of businesses can use the cash-basis method. If you own a C corporation or partnership with average annual gross receipts for the past three tax years that exceeds $25 million, you must use accrual accounting.
According to the IRS standards, you cannot use cash accounting if you purchase, produce, or sell merchandise and rely on inventory as a form of income. However, there is always an exception. If you are a small business taxpayer, you can choose to not keep inventory if your annual gross receipts are less than $25 million in three years.
Hard to Switch
As a company grows, you may decide to switch accounting methods. To change from cash-basis to accrual accounting, adjustments must be made. It’s not easy to simply decide one day you are going to change the way you account for everything in the business.
When transitioning to accrual accounting, you must remember to:
- Add all accrued and prepaid expenses
- Add your accounts receivable
- Subtract all cash receipts, cash payments, and customer prepayments
In addition, you must formally request a change with the IRS and file Form 3115 which is the “Application for Change in Accounting Method.”
Cash Basis Accounting vs. Accrual Accounting
In accrual accounting, revenue and expenses are recognized and recorded when they happen, while cash-basis accounting only documents the line items when cash is received or paid out. It’s a snapshot of your business transactions and only focuses on payments that have actually happened. Accrual accounting takes a more in-depth look and focuses on obligations.
A cash-basis accountant debits the expense and credits cash in the period when a bill is paid. An accrual-basis accountant debits a prepaid expense asset account in the current period and credits cash.
Generally Accepted Accounting Principles
As mentioned before, cash-based accounting is not part of the generally accepted accounting principles (GAAP) and can deeply skew your financial statements. The accrual method is part of GAAP and is the popular choice when it comes to business accounting. It’s the most commonly used method by publicly traded companies and leads to more accurate financial reporting.
The accrual method smooths out earnings over time. It accounts for all expenses and revenues as they are generated rather than being recorded intermittently under the cash-basis method.
For example, under cash-based accounting, a retailer will look extremely profitable in Q4 as people buy for the holiday season. On the flip side, the following Q1 (and tax year) will look unprofitable as consumer spending declines after the holiday rush. The end of the year is what truly bolsters annual sales.
Although the key to a cash method is the ease of use (it only accounts for cash paid or received), this strategy might overstate the financial health of a company. Especially if they are cash-rich but have a large volume of accounts payable.
If AP far exceeds the cash on the books and your current revenue stream, this could mean trouble. At any given time, an investor might believe a company is making a profit when they are actually hemorrhaging money.
The accrual method includes the data from accounts payable and accounts receivable. As a result, it forms a more accurate picture of the long-term profitability of a business. The reason for this is because the accrual method accounts for all revenues when they are earned, and all expenses when they are incurred.
For example, a company might have ongoing sales in the current quarter that would only be recorded under the accrual method. If you were using a cash system, an investor might not conclude the business is profitable during this time period.
That’s because revenue isn’t expected until the following quarter. The company is doing well but they have nothing to show for it when using the cash-based method. Only the accrual method will demonstrate profit to investors.
The accrual method doesn’t track cash flow. As a result, it might not account for a company that has a serious cash shortage in the short term, even if they look good in the long run.
Accrual accounting is also more difficult to track. Especially when you are dealing with prepaid expenses and unearned revenue. However, CPAs choose this method to better determine taxable income for your tax returns.
Both types of accounting have advantages and disadvantages, and each only show a part of the financial health of a business. When making critical investment decisions, it’s important to fully understand how both strategies work.
Accrual Accounting vs. Cash Basis Accounting Example
Let’s say you own a company that sells medical equipment. If you sell $4,000 worth of hardware, under the cash method, that amount is not accounted for until the customer comes with cash in hand or a payment is made.
Under the accrual method, the $4,000 of revenue is immediately recorded, even if the money is received weeks later.
The same applies to expenses. If you receive a water bill for $200, under the cash method, nothing is added to the books until the bill is paid. Under the accrual method, the expense is recorded the day the bill is received, not the day it is paid.
Which is the Best Method?
This depends on several factors. Cash basis accounting is easier but accrual accounting is more accurate. That’s because it involves all aspects of your finance department, including accounts payable and accounts receivable. The accrual method is the most common but that doesn’t mean it’s the best fit for your business.
A Universal View
For accounting purposes, the most successful strategy, regardless of the industry, is the accrual method. Cash-based accounting can truly distort the bigger picture and incorrectly reflect income. This has a serious effect on who invests in your business. For startups, this is a crucial move.
In cash-based accounting, income is only recognized when money is received and an expense when money is paid. Accrual recognizes income when goods are shipped or services rendered. An expense is recognized when a business is obligated to pay it (i.e. receives an invoice).
Accuracy and Transparency
If in a given period you collect very little receivables, but pay a lot of bills, under cash accounting, you have expense without any income. In this case, it will appear as if the business has lost money.
On the other hand, if you don’t pay any bills but collect a lot of receivables, you have a lot of income on record. This is a major distortion of what has actually occurred. In accrual-based accounting, it doesn’t matter how many bills you’ve collected or paid.
Income (whether it is received or not) is always matched to an expense (whether it is paid or not). This results in a proper match of revenue. The expense is generated to produce the inflow of cash.
In business, it is possible to use one method for accounting and the other for tax purposes. But, as everyone knows, tax issues can get complicated. For best results, always use the accrual method for serious accounting and cash-based for smaller operations.
Modified Cash Basis Accounting
Modern accounting calls for a hybrid of both systems. Modified cash-basis accounting has more accounts because it uses the same ones as accrual. However, income and expenses are only recorded when money changes hands. This technique employs double-entry bookkeeping and is a preferred method for most financial transactions.
Overall, the accounting system you choose should fit your business model and make it easier when the IRS comes knocking. Whether that is a cash-basis or accrual method of accounting, as long as you know who owes you and what you owe, you’re on the right track.