How businesses report their financial performance to stakeholders is an important factor in accounting and overall financial management. Businesses can either use the cash basis accounting method or the accrual method. The decision is based on a lot of factors, however, it majorly depends on the size of the business.
Cash basis accounting is a good route for businesses that are new and small, as it is easy to follow and does not require a lot of resources.
In this blog, we are going to understand what cash basis accounting is, its pros and cons, and how financial statements are prepared under this accounting method.
Cash basis accounting is the accounting method that recognizes transactions when actual cash is received or paid out. This means that under the cash basis accounting method, a journal entry for a transaction will only be recorded when there is an exchange of actual cash with vendors or customers.
The cash basis of accounting contrasts with the accrual accounting method, where a transaction is recorded as and when the income is earned and expense is incurred, and it does not depend upon whether actual transaction has taken place.
Cash basis accounting is an easy and straight-forward method and is therefore used by self-employed individuals and small businesses who are cash rich.
However, accounting standards such as the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) consider the accrual accounting method as more accurate. Due to this, publicly traded companies don’t use the cash basis accounting method.
Now that we know what cash basis accounting is, let’s consider a couple of examples to understand the accounting method better.
If a business provides a service to a client on credit, it won’t record the journal entry on the date when the service was rendered. Instead, they will document the transaction in their books when the client actually pays for the service. The date on the journal entry will be when the client has paid for the service.
Let’s look at the journal entry for this scenario.
Date of service provided: 1st January, 2024
Date when the service was paid for by the client: 27th February, 2024
Date |
Accounts |
Debit |
Credit |
27/02/2024 |
Cash |
$12000 |
|
Service revenue |
$12000 |
||
Received cash for services provided |
Similarly, if the company pays for their rent earlier than the due date, the journal entry will be recorded on the date when the rent is paid and not when the rent is due.
Date of rent due: 30th January, 2024
Date when the rent was paid: 15th January, 2024
Date |
Accounts |
Debit |
Credit |
15/01/2024 |
Rent expense |
$1000 |
|
Cash |
$1000 |
||
Paid 12 month’ rent for office space |
Just as is the case with journal entries, financial statements report transactions when money is exchanged in cash basis accounting. Here’s an overview of how financial statements present the financial position of a company under the cash basis of accounting:
According to cash basis accounting, the income statement shows only the revenue that is received from the sales of goods and services and the expenses that are paid for operations. The net income is calculated as the difference between the total revenue and the total expenses.
The balance sheet, in case of cash basis accounting, shows assets, which is typically the cash account, liabilities that have been already paid for with cash, and the owner’s equity or their retained earnings as per the cash transactions.
Assets such as accounts receivable or liabilities such as accounts payables are not represented on the balance sheet under the cash basis of accounting as cash hasn’t been received or paid for these accounts.
As per the cash basis accounting method, the cash flow statement shows the sources of cash received or paid for operating, financing, and investing activities.
Cash basis method of accounting can be advantageous for small businesses for a number of reasons.
While cash basis accounting is a good system for some situations, in the long run it’s better for businesses to opt for the accrual method. Here are the key reasons why:
In the finance and accounting industry, accrual and cash basis accounting are the two major accounting methods used. Both of these methods contrast starkly when it comes to how they present a company’s financial position.
Let’s look at some of the key differences between the accrual method and cash basis accounting:
Criteria |
Cash basis accounting |
Accrual accounting |
Definition |
Cash basis accounting records transactions when actual cash is exchanged. |
Under the accrual method, transactions are recorded when revenue is earned or expenses are incurred, regardless of when cash is received or paid. |
Accuracy of financial position |
Doesn’t always represent how well a company is actually doing financially and could be misleading. |
Provides an accurate picture of a company’s financial position. |
Complexity |
Simpler and more straightforward. |
More complex as it reports active tracking of AR and AP. |
Users |
Used by small businesses and self-employed individuals. |
Used by public companies who have to adhere to GAAP and IFRS. |
Tax implications |
Taxes are paid on the money that is actually received. |
Taxes are paid on all the revenue earned, including the cash that the company has not yet received. |
Financial reporting |
Financial statements only report on cash transactions. |
Financial statements reflect the accurate financial health due to the inclusion of AR and AP accounts. |
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The cash method of accounting is a recognized accounting method where revenue and expenses are reported only for the transactions where actual cash is exchanged. This is a simple and straightforward accounting method as compared to the accrual method, which is much more complex.
While recording transactions under the cash basis accounting method, businesses need to account for cash receipts and disbursements as such transactions occur. It does not account for accounts receivable and accounts payable, as the transactions are recorded when money is exchanged.
Cash basis accounting is much simpler than the accrual method of accounting and is therefore suitable for small businesses and self-employed individuals. It does not require you to have a separate accounting team or even an accountant. Businesses could simply use accounting software and track their cash inflow and outflow.
No, cash basis accounting is not GAAP compliant and therefore can only be used by businesses that do not require to adhere to the GAAP accounting standards. This accounting method does not take into account AR and AP accounts and hence does not portray a company’s accurate financial position.
Cash-based accounting cannot be used by large enterprises and publicly traded companies as it is not GAAP compliant. Public companies need to accurately record transactions and report on their AR and AP accounts so as not to mislead stakeholders. This is not the case with cash-based accounting, which only records transactions when cash is exchanged.
No, inventory assets cannot be recorded under the cash basis accounting method as it only recognizes transactions when cash is exchanged. This accounting method does not take into consideration the time it takes for inventory to get purchased, sold, and produced.
Yes, businesses using the cash basis accounting method can be audited. However, the auditor will look for different things when auditing a business using the cash basis method than when a business uses accrual accounting. They will focus on evaluating the completeness of cash receipts and check if revenue is recorded when cash was received.
Yes, small businesses that do not need to adhere to GAAP accounting standards can use the cash basis method of accounting. In cases where a small business does not own inventory, cash basis accounting is a good choice as it is simple and owners could just use an accounting software to track their cash flow.
The cash method of accounting records journal entries when actual cash is exchanged. For example, if a company provides services to a customer on 1st January, 2024, but the client pays on 15th January, 2024, the accounting books will record the latter date i.e. 15th January, 2024.
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