Cash Basis Accounting – Meaning, Examples & Benefits

Introduction

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.

What is Cash Basis Accounting?

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.

Who uses Cash Basis Accounting?

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.

Examples of Cash Basis Accounting

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

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

Financial Statements in Cash Based Accounting

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:

Income statement

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.

Balance sheet

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.

Cash flow statement

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.

Benefits of Cash Method of Accounting

Cash basis method of accounting can be advantageous for small businesses for a number of reasons.

1. It’s simple and straightforward: The cash basis accounting method is easy-to-understand and doesn’t require complex accounting software. The method could especially benefit small business owners who don’t have much inventory and the volume of transactions are easily manageable.
2. Requires less staff: Cash basis accounting does not require businesses to hire an accounting team or even a full-time accountant for that matter. Business owners could use simple accounting software and easily keep track of their cash inflow and outflow.
3. Provides an accurate picture of cash in hand: It’s easy to track cash on hand with the cash basis method of accounting. It shows a company’s current financial position accurately based on the cash inflow and outflow at any given time.
4. Income tax is paid on the money you have received: Unlike the accrual method of accounting, you only have to pay taxes on the money that you have already received from customers under cash basis accounting.

Disadvantages of Cash Basis Accounting

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:

1. GAAP unapproved: Cash basis accounting is not GAAP or IFRS approved; therefore, public companies cannot use this method of accounting. It’s only suited for small business owners.
2. Short-term cash flow indicator: Since the cash basis method does not consider factors such as inventory that a business owns, collection time of invoices and accrued expenses, it does not paint an accurate picture of a company’s financial position. This is especially true if a company owes a lot of debt, as those transactions are not reported on financial statements.
3. Misleading for stakeholders: The cash basis method does not accurately represent a company’s financial position because accounts like accounts payables are not reported on the balance sheet. This could potentially show a company is more profitable than it actually is if it has unpaid bills.

Accrual Method Vs Cash Basis Accounting

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:

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FAQs

Q1. What does the cash method of accounting mean?

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.

Q2. How do you record cash basis accounting?

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.

Q3. Why should you use cash basis accounting?

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.

Q4. Is cash basis accounting GAAP compliant?

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.

Q5. Who cannot use cash-based accounting?

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.

Q6. Can you record inventory assets with cash basis accounting?

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.

Q7. Can you audit a business that uses cash basis accounting?

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.

Q8. Can small businesses use cash basis accounting?

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.

Q9. How does this cash method of accounting work?

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.