What Is Accounting On A Cash Basis? (With Uses And Examples)
By Indeed Editorial Team
Published 8 September 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Cash basis accounting is a method where a business records income as it receives cash and registers expenses as it pays out cash. Small enterprises that primarily conduct business in cash prefer this method of accounting, as this system offers adequate information to monitor financial standing. Learning about this concept can help you determine if a business is documenting enough profit to keep its operations running well. In this article, we answer the question, 'What is accounting on a cash basis?', explain why a business may use this method, discuss its advantages and drawbacks and share some examples.
What Is Accounting On A Cash Basis?
The answer to 'What is accounting on a cash basis?' is that it is a method of calculating revenue based on the cash transactions a person or firm makes. For instance, if a company receives an electricity bill for January and pays it in February, it becomes a February expense. The cash basis system does not consider credit account transactions, which is why many small businesses and individuals prefer using this financial reporting method. This method may be popular among small business owners, but the generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) find it inadequate.
The cash method of accounting is one of the most straightforward methods of reporting finances. The Income-tax Act, 1961 allows non-corporate entities, such as individuals or trusts, to use this method. With this type of accounting, it is easy to determine when a transaction occurs, allowing businesses to simplify all their transactions. A company may access its bank account to analyse its transaction history, and this does not typically require the help of a specialised accounting professional.
Who Uses The Accounting On A Cash Basis System?
Proprietors and small business owners who prefer cash transactions generally use the cash basis accounting system. Some businesses may not use credit systems for their supply chain or sales. Such enterprises are more likely to utilise this accounting method to measure their financial standing. There are also many government agencies, non-governmental organisations and non-profit organisations that do not frequently conduct their operations on a line of credit, giving preference to cash-based accounting.
Why Does A Business Use The Cash Accounting Method?
Since the assessment of financial performance is easier with the cash accounting method, business owners who use this approach seldom hire accountants. This helps them to reduce their costs. The cash-based accounting method is often the preference for:
Companies that manage their operations with only a few transactions in a day
Companies that operate without an inventory monitoring system
Companies that have few employees
Companies that have single owners or simple partnerships
Companies that are not liable for publishing financial audits or issuing financial statements
Companies that have customers paying in cash or via debit cards
Companies that prefer single-entry over double-entry accounting systems
Examples Of Cash Basis Accounting
Below are some examples of accounting on a cash basis to help you better understand the method:
A furniture manufacturer supplies a batch of office furniture to a start-up that is equipping its new office. With their high cash flow, the start-up clears the manufacturer's due payment in cash in October. The manufacturer, a small business, enters this transaction in its accounts tally as October revenue by employing the accounting on a cash basis system. If this were a credit transaction where the manufacturer might receive the payment in November or December, it would not form part of the October revenue.
A plumbing company secures a contract for carrying out work for a small restaurant. According to the agreement, the plumbing company receives payments for the project only after completing the work. Since it is not immediately receiving funds from the restaurant, it invests its own money to complete the job.
According to the principles of cash basis accounting, this money becomes an expense for the current month's tally. Also, the payment that the plumbing company receives in the next month becomes that month's earnings. The accounts then show that the plumbing company is incurring losses in the month when it is spending the cash, even if it receives the payment in the next month.
A gardener secures a contract for landscaping the premises of a new office complex. The contractors promise to pay cash upfront for the procurement of equipment and raw materials, but they plan to disburse the full payment upon project completion. If the gardener uses cash basis accounting, they calculate the expenses and initial disbursements in the current month. If the project takes time to complete, the system only shows revenue after the project is finished, which may be in the next financial cycle.
Advantages Of Accounting On A Cash Basis
Below are some key advantages of accounting with the cash basis method:
It is less complicated
Accounting on a cash basis is a system of calculating finances by taking uncomplicated steps to record transactions. The method is easy to follow and helps small businesses analyse their financial history quickly, without extensive accounting and financial knowledge. They only monitor the cash they receive and pay to assess their cash flow efficiently.
It requires less investment
Elaborate accounting systems, like the accrual method, may require proficient accountants or consultants to assist business owners in monitoring their financial records. In the cash method, a business owner can manage their accounts on their own. This way, they reduce operational costs by making it unnecessary to hire accounting specialists. This is especially beneficial for small businesses that may not have a large cash flow.
It offers tax advantages
When a business owner manages their transactions on their own, it helps them to understand their finances better and make tax-related decisions that align with their business's requirements. This complete control over finances may give them the freedom to conduct cash transactions in a way that offers them maximum tax benefits. Using cash-based accounting, business owners may increase their expenditures and lower their earnings according to the tax cycle.
It gives an exact account tally
Cash-based accounting focuses on conducting business with the cash a company has in its account, helping the company to do business in the present. Since this type of financial reporting involves no credit system, future expenses and income are not part of the transactions. This offers transparency and helps business owners remain aware of how much earnings and expenditures they record.
Drawbacks Of Accounting On A Cash Basis
Below are some potential drawbacks of accounting using a cash basis method:
Less accurate accounts
Accounting on a cash basis may be a simple accounting method, but it may not be the most accurate process of recording financial transactions. This is primarily because it rarely represents all the expenses and revenue of a business. If a company uses cash-based accounting and expects a payment next month, it may not consider this payment as earnings until the time it appears on the record books. This accounting method shows such future transactions as current losses.
No record of expected payments
Since the cash-based accounting system may not always consider the payments that a business expects to receive in the future, it shows no records of accounts receivable. This may create a challenge for business owners and their clients. It may become complicated for small business owners to tally their payments if their business involves carrying out transactions later in a cycle.
No audit requirement
A business may find it challenging to comply with various audits and inspections, since there may not be a requirement to issue financial statements under the cash system. The cash system creates the potential for manipulation and deferred payments with cheques and late deposits, as there may be no immediate invoices of an expected payable amount. The current ledger may have no records of expected future payments, which may cause discrepancies in the accounting system.
Cash Basis Accounting Vs Accrual Accounting
Cash basis accounting is popular among small businesses, while large companies and chain outlets prefer to use accrual accounting. The latter helps companies to document their revenue at the exact time of earning, irrespective of when the money reaches the account. This means that whenever a business delivers its products or services to a client, the accrual method includes this as earnings, expecting the client to pay the money in the future.
Larger companies typically hire accounting specialists due to the complexity of accrual accounting, but small businesses can evaluate their transactions without any external assistance. The accrual accounting system also takes accounts payable and accounts receivable into consideration. This offers greater transactional precision.
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