Cash Accounting

What is cash accounting?

Cash accounting is a bookkeeping method that focuses on available funds. Businesses use this technique to record transactions when they make or receive a payment. In other words, these companies only recognize a transaction after receiving a sale or a payment to a vendor for products or services. Cash refers to bank balances, checks, bills, coins, and money orders.

Although cash basis accounting may only help manage finances for some businesses, accounting software can save time and other resources through efficient financial data management. 

Who uses cash accounting?

Since the cash method of accounting records revenue and expenses when the cash transfer is involved, it’s not feasible for large corporations, businesses that carry inventory, or organizations that provide services on credit.

Under the Generally Accepted Accounting Principles (GAAP), US companies and corporations with an annual average income of more than $25 million for three consecutive years are required to use an accrual basis of accounting. 

However, for self-employed people and small businesses, as long as the sales are less than the $25 million mark, either method of accounting can be used, depending on their bank requirements. For small businesses, the cash basis method is easy to maintain financial records without worrying about receivables or payables. It also gives them a clear idea of how much money they have for purchases. 

Example of cash accounting

Suppose  ABC company sells food ingredients. It bills a customer $2,000 for raw materials on May 10th and receives the payment on June 10th, per its 30-day credit policy.

According to the cash method of accounting, the company records the sale in the cash flow statement on June 10th, when the amount is received. 

When considering expenses, if ABC company raises a purchase request of $800 for an ingredient on April 22nd and pays the vendor on May 22nd, the company records the amount on May 22nd.

The income statement for ABC would look like this:

As seen in the above example, using the cash method, June appears to be a profitable month and May a loss-making one. However, upon deeper analysis, we can see that May is the month that has recorded sales without any expenses.

Advantages of cash accounting

Small businesses can find many advantages from using cash basis accounting.

• Reasonable learning curve: Bookkeeping is simple and straightforward with this method of accounting. Maintaining records can be done manually or using any accounting software, without the help of an outside professional.
• Up-to-date cash flow information: For small organizations, cash accounting is a great way to understand how much money the business has on hand. This short-term assessment provides a clear picture of the cash flow, and by studying it, the bookkeeping department can evaluate the use of resources.
• Tax purposes: Tax returns are only filed on cash received, allowing businesses to time their transactions to their advantage by slowing down or speeding up expenses.
• Easier record management: The cash method is a single-entry system that records each transaction as cash once, making tracking records simpler.

Disadvantages of cash accounting

While the lack of complexity is appealing, cash accounting also has disadvantages.

• Short-term accuracy: When considering long-term profitability, cash accounting records may be misleading. Since the cash method doesn’t consider invoiced amounts or future expenses, profit data can be inaccurate. For instance, a company registering fewer sales for a month while receiving outstanding payments shows that month as highly profitable, whereas the net income is less.
• Opportunities for data discrepancies: The cash method of accounting is vulnerable to simple human error and malicious human intent. It’s possible that dishonest employees could manipulate records by not cashing received checks, raising expenses, and hiding revenue.
• Restrictions: GAAP requires businesses to produce financial records using the accrual accounting method since it records sales when they occur. According to the IRS, corporations, businesses that maintain inventory, or businesses with an annual average income exceeding $25 million must also use accrual accounting.
• Loan: Some lenders may prefer accrual basis financial statements when providing a loan since it tells a more accurate story of a company’s financial health.

Cash vs. accrual accounting

Businesses must decide on an accounting system because it impacts tax calculations. The difference between cash accounting and accrual accounting is when revenue and expenses are recorded.

The cash method of accounting only records income and expenditures when cash changes hands. Cash inflow and outflow are recorded for financial transactions. Accounts receivable (cash receipts) and accounts payable are not a factor; they’re only added to an income statement when the bill is settled.

Additionally, inventory, partial payments, or uncollectible accounts aren’t monitored. In this instance, the only taxable income is money received upon selling a product or service. 

It suits small business owners, sole proprietors, freelancers, and independent contractors. 

The accrual method of accounting is more complex and time-consuming. It recognizes earned revenue and accrued expenses, regardless of any cash credited or debited. The financial statements record all receivables, payables, and inventory updates. Therefore, they provide a more accurate picture of a company’s financial health for long-term planning.

It’s a GAAP-compliant method that banks accept and investors require. With accrual basis accounting, even outstanding payments or accrued revenue are taxable. 

Large and small businesses can employ accrual basis accounting, and it’s mandatory for companies whose average annual revenues exceed $25 million.

Recording and managing cash flow is imperative for handling finances. Take a look at how cash management can help maintain financial stability.