Accounting basics: What is cash accounting?

Using a cash-based accounting system in your business can have advantages as well as disadvantages. Which accounting system you use in your business depends on the circumstances in which your business operates.

There are two major approaches to managing a company's accounting system: cash basis accounting vs. accrual basis accounting. Which method your company uses depends upon your tax status as well as when you choose to recognize income and deduct expenses. There are some cases in which the IRS will prohibit a business from implementing cash-based accounting. However, if your business is not mandated to implement an accrual accounting system for tax purposes, then it is up to you as the business owner to decide which accounting system works best for your business needs.

What is cash accounting, also known as cash basis accounting?

Most small businesses and individuals run their daily operations and prepare their income taxes based on a cash accounting system. Cash accounting refers to the accounting method in which payment receipts are recorded during the period the payment is received. Cash accounting also refers to the period when expenses are recorded when they are paid. To put it in plain words, all revenue and expenses are recorded when the cash is received and paid.

You may also see cash-basis accounting, referred to as cash-basis accounting. This term is not to be confused with accrual accounting, which refers to the recognition of income at the moment it is earned and records expenses when liabilities are acquired, no matter when the cash is received or paid.

Who uses cash-basis accounting?

Cash basis accounting is generally the preferred method of accounting for small businesses and self-employed individuals because of its simplicity in recording transactions.

The IRS permits cash-basis accounting methods under many circumstances, but there is a list of businesses that cannot use cash accounting. Generally speaking, companies that must manage an inventory of products will generally use the accrual accounting system.

What is cash accounting vs. accrual accounting?

Cash accounting refers to only one form of accounting. Another form of accounting is called accrual accounting. This is where revenue and expenses are recorded at the time they happen. It is common for small businesses to use cash accounting instead of the accrual method of accounting. However, corporations are required to implement an accrual accounting system.

Once transactions are recorded in a cash-basis accounting system, they often do not show up in the company's accounting system. It is for this reason that cash accounting systems are less accurate than accrual accounting systems in the short term.

A small business is able to choose using a cash-basis accounting system or an accrual accounting system to record income. According to the IRS, a small business is defined as having less than $10 million in assets.

What is an example of a cash accounting system?

It may be difficult to imagine how a cash accounting system works. Here is an example to help you understand cash accounting in action.

Let's say that Luxe Bakery received $2,000 for the sale of two wedding cakes to one happy couple. The bakery recorded the sale as having occurred on May 2, even though the couple actually placed the order for the cakes on April 1. Why? Luxe Bakery did not receive the payment for the cakes until they were physically delivered on May 2. This is how a cash accounting system works on a day-to-day basis.

If this same scenario were to happen under an accrual accounting system. The Luxe Bakery would have recorded the $2,000 sale on April 1, even though there was no exchange of funds yet.

It's also important to note that a company records expenses when they are paid, not when they incur them under a cash accounting system. Let's say that a company hires a carpet cleaning service on Oct. 15, but the company does not pay the invoice for the carpet cleaning services until Nov. 15. In this instance, the transaction would be recognized on Nov. 15 in a cash accounting system. However, the expense would be recorded in the company ledger on Oct. 15 if the transaction were initiated in an accrual accounting system.

What are the benefits and disadvantages of a cash-basis accounting system?

If you are a small business owner, then you will find that all accounting methods have both advantages and disadvantages. Simply put, there is not one method that is guaranteed to work over another for your business. It's important that you, as a business owner, take the time to understand the benefits and disadvantages of both systems.

Easy to understand

The cash-based accounting system tends to be the most simple to understand option over the accrual accounting system. The system for recordkeeping is straightforward and easy to implement. If you use the cash system, you may choose not to utilize the services of a professional accountant.

Cash flow is easy to see and predict

The cash accounting method is similar to a cash flow statement. Recording when your business receives funds or when you pay bills in a cash accounting system offers an accurate depiction of how much cash is in your bank account. If your business happens to experience an influx of cash during any time of the year (i.e., end-of-year holiday sales), the cash method can help you plan your strategy for growing your business.

Use of a single-entry system

The cash-basis accounting system can be done with a single entry system, getting rid of the necessity to use a more complicated accounting program. Month-end bank reconciliations tend to be easier with cash-based accounting.

Lack of long-term view of business sales

While implementing a cash-based accounting business does give an accurate depiction of a business' cash flow, it may be misleading when it comes to long-term profitability. A major complication of using a cash accounting system is that it may not offer an accurate picture or depiction of the liabilities that have been incurred but not paid for. As a result, the books make the business seem to have more cash than what is actually there. On the other side of the coin, a company that has recently completed a large job and is waiting for payment will look less successful than it is due to the amount of expenses that were incurred, such as materials and labor. This can also happen if your company pays an annual bill like a health insurance premium at one time. This can make profits look low for the month when, in reality, the employees will have insurance paid for the entire year. A cash accounting system can either inflate or understate the success of a business if payments have happened early or have not occurred yet.

Choose the accounting system that is best for your business

If your business is quite small, then recording your income on a cash basis may prove to be the easiest way to keep track of your cash flow. However, it must a cash accounting system can also limit your business from making predictions that can help your company grow. It is possible to decide to start off with a cash accounting system and then make a transition to an accrual method of accounting as the company grows. No matter which method you choose, it is important to list out your pros and cons for each method before making any decision.