CASH BASIS ACCOUNTING: Definition, Expense Recognition & Basic Principle 

cash basis
image credit; bench accounting

If you own a business, the term ”Cash basis accounting” might not be new to you. This is because you might be using this accounting method for your business or the accrual method. Whichever method of accounting you’re using both cash basis accounting vs accrual, you need to understand the details of it. Such details include its definition, an example of cash basis accounting, and examples of companies that use cash basis accounting. All the information above and more are the content you will find in this article.

Cash Basis Accounting 

The cash method of accounting is also known as the cash receipts and disbursements method of accounting. This method of accounting is typically rooted in cash accounting records and revenue. Meaning that, when you receive cash, as well as the expenses in cash, it is basically a cash basis.

You can also say that it refers to an accounting method that recognizes revenues and expenses at the time you receive cash or pay cash out. It is also the practice of recording revenue when your business receives cash and also recording expenses when you pay out in cash.

This method of accounting is commonly used by individuals and small businesses since it involves the easiest accounting process and is also suitable for people in inventory. Understanding this method further typically means that when your business records transactions, they are on a cash basis. This affects business accounting upon exchange of consideration. 

Understanding This Method

So, does this mean that cash basis accounting is less accurate than accrual accounting in the short term?. I will answer this question by reminding you that the Tax Reform Act of 1986 prohibits that cash basis accounting method from being put in use for C corporations. As well as, tax shelters, certain types of trusts, and partnerships that have C Corporation partners why? We will discuss these reasons further.

For instance, if an engineer secures a major contract but will only receive compensation upon completion of his project, using cash-basis accounting, the engineer will only be able to recognize the revenue upon project completion, which is when he/she receives cash. However, during the time of the project, he records the project’s expenses as they come in, even if the project’s time span is greater than one year. Then, the business income statements will appear to be wrong as they will show the business incurring big losses one year following great gains the next.

Some of the Advantages of the Cash Basis Method of Accounting

This method of accounting has two basic or major benefits and they include the following;

Ease of Use

To keep records with this method of accounting, you don’t require a high knowledge of accounting in general. There are also many accounting software packages that are currently available online for this method of accounting, as well to ensure their easy use.

Taxation

This method of accounting is often in use to record financial results, especially for tax purposes. Now, a business can increase a few payments in order to lower its taxable profits, thereby postponing its tax liability through the aid of this method. 

Cash Basis Accounting vs Accrual 

Firstly before we compare cash basis accounting vs accrual, let’s look at the two methods independently. A cash accounting basis is a method where receipts of payments are put on record during the period in which they receive them. While your business records expenses during the period in which they are paid.

The Accrual method of accounting is a method where you record revenue or expenses immediately after a transaction occurs not when you receive payment. Accrual accounting is disconnecting from when the money in question actually changes hands. Which emphasizes the effect of timing and also yields a more accurate picture of a company’s business activity.

Importantly, the striking difference between accrual vs cash basis accounting is mainly the time in which the business recognizes revenue and expenses. While the cash method recognizes the revenue and expenses immediately, the accrual method concerns anticipated revenue and expenses.  

Differences in Cash Basis vs Accrual Accounting

Having understood what these two methods of accounting means, you could tell what their differences are. However, these differences include;

Accrual Method

  • The Accrual method of accounting accounts for revenue and expenses when transactions happen. But, this is before the business receives or pays out the money.
  • This accounting gives a more perfect view of a business’s financial state because it includes accounts payable and accounts receivable.
  • Meanwhile, the accrual method of accounting is often in use by large companies, especially the publicly-traded ones. Typically because it smooths out their earnings over time.

Cash Basis Method

  • The Cash basis method of accounting accounts for revenue and expenses when the business pays or receives cash relating to those particular transactions.
  • This method of accounting is often in use by sole proprietors and small businesses because of their taxation.
  • GAAP  which is a renowned financial body likes the accrual accounting method simply because it records sales at the time they occur. This typically provides a clear glimpse into a business’s performance.

Example of Cash Basis Accounting 

This is an example of an accounting method based on cash basis accounting records and revenue when cash is received, as well as the expenses when they are paid in cash. This method of accounting is mostly in use by small businesses and sole proprietors. This is because it is easy to use as well as taxation friendly.

Now, we want to use examples to deepen your knowledge of this method of accounting. These examples typically reflect how small businesses operate using the cash basis method.

Some Examples of this Method of Accounting For Small Businesses

These examples typically include;

#1. When you buy bakery supplies, the company typically pays cash for these supplies. Under this method of accounting, the company then has a business expense and a reduction in its cash balance. This expense is in the picture because cash is typically involved.

#2. Other examples of how cash basis accounting would work with revenues, considering a sole proprietor that sells to other small businesses. And his customers pay their invoices in 40 days. The business would record revenues from sales when the payment actually arrives, 40 days or after the invoice is sent.

#3. Where expenses like payroll, are involved, a small business can record the expense of paying workers on payday. This means that these accounts are for recording payments to workers when paychecks are distributed, and not when the workers earned the pay. 

#4. This method of accounting perfectly views a lot of small corporations’ financial situations. For instance, coffee shops or eateries, are always suitable for cash accounting. This is typical because there’s little change in the timing of when they receive money and pay bills.

#5. Other major examples of cash basis accounting, involve most small businesses paying bills on time, within 30 days. They typically get paid when a customer comes in with cash or credit card, then receive the credit card payments in a couple of days. Now there isn’t a lot of change in how they manage the business either if they use cash or accrual.

Examples of Companies that use Cash Basis Accounting Definition 

Generally, with the above definition of cash basis accounting and its examples you would be able to know the and best suitable companies for this method of accounting. However, there are reasons which make these companies choose this method of accounting and they include. Easier to use, taxation, etc.

Big and public companies on the other hand have been mandated to use the accrual method of accounting to report its transaction. Meanwhile, the accrual method of accounting is the standard method of financial reporting for public companies.

Mostly, small businesses and sole proprietors use this method of accounting. Sole proprietors, most importantly, ones who don’t have inventory, are the best users of the cash method of accounting.

Understanding the Examples of Companies that use the Cash Basis Method of Accounting

Although many businesses use the accrual method of accounting, most individuals and small businesses use the cash method of accounting which is a simple accounting method perfected for small business owners. If you own a small business and want to use the cash-basis method for your records, in order to use this method. You typically have to record each transaction as money transacts into hands.

 Again, most small businesses and sole proprietors love to use cash accounting simply because it’s easier. And it also aids maintain and understand the records of the business. Although the accrual method of accounting doesn’t show an accurate depiction of cash flow, it mostly gives you a real idea of a long-term income and expenses.

Although the cash basis method is among the best examples for accounting for most small companies like restaurants, small firms, and sole proprietors. This method still has some disadvantages to it and they include;

  1. It fails to show the full picture. One major disadvantage of this method is that it gives your business a limited look, particularly in your income and expenses section.
  2. There are restrictions on the use of this method. Typically, not all businesses can use this type of accounting
  3. It’s usually difficult to switch over to another method of accounting 

Conclusion 

The definition of the cash basis accounting method is easy to use as well as understandable. The essential work you need to do is to know how to properly differentiate between the cash basis accounting vs the accrual method. Know the example of companies that use the cash basis accounting as well as the example of the cash basis accounting.

FAQs

What is the cash basis in accounting?

Cash basis refers to a major accounting method that recognizes revenues and expenses at the time cash is received or paid out. This contrasts with accrual accounting, which recognizes income at the time the revenue is earned and records expenses when liabilities are incurred regardless of when cash is received or paid.

How do you do cash basis accounting?

To use the cash-basis method, you record each transaction as money changes hands. When you pay a vendor, you record the expense. When a customer pays you, you record the revenue. Many sole proprietors and small partnerships prefer to use cash-basis accounting

Who uses cash basis accounting?

Company: Generally, small businesses and sole proprietors use cash basis accounting. Meanwhile, the accrual method of accounting is the standard method of financial reporting for public companies

What is the difference between cash basis and traditional accounting?

Cash basis records money when it actually comes in and goes out of your business, traditional accounting records income and expenses when you invoice your customers or receive a bill. Records you must keep under traditional accounting: all your sales and takings (income) all your purchases and expenses.

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