What Is Cash Basis Accounting?
Cash basis accounting is accounting that only reports business transactions with a cash component. Transactions are only recognized when they involve either a receipt of cash or payment of cash.
Cash basis accounting has the advantage of being simple and is most suitable for small businesses with just a few assets and liabilities.
However, a major flaw of cash basis accounting is that it measures revenues and expenses narrowly. For example, it takes no note of credit transactions. Nevertheless, cash basis accounting may be appropriate for some businesses. Read on to find out more about cash basis accounting, how it works, and its advantages and disadvantages.
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Cash Basis Accounting Definition
Cash basis accounting is a system of accounting that reports only transactions that involve increases or decreases of cash. Revenues are entered in the accounts only when customers pay, and expenses are recorded only when they are paid. Cash basis accounting differs from accrual accounting in how revenue and expenses are measured.
The main disadvantage of cash basis accounting is that revenues and expenses may not always be matched on the income statement. For example, the cash from sales may be received in one period, but the sales commissions connected with the sales could be paid in another period. Accrual accounting matches revenue to related expenses. As a result, accrual accounting provides a better picture of a company’s financial performance and position.
Cash Basis Advantages and Disadvantages
Advantages
- Cash basis accounting is simple.
- This method provides a ready-made “statement of cash flows.”
- The financial statements are easy to prepare.
- The net income is the same as the net cash flow from operating activities.
Disadvantages
- Not in accordance with the Generally Accepted Accounting Principles (GAAP).
- Revenues and expenses are not matched in the same period.
- Many balance sheet items are excluded.
Cash Basis Accounting vs. Accrual Basis Accounting
The main difference between cash basis accounting and accrual accounting is the timing difference in recognizing receipts and expenses.
Accrual accounting recognizes and records revenues in the accounting period they are earned, while cash basis accounting only does so when the cash is received. Similarly, accrual accounting recognizes expenses when they are incurred. But, they must be paid first before being recognized under cash basis accounting.
Another important difference is that accrual accounting is in accordance with GAAP, but cash basis accounting is not.
The example below shows the difference between cash basis and accrual accounting.
Jack Sprat LLC is a website designer. In August, the company did work for ecommerce retailer Toddlers Toys and billed $5,000. It received $2,500 in September and the balance in October. In September, it received an invoice for $1,500 from Acme Advertising, which it paid in October. The accounts for those transactions are shown below.
| August | Cash Basis | Accrual | |||
|---|---|---|---|---|---|
| Debit | Credit | Debit | Credit | ||
| Receivables | $0 | $5,000 | |||
| Sales | $0 | $5,000 | |||
| Design services for Toddlers Toys | |||||
| September | Debit | Credit | Debit | Credit | |
|---|---|---|---|---|---|
| Bank | $2,500 | $2,500 | |||
| Sales | $2,500 | ||||
| Receivables | $2,500 | ||||
| Cash received fromToddlers Toys | |||||
| Advertising Expenses | $1,500 | ||||
| Payables | $1,500 | ||||
| Services from Acme Advertising |
| September | Debit | Credit | Debit | Credit | |
|---|---|---|---|---|---|
| Bank | $2,500 | $2,500 | |||
| Sales | $2,500 | ||||
| Receivables | $2,500 | ||||
| Cash received fromToddlers Toys | |||||
| Advertising Expenses | $1,500 | ||||
| Payables | $1,500 | ||||
| Services from Acme Advertising |
When to Use Cash Basis Accounting
Cash basis accounting is okay when most or all business activities are cash transactions. If the business sells on credit or buys on credit, it won’t work so well because cash basis accounting omits what may be quite substantial assets (the accounts receivable) and liabilities (the accounts payable). It’s also not appropriate for businesses that carry large amounts of inventory for resale or raw materials.
However, inventory in smaller amounts can be treated as “non-incidental materials and supplies” and can be written off in the accounting period sold or used.
Constructive Receipt
Businesses using cash basis accounting must become familiar with the concept of constructive receipt. For tax purposes, you have constructive receipt of income when that income becomes available to you. This means that if a customer pays you in December, but the check is not picked up until January, you must still report that income as received in December.
Cash Basis Accounting Frequently Asked Questions
What does cash basis accounting mean?
Cash basis is a method of accounting that records transactions only when they involve cash.
Cash basis accounting measures revenues when cash is received from customers and expenses when the business pays for those expenses.
What is the difference between cash and accrual accounting?
With cash accounting, revenues and expenses are recorded when payment is received or made. In accrual accounting, revenues are recorded when they are earned, and expenses are recorded when costs are incurred.
What financial statements are used in cash basis accounting?
Cash basis accounting uses the same financial statements as accrual accounting: an income statement, a balance sheet, a statement of cash flows, and a retained earnings statement.
Is there a difference in balance sheets between cash and accrual accounting?
A cash basis balance sheet does not show many items that appear on an accrual accounting balance sheet. Items such as inventory, accounts receivable, accounts payable, prepaid expenses, and accrued expenses are omitted from a cash basis balance sheet.
Should small businesses use cash or accrual accounting?
Cash basis accounting may be suitable for a business if most of its transactions are in cash. However, if it carries large amounts of inventory or engages in a lot of credit transactions, the accrual method is more appropriate. The Tax Cuts and Jobs Act (TCJA) allows businesses with less than $25 million in gross receipts to use cash basis accounting.
