Financial Literacy

What is Cash Basis Accounting?

While every public company uses accrual basis accounting in its financial reporting, it’s not the only bookkeeping standard out there. Cash basis accounting also has practical applications in business. Cash basis accounting is a method where income and expenses are recorded only with the payment of cash to or from the business. Though not the best method for accurate records, it’s a simple practice suitable for small businesses with mainly cash transactions.

Cash basis accounting provides a neat and tidy real-time picture of a business’ cash-on-hand. There are no accounts payable or receivable to worry about, and the books only reflect balances as they stand currently. Here’s a look at cash basis accounting: its pros, cons and useful applications. 

Cash basis accounting is good for small businesses

Cash Basis vs. Accrual Basis

Cash basis accounting involves ledger entries at the time cash changes hands. This is in contrast to accrual basis accounting, which records entries at the origination of transactions. As a result, there’s no need for accounts payable or receivable when following a cash basis. This effectively simplifies books and bookkeeping. Unfortunately, it does so at the expense of accounting accuracy. Cash basis accounting is best-used for simple point-of-sale transactions. For example:

Suzie operates a lemonade stand and charges $1 for a cup of lemonade. Patrons pay her upfront and she gives them a cup of lemonade upon receipt of payment. Suzie can look at the money in her till at any time to figure out how many cups of lemonade she’s sold and for an accurate accounting of how much money she’s made. 

The problem with cash basis accounting is that many businesses don’t have the luxury of point-of-sale transactions. They rely on exchange of goods or services on credit, while incurring expenses upfront. For example:

ABC Construction is building a new home for Jim. Jim pays 20% of the cost upfront and ABC Construction uses that down payment to acquire materials. The build takes eight months and during that time, ABC Construction needs to pay its workers. When construction is complete, Jim pays the remaining 80%.

In this situation, accrual basis accounting journals all transactions accordingly. Cash flow is constantly in flux, and accrual basis accounting shows this. Cash basis, on the other hand, would show spikes in income at the start and end of the project, and steady expenses for its duration. The balance sheet would look irregular and inconsistent on a cash basis. 

Cash Basis Key Takeaways

  • Businesses record revenues and expenses when cash changes hands.
  • No accounts receivable or payable.
  • Cash received and cash disbursements dictate net income.
  • Violates GAAP matching principle.
  • Best-suited for small service-based businesses and non-profit organizations.

Accrual Basis Key Takeaways

  • Businesses record revenues and expenses at the point of origination.
  • Includes accounts receivable and payables.
  • Revenues earned and expenses incurred in the accounting period account for net income.
  • Compliant with and required by GAAP.
  • Used by public companies and large organizations.

The Benefits of Cash Basis Accounting

The chief benefit of cash basis accounting is that it’s much simpler for small businesses. From a logical standpoint, it makes sense to only record expenses and income when they’re received. And, for small businesses with simple point-of-sale transactions, there’s really not much of a need for accrual—especially if there’s no inventory to worry about. 

Cash basis accounting is also useful for understanding cash on-hand. Because all transactions hit the ledger when money changes hands, bank balances are all accurate to the moment. Because accrual basis accounting takes accounts payable and receivable into account, ledger balance and account balance can differ. Again, cash basis offers a simplified mode of accounting in this case. 

The Drawbacks of Cash Basis Accounting

Though it paints a real picture of current account balances, cash basis accounting does a dismal job of showing financial health. Cash flow becomes tremendously skewed due to the erratic timing of payments and revenue. Business owners trying to get an accurate picture of sales or cash flow will have a difficult time nailing down trends. 

Cash basis accounting is also oversimplified for companies with inventory or contract-based revenues. The more complex a company’s operations become, the more varied the cash flows. Inventory as an asset and future revenues are important considerations for company valuation—both of which aren’t accounted for under a cash basis. 

The Choice Between Cash and Accrual

Small businesses have the option to choose cash or accrual basis when representing their finances to the IRS. Preference falls to the business operator, and many small businesses choose cash basis because it’s simpler. However, once the business reaches $25 million in average annual gross receipts from sales for the three preceding tax years, the IRS requires a shift to accrual basis accounting. It’s in the interest of most growing businesses to make the shift before required. 

The SEC and IRS require all public companies to adopt accrual basis accounting. Moreover, public companies need to adhere to Generally Accepted Accounting Principles (GAAP) whenever possible, which means following accrual standards. Cash basis accounting doesn’t follow double-entry accounting standards, which nullifies it under GAAP.

Accounting Standard Matters

The accounting standard a business chooses can weigh heavily on how it understands its own finances. Cash basis is often good for a real-time look at available funds and to understand the company right now, as a snapshot. That said, it tends to fall short when delivering reliable insights about trends and cash flow. Small businesses need to be aware of the pros and cons of cash basis accounting, and decide whether it’s right for them based on their operations. But, did you know that you can invest in small businesses in the market? Sign up for the Profit Trends e-letter below to learn more. Profit Trends provides daily stock insights and trends that may enhance your portfolio!


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