What Is Cash Basis Accounting? The Pros and Cons of This Method
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Last Updated: 09/06/2022
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Cash basis accounting has both advantages and disadvantages. The business's facts and circumstances will determine whether the cash basis method is appropriate for its situation.
In the realm of accounting, there are two principal methods of managing your financials: cash basis accounting and accrual basis accounting. For tax purposes, the accounting method that you use is crucial because it determines when you recognize income and deduct expenses. In some cases, as discussed below, the IRS will prohibit a business from using the cash method. However, if your business is not mandated to use the accrual method, you can decide which method of accounting to use.
What Is Cash Basis Accounting?
Under the cash method of accounting, transactions are recorded when cash is received or paid. In other words, revenue is recorded when cash payment is received for the sale of products or services, and expenses are recorded when cash is paid to vendors for purchases of products or services. Most small businesses and individuals operate on a cash basis and prepare their income taxes using this method.
How Do You Record Business Transactions Using Cash Basis Accounting?
Businesses often choose to use the cash basis accounting method to avoid the need for more complex recordkeeping. With cash basis accounting, a transaction is recorded when payment is given or received. When you pay an invoice, you will record this amount in your accounting records, no matter if the work was done last week or last month. When a customer pays you, the revenues are recorded when the payment is received, even if time has passed since you provided a product or service.
Who Uses Cash Basis Accounting?
Cash basis accounting is often used by small businesses and self-employed individuals that prefer a more straightforward method of recording transactions. The IRS allows the cash method of accounting under many circumstances, but there is a list of excluded entities, or types of businesses that may not use the cash basis. Companies that keep inventories of their products on hand will generally need to use the accrual method. Larger corporations must use the accrual method unless they meet the IRS' Gross Receipts Test, with average gross receipts of $26 million or less over the past three tax years (indexed for inflation).
What Is an Example of Cash Basis Accounting?
As an example, if you're the owner of a landscaping company and your crew finishes up a big job in May, but you don't get paid until July, you would record the income in your July books. The only exception to this rule is when expenses are paid with a credit card. In this case, the expense is considered paid on the date it's charged to the card.
What Is Accrual Accounting?
Under the accrual method of accounting, rather than recording revenues and expenses when cash changes hands, revenues are recorded when earned and expenses are recorded when incurred. The IRS requires businesses that hold merchandise in inventory to use the accrual method.
An exception to this rule are those businesses that meet the definition of a "small business taxpayer" with an average annual gross receipts figure over the last three years of $26 million or less; these businesses are not required to use the accrual method.
What Is the Difference Between Cash Basis and Accrual Basis?
The main difference between the cash basis and accrual basis of accounting is the timing of when expenses and income are recorded in your financial statements. With the cash basis, you record transactions when the payment is exchanged. Accrual basis accounting records income as it's earned and expenses when they are incurred. For example, if you pay for a business insurance policy in one lump sum at the beginning of the year, you would record this entire transaction on the cash basis when it's paid. Using the accrual basis, you would record a portion of the cost each month over the entire year.
Pros and Cons of Cash Basis Accounting
All accounting methods have advantages and disadvantages, and there isn't one method that will work well for every business. As a small business owner, it's important to understand the benefits and disadvantages of cash basis accounting to decide if it's right for your small business.
Advantages of Cash Basis Accounting
Easy To Understand
Cash basis accounting tends to be simpler to understand than other accounting methods. Recordkeeping is straightforward, as income and expenses are recorded upon receipt, without the need to break out amounts over longer time periods. If you choose to implement the cash method for your small business, it may not be necessary to seek the help of a professional accountant.
Shows Cash Flow
The cash accounting method most resembles a cash flow statement. When it comes to receiving payments and paying bills, recording transactions using the cash basis accounting method can provide an accurate picture of how much cash your business actually has on hand. If your small business experiences cash fluctuations throughout the year due to seasonal sales, the cash method of accounting may be beneficial to help you allocate your resources.
The cash method can be done with a simple single-entry system, so a complex accounting program is not always necessary. Month-end bank reconciliations should be easier when you are not booking accruals. However, single entry systems also have drawbacks, which are outlined below.
Disadvantages of Cash Basis Accounting
While the simplicity of the single-entry system needed for the cash method can be an advantage, it also has some disadvantages. The accrual method necessitates the use of a double-entry system, which is based on accounting equations. Such time-honored accounting principles are intended to provide a standardized, more accurate picture of profit and loss that can be used as a basis for business analysis. Also, utilizing the accrual method can provide far greater control of transaction posting, and can reduce the chance of errors.
While cash basis accounting does indicate the health of the cash flow of a business, it may offer a misleading picture of longer-term profitability. This is because the cash method doesn't show income that has been invoiced but not received. Furthermore, it doesn't take future expenses into account, which can be misleading. For example, your books might show one month as being extremely profitable. However, deeper insight may reveal that sales were actually slow, but a number of customers paid their outstanding bills. Paying an annual bill such as an insurance premium in one lump sum could also throw off your profit for one month, although the policy will be in effect for an entire year.
According to the IRS, your choice of accounting method should properly reflect the income and expenses you report for tax purposes. You cannot use the cash method if your business maintains inventory, is a corporation, or has gross receipts in excess of $26 million per year. These are the general rules, but there are exceptions — so if you feel that your business falls into one of these categories, you should consult a professional.
Set Up the Right Accounting Software for Your Business
While cash basis accounting may be more simplistic, it may also limit you from making more predictive decisions for your business. As your company grows, you may need to consider converting from cash to the accrual method. Before you make any changes, measure out the pros and cons for each method with your particular business in mind. Remember that online accounting software can be helpful in setting up the accounting method of your choice.