Cash-basis accounting uses a single-entry system that records revenues and expenses only when cash is paid or received.
For bookkeeping and recording purposes, business owners can use cash basis or accrual basis of accounting.The cash-basis accounting method records the revenues and expenses only when the cash is actually exchanged. Small businesses or individuals usually use it as it is a simple and easy way. In contrast, accrual basis accounting tracks the actions taken by businesses that result in earnings or expenses regardless of when the cash is paid or received.
Who uses the Cash Basis of Accounting?
Let’s have a closer look to understand who can use the cash accounting methods:
- The cash method is an easy way of accounting for small business owners or individuals as it requires minimal accounting knowledge. It empowers small business owners with the capability to manage the company’s revenue or expenses effectively.
- If the company’s annual gross is less than $25 million, the IRS will allow individuals or small businesses to follow the cash accounting method for smooth cash management.
- Companies using a single-entry system rather than a double-entry system can use a cash accounting system.
- The cash method is more useful for businesses that operate without inventories and are more service-based.
Cash Method for Income Tax
Cash accounting methods can be beneficial for small businesses or individuals while paying tax for two reasons. First, cash accounting allows businesses to easily answer questions regarding financial losses, expenses, or annual revenue while paying tax. Second, cash accounting helps businesses that have a major focus on inward cash flow that makes it easier for them to record the dates of the cash received, which makes paying taxes easier.
For instance, the IRS allows S corp or small businesses in the U.S. to use the cash method while paying taxes, but the Tax Reform Act of 1986 restricts C corporations and certain partnerships from using the cash method. Cash accounting can lead to misleading financial statements during periods of fluctuating cash flows, potentially affecting business decisions and financing options.
Significance of Cash Basis of Accounting
The cash accounting method helps in the operation of businesses by showing the cash provided or used in a company’s operating activities. It helps to record revenue or expenses based on the inflow or outflow of cash. For instance, cash receipts for goods or services sold and cash payments for taxes, supplies, and other expenses are recorded when there is an exchange of cash. Cash receipts from customers are only recorded in cash-basis accounting when the cash is actually received. Similarly, cash paid to a supplier for purchasing equipment or paying cash to employees can be accounted for in cash-basis accounting.
However, businesses with inventories are required to account for their inventories at the start and closing of the tax year. This is why accounting for inventories or goods can be difficult for small businesses, as they use cash methods, which focus more on the flow of money than tracking the inventories or goods. Consequently, small businesses with annual gross less than $25 million are allowed to have inventories as services rather than as goods to continue using the cash method for accounting.
Advantages of Cash Accounting
- Simplest Way to Understand
Cash basis accounting is an easy and simple method of accounting. It helps to keep records of the income and expenses of a company on receipts with the dates. This method makes it easy for small businesses to manage the cash flow without seeking any professional help.
- Shows Cash Flow
The cash accounting method provides receipts that provide cash flow statements. Cash accounting records the cash transactions of a company by making it easier to keep track of the cash when it is actually paid or received. Small businesses can notice cash fluctuations easily by using the cash accounting method.
- Single Entry System
Cash methods can be done with a single-entry system without getting into the complex accounting method. This makes month-end bank settlements easier. However, single-entry systems also have drawbacks for cash methods.
Disadvantages of Cash Accounting
However, while cash-basis accounting is an easy and simple way to keep records, it can show inaccuracies in the business’ financial analysis as it accounts for cash only when it is paid or received.
- Single Entry System
A single-entry system is an advantage of the cash accounting method, but it can also be a disadvantage. The cash method through a single-entry system can sometimes show inaccuracies, which affect the business’s health and growth. In contrast, a double-entry system is used in the accrual accounting method, which is based on accounting equations. It provides accurate information on profit and loss, which can be used as a basis for business analysis.
- Short Term Indicator
Cash basis accounting shows the health of the cash flow of a business by keeping a record of the inflow and outflow of cash, which may offer misleading information about longer-term profitability. It happens because the cash method doesn’t record the revenue that has been earned but has yet to be received. Furthermore, it can be misleading because the cash method shows income only when it is on receipt, which can cause a loss to a company.
For instance, if a company sells furniture in a month, and some customers pay the cash in the same month while some customers don’t, then the profits of that particular month will be inaccurate.
- Restrictions
The IRS restricts the large business owners to use cash methods because it can be complicated to track financial records. It can mislead them regarding the financial condition of the company while paying tax.
Is Cash Accounting better than Accrual Accounting?
Cash accounting and accrual accounting can differ on the various factors:
- Revenue and Expense Recognition
In cash basis accounting the revenue and expenses of a company is recorded when the cash is actually received or paid. Whereas, in accrual method follows the Generally Accepted Accounting Principles (GAAP) for the recognition of revenue and expenses are not depended upon the flow of cash. Revenue is recognised when it is earned, similarly expense is recognised when an asset is purchased for the company.
For instance, if a clothing company sold a fabric to a consumer then in that case cash accounting method will record the revenue of the company when the cash is actually paid, whereas according to accrual method the revenue was generated when the company sold the fabric.
- Single Entry and Double Entry
The cash method uses a single-entry system to record the inflow and outflow of cash as income or expense. The accrual method uses a double-entry system in which every transaction is recorded under two accounts. The transactions resulting from the credited account should be similar to those of the debited account.
- Taxes
The cash and accrual method both have a significant effect on the tax because the recognition of revenue and expense differs according to cash or accrual method.
For instance, a company prepared an invoice of $10,000 to their customer on August 20, 2024, and the customer paid the amount on March 1, 2025, then the businesses using the cash method don’t have to add this earnings to the tax for the year 2024, whereas according to the accrual method as revenue is already generated the company will include this revenue in the year of 2024.
- Reporting
Companies keep a financial statement record to keep track of the performance and growth of the company, which is important for every business. These financial statement records have three useful statements that are; cash flow statement, balance sheets, and income statement or profit or loss statement.
The cash flow statement provided by the cash method gives a view of how much money is there in the company at that given point of time by keeping a record on actual paid or received cash. In accrual method, the revenue is made without keeping a track on actual cash flow.
Balance sheets generally provide information on the company’s assets, liabilities, and investments (equity). In the cash method, the company doesn’t record the account receivables or payables. This is why the balance sheet doesn’t show the liabilities or assets, whereas accrual accounting provides a clear picture of the company’s assets, liabilities, and equity.
Income statements offer a comprehensive overview of a company’s revenue, expenses, and profit or loss over a specific period. In cash accounting, however, the picture of income needs to be more accurate, as it only reflects cash flow when transactions are actually paid or received. This approach may result in an inaccurate income statement, failing to account for revenue when it is earned. In contrast, accrual accounting presents a clearer representation of the income statement by recording all revenues and expenses as they occur, regardless of cash flow.
Generally Accepted Accounting Principles (GAAP)
GAAP is the accounting principles or procedures that explain the accepted accounting procedures that a company should use at a particular time. Its purpose is to provide an accurate view of a company’s financial condition. Accrual accounting uses accounting principles similar to GAAP, whereas cash accounting doesn’t use the principles that lead to a misreading of a company’s financial condition and operations.
Conclusion
Small businesses usually use the cash method for accounting as it is a simple and easier way than the accrual method. This helps to manage the cash flow in an easier way and also simplifies the tax reporting, as businesses can easily track cash inflows and outflows. However, the reporting of actual cash transactions can mislead a business’s financial condition and operations as it records transactions only when cash is actually paid or received. In contrast, accrual accounting provides a clearer view of a company’s financial position in the long run by recognizing revenues and expenses when they are acquired, regardless of actual cash flow. This method adheres to the Generally Accepted Accounting Principles (GAAP) and presents precise knowledge about the company’s profitability and financial condition at that point in time. As a result, cash accounting can be more profitable for small businesses operating without inventories, but in the long run, as a company grows and engages in more complex transitions, it will need to transition to an accrual accounting method.