Cash basis accounting

Cash basis accounting is an accounting method that reports revenue and expenses as they are received or paid. In other words, the cash method shows how cash comes in and goes out of a business. Cash basis accounting uses single-entry bookkeeping. It covers only short-term transactions. Thus, accounts like accounts receivable, accounts payable, or long-term transactions do not apply here.

Who uses cash basis accounting in business?

Individuals and small businesses that do practically all of their business in cash mostly use this method of accounting. In other words, this accounting method is ideal for individuals or companies with large cash flow. However, cash basis accounting is not permitted by the Tax Reform Act of 1986 in C corporations, tax shelters, some types of trusts, and partnerships with C Corporation partners.

Advantages of Cash Basis Accounting

This method comes with some upsides, including:

1. Its ease of usage: This method of accounting is relatively simpler, straightforward, and easy to maintain. A person without a sound knowledge of accounting can use this method easily. It is so easy to use that many small business owners do not hire accountants when using this method.
2. It gives you an insight on the cash at hand: Cash accounting is only concerned with the physical funds that come in and out of business. Hence you can easily see how much funds you have at hand.
3. Tax advantage: This method offers a potential tax advantage for businesses. Since you can only record transactions when physical cash comes in or out, you can control the timing of transactions. Therefore, you can accelerate some expenses and slow down revenue, thus lowering your tax liability.

Despite the advantages of cash accounting, there is also a downside. The downsides to it. They include:

1. Inaccuracy: It may fail to show the actual state of your company. For example, you might assume that your company is doing well because there is a lot of cash at hand, while in reality, there are some unsettled debts. Likewise, it could appear that the business is not doing great due to a lack of cash when many people owe you.

Due to the inaccuracies in cash basis accounting, some businesses with poor cash flow may not be fancied by potential investors. Most businesses may choose an accurate accrual accounting method since it's more reliable.

1. Manipulation: A company can change its reported results by failing to cash received checks or by modifying the due date for its liabilities.
2. Lower chances of obtaining loans: Some lenders may be reluctant to loan businesses reporting on this method since it doesn't produce reliable financial statements.

An alternate method of recording transactions is the Accrual method. The accrual accounting method reports income (revenue) and expenses based on credit, accounts receivables, and accounts payable. This method doesn't report revenue or expenses in relation to cash. Instead, it reports revenue when earned and expenses; when incurred. Businesses with more than $25 million in gross receipts over the last three years mainly require Accrual accounting.

A significant advantage of this method of accounting is that you know the actual state of your business, even on a long-term basis. In addition, you can accurately tell if your business is profitable, which is a good indicator for potential investors. The disadvantage of accrual accounting is that it is complex and can be catastrophic if cash flow is not properly monitored.

Conclusively, Cash basis accounting is a type of accounting method that notes revenues and expenses when cash is received or paid out. Although it is a simple method of accounting it doesn't give a clear picture of the business's financial situation.

One of the main reasons why proper accounting services are essential for your business is to maintain accurate financial records.