What Is Cash Basis Accounting?
Cash basis accounting is an accounting system that recognizes revenues and expenses only when cash is exchanged. Businesses account for their income and expenses when they actually receive payment or when they actually pay for an expense. The cash basis accounting system does not consider income from credit accounts.
The cash system of recording transactions is only used by individuals and small businesses that deal exclusively in cash. Cash basis accounting is not acceptable under the generally Acceptable Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS).
What this article covers:
- What Is the Difference Between Cash and Accrual Accounting?
- Who Uses Cash Basis Accounting?
- Can You Be Cash Basis If You Have Inventory?
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Is the Difference Between Cash and Accrual Accounting?
While the cash basis accounting recognizes revenues and expenses only when cash is collected or disbursed, the accrual basis of accounting recognizes revenues and expenses when they occur or when they are earned.
In the accrual method of accounting, account receivable and account payable are used to track amounts due from customers on credit sales and the amount your business owes to the vendor on a credit purchase.
The choice of the accounting system has a major impact on the operations. Listed below are some of the key differences between cash and accrual accounting.
|Basis||Cash Basis of Accounting||Accrual Basis of Accounting|
|Ease of use||Simple, straightforward and easy to use||An intricate but widely used system|
|Meaning||Revenues and expenses are recorded when cash is exchanged||Revenues and expense are recorded at the point of purchase or sale|
|Credit accounts||There is no record of accounts receivable and accounts payable. The system might overstate the health of a company that is cash-rich||Includes accounts receivables and payables and as a result is a more accurate picture of the profitability of a company|
|Net income||The net income is based on the cash received and cash disbursements rather than revenues earned, and expense incurred||The net income is based on the revenues earned and expenses incurred in the accounting period|
|Balance Sheet||The balance sheet omits certain assets and liabilities.||As far as reporting of assets, liabilities and stockholders’ equity is concerned, the balance sheet is complete|
|Accounting Standards||Violates the matching principle of GAAP||Required by GAAP and IFRS|
|Used by||Best suited for small service-based businesses, individuals, non-profit organizations etc.||Used by all the public companies and other organizations that must file audited financial statements|
Who Uses Cash Basis Accounting?
Cash basis accounting can be adequate and preferred by some small businesses, government agencies, non-profit organizations, community association and small service businesses that do not deal with inventory.
Businesses that do not sell or buy on credit can use the cash basis of accounting for evaluating their financial performance.
Here are some common reasons why businesses may use cash basis accounting.
- The business uses simple single-entry accounting rather than double-entry accounting
- The company operates as a sole proprietorship or partnership. It does not publish financial statements like public companies for audit
- At the time of sale, the customer pays by cash, wire transfer, check or credit/debit card
- The business does not deliver goods and services on credit
- There are few financial transactions each day
- The business has only a few employees
- The business has no inventory to be tracked or valued such as service businesses
Can You Be Cash Basis If You Have Inventory?
If a business has inventory, the IRS usually requires the accrual basis accounting for recording it. There are, however, certain exceptions when businesses with inventory can used cash basis accounting.
At the start and end of every tax year, businesses have to account for inventory. If a business chose to track purchases and sales using cash basis accounting, it would lead to huge gaps between inventory accounting and the reported revenues and expense.
This is the reason why most businesses with inventory select the accrual-basis of accounting or a modified version of cash-basis accounting
The IRS allows some exceptions to the rule against cash-basis inventory.
- The exception is usually applied to small businesses and sole proprietorships that are not otherwise be prohibited from following cash-basis accounting.
- The individual taxpayer must not earn more than $1 million in a year. Small businesses may also qualify if they earn more than $1 million but less than $10 million dollars. This is determined by annual gross receipts for the past three years.
The primary reason why businesses choose cash basis accounting is due to its simplicity and ease of use. People with little or no financial accounting knowledge can implement the system without the need for a trained accountant.
The disadvantage of the cash basis accounting is that it can paint an inaccurate picture of the business’s financial health and growth. This is because the related expenses may be recognized in a different period than the revenues. The result can be incorrectly high or low reported profits.