As a business owner, it is important to know that there are two types of accounting methods to manage your bookkeeping, and they go by the name of accrual accounting and cash basis accounting.
Both are different, each has their benefits, but in this article, we will see what is and what are the advantages of cash basis.
If this seems interesting to you, keep reading.
What is cash basis accounting?
Cash basis accounting is the accounting process, which acknowledges revenues and expenses only when cash is received or paid out, meaning when that money leaves or enters your bank account.
It is the total opposite of accrual accounting, which records income when revenues are earned, not when payments/ cash are received.
Considered as the simplest accounting, it is mostly used by small businesses as it does not deal with accounts receivable nor accounts payable or any other liability for that matter.
Therefore, it is only reported on the income statement when cash has been exchanged, that is to say, received and as an expense only when cash has been paid.
Cash basis accounting is not acceptable under the generally Acceptable Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS).
What are the advantages of cash basis accounting?
There are many advantages to the cash basis accounting system that are:
- Inexpensive: It is cheaper and easier to use compared to accrual accounting, especially for small businesses who do not have the means to create an accounting department structure or hire a suitable accounting firm.
- Trackable: It is easier to track because it only surveys when that transaction, money exchange, has taken place. It lets directly see the money you have, what you see is what you get and doesn’t consider forthcoming expenses.
- Taxation: Because it helps control the time of transactions, you can accelerate payments to reduce tax profits, especially losses, to only pay taxes for money you have received.
So, basically, some businesses could precipitate their expenses and decelerate their revenue to avoid high tax liability as they prefer to avoid losses for an accounting period since they are meticulously taken into account by creditors, who would consider it as a decline in the creditworthiness of a business
How do you calculate cash basis accounting?
As expenses or revenues are only recorded when cash is exchanged.
Therefore, it is easy to calculate cash basis accounting, you need to subtract the total of your cash basis expenses from your cash basis income, which results into your net income on your balance sheet.
The formula of that net income would be:
Equation: (Revenues – Expenses = Net Income)
Of course, the goal here is for your net income to be positive rather than negative.
Your revenue is at $40,000 and your expenses include:
Utilities (gas, electricity and water): $4,000
To find out how much net income you made, you must use the formula like such:
Net income = $60,000 - $10,000 = $50,000
Your net income would then be $50,000.
What is wrong with cash basis accounting?
There are a few disadvantages to cash basis accounting, and those are:
Hinders decision-making: Because it only records daily finances and doesn’t give a long-term view of your financial situation, one can’t make decisions without knowing their upcoming financial situation.It also would be very difficult for companies who mostly sell product or services on credit.
Fraud: A company can cash in his checks late on or request delayed payment for the period of its tax liability.
Investors: This type of accounting is quite disadvantageous for companies that are looking to expand their business, but can’t and most likely will not find any lenders because they simply do not believe that cash basis accounting is the actual representation or picture of the company’s financial situation.
For example: A company might be making lost of sales in Q1 (quarter), but is not expected to receive cash until Q2 (quarter 2) and because cash basis only recognizes payments when money is exchanged, the investor looking at the company’s finances will think that it is not worth, when it is actually thriving.
Audit: Auditors verify that a company is reporting factual financial statements and will not recognize the cash basis accounting as accurate, either. It does not cut it for them.
Short-term: At some point, if you are a company that intends to grow your business, then you might feel restricted by this form of accounting and might need switching from cash to accrual accounting.
Your accounting books will have to include:
- Accounts receivable and accounts payable
- Accrual expenses
- Cash payment, receipts and prepayments omission
What is the difference between accrual accounting and cash basis accounting?
It is the most common of the two and records revenue and expenses when they occur and not yet invoiced nor when cash is exchanged.
It is also used by big companies, corporates once you make over $25 million of gross receipts per year, as it is required by the IRS.
Furthermore, it gives an accurate representation of a company’s financial position thanks to the inclusion of accounts receivable and accounts payable.
It doesn’t track cash flow, so if a company is encountering money issues in the short term, it might seem like a longer term than it is.
Example 1: You are an interior design company owner and was hired to decorate someone’s house. Unlike cash basis, you will record the revenue as soon as you have finished the job, even though you have not yet actually received any payment.
Which means if you’ve completed your work, the 10th of June and the customer has paid you on July 20th, your record of revenue would still be on the 10th of June.
Example 2: If you receive an internet bill of $200, in the cash basis method, this bill is not added into the books before it is paid, though, under the accrual accounting, it is recorded the moment you receive and become aware of that bill.
Cash basis accounting:
Cash basis account does not include account receivable or account payable. It is quite beneficial in the short term rather than the long term, like accrual accounting.
It is easier to track a company’s cash flow, therefore preferred by small companies, but not recommended for bigger corporations.
Example 1: You are a contractor and was hired by someone to do a job. The customer owes you $10,000 but gave you $5,000 in cash and credits $5,000.
Your revenue reported on the income statement would not be the credit, but the cash you have earned. So, your income would be $5,000.
Example 2: Let’s say a manufacturing company sells $10,000 worth of cosmetics in December, but gets paid the following year in January.
Even though, its sales will have taken place in December, it would not be recorded until January as that is the month the company received its money in cash for the sale.
Finally, whichever accounting method you choose will depend on certain factors, such as money tracking or tax purposes. Though, it would be recommended to use accrual for weighty accounting and cash basis for small business type of accounting.