What is 'Cash Basis'
Cash basis refers to a major accounting method that recognizes revenues and expenses at the time physical cash is actually received or paid out. This contrasts to the other major accounting method, accrual accounting, which recognizes income in a company's books at the time the revenue is earned, but not necessarily received, and records expenses when liabilities are incurred, but not necessarily paid.
BREAKING DOWN 'Cash Basis'When transactions are recorded on a cash basis, they affect a company's books only once a completed exchange of value has occurred; therefore, cash basis accounting is less accurate than accrual accounting in the short term.
Example of Cash Basis Accounting
For example, say a construction company secures a major contract in a given year but is only going to be paid for its efforts upon completion of the project. Using cash-basis accounting, the company is only able to recognize the revenue from its project upon its completion, while it records the project's expenses as they are being paid. If the project's time span is greater than one year, the company's income statements are misleading; they show the company incurring large losses one year followed by great gains the next.
Benefits of Cash Basis Accounting
Cash basis accounting is simpler and cheaper to perform than accrual accounting, and for small business owners and independent contractors with no inventory, it usually meets their financial needs. It also gives a business an accurate picture of how much cash it has on hand.
Disadvantages of Cash Basis Accounting
The cash-basis method can paint an inaccurate picture of a business' health and growth. For example, if a business has slow sales one month but a large number of clients happen to pay their invoices that month, cash-basis accounting indicates a large influx of cash when sales are actually slow. If the business owner tries to compare numbers from that month with numbers from other months to make projections or assess trends, he has an inaccurate view of what is happening.
In contrast, with the accrual method, payments are recorded when the deal is sealed, giving the business owner a better sense of the company's actual sales and profits. Additionally, cash-basis accounting can make obtaining financing more difficult due to its inaccuracy.
Choosing Between Cash-Basis and Accrual-Method Accounting
The Internal Revenue Service allows most small businesses to choose between the cash and accrual method of accounting, but the IRS requires businesses with over $5 million in sales per year or over $1 million in gross receipts for inventory sales to use the accrual method. Businesses must use the same method for tax reporting as they do for their own accounting records.