What is Cash Accounting?
Cash accounting is an accounting method in which payment receipts are recorded during the period they are received, and expenses are recorded in the period in which they are actually paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively. Cash accounting is also called cash-basis accounting.
Understanding Cash Accounting
Cash accounting is one of two forms of accounting. The other is accrual accounting, where revenue and expenses are recorded when they are incurred. Small businesses often use cash accounting because it is simpler and more straightforward and it provides a clear picture of how much money the business actually has on hand. Corporations, however, are required to use accrual accounting under Generally Accepted Accounting Principles (GAAP).
- Cash accounting is simple and straightforward. Transactions are recorded only when money goes in or out of an account.
- Cash accounting doesn't work as well for larger companies or companies with a large inventory because it can obscure the true financial position.
- The alternative to cash accounting is accrual accounting where transactions are recorded when an order is made rather than paid.
Example of Cash Accounting
Under a cash accounting system, if Company A receives $10,000 from the sale of 10 computers to Company B on November 2, the accountant records the sale as having occurred on November 2. The fact that Company B placed the order for the computers on October 5 is irrelevant, because it did not pay for them until they were delivered on November 2. Under accrual accounting, by contrast, the accountant would have recorded Company A as having received the $10,000 on October 5, even though no cash had changed hands yet.
Similarly, under cash accounting companies record expenses when they actually pay them, not when they incur them. If Company C hires Company D for pest control on January 15 but doesn't pay the invoice for service completed until February 15, the expense would not be recognized until February 15 under cash accounting. Under accrual accounting, however, the expense would be recorded in the books on January 15.
Limitations of Cash Accounting
A drawback of cash accounting is that it may not provide an accurate picture of liabilities that have been incurred but not yet paid for, so the business might appear to be better off than it really is. On the other hand, cash accounting also means that a business that has just completed a large job for which it is awaiting payment may appear to be less successful than it really is because it has expended the materials and labor for the job but not yet collected payment. Therefore, cash accounting can overstate or understate the condition of the business if collections or payments happen to be particularly high or low in one period versus another.
There are also tax consequences for businesses that adopt the cash accounting method of recognizing cash inflows and outflows. In general, businesses can only deduct expenses that are recognized within the tax year. The choice of revenue/expense recognition method can determine which year a business can deduct its expenses. If a company incurs expenses in December 2017, but does not make payments against the expenses until January 2018, it would not be able to claim a deduction for the fiscal year ended 2017, which could significantly affect the business' bottom line. Likewise, a company that receives payment from a client in 2018 for services rendered in 2017 will only be allowed to include the revenue in its financial statements for 2018.