Cash Accounting

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.

Also called cash-basis accounting.

BREAKING DOWN '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).

Under a cash accounting system, if Company A receives $10,000 from the sale of 10 computers to Company B on Nov. 2, the accountant records the sale as having occurred on Nov. 2. The fact that Company B placed the order for the computers on Oct. 5 is irrelevant, because it did not pay for them until they were delivered on Nov. 2. Under accrual accounting, by contrast, the accountant would have recorded Company A as having received the $10,000 on Oct. 5, even though no cash had changed hands yet. Also, we can also apply the same concept to a transactional event whereby Company B purchases $20,000 worth of equipment from Company X. The expense would be recorded the day cash changes hands between both companies.

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 Jan. 15 but doesn't pay the invoice for service completed until Feb. 15, the expense would not be recognized until Feb. 15 under cash accounting. Under accrual accounting, however, the expense would be recorded in the books on Jan. 15.

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. At the same time, cash accounting 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 reaped the rewards. Therefore, cash accounting can overstate and understate the condition of the business if collections or payments happen to be particularly high or low in one period versus another.

There are 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 the following year for services rendered the year prior will only be allowed to include the revenue in its financial statements for the following year.