What Is Cash Cost?
Cash cost is a term used in cash basis accounting that refers to the recognition of expenses as they are paid in cash. Cash costs are recognized in the general ledger at the point when cash (or an alternative form of payment) exchanges hands. This method is contrary to the accrual basis of accounting, in which expenses are recognized in the general ledger at the point that they are incurred, not when they are paid.
- Cash cost is a term used in cash basis accounting that refers to the recognition of costs as they are paid in cash.
- It is essential to realize that cash costs include payments from checking accounts and debit cards, in addition to physical cash.
- Using cash cost gives a company access to the considerable advantages of cash basis accounting for small businesses.
- Cash costs can understate expenses for businesses that use a significant amount of credit.
Understanding Cash Cost
It is essential to realize that cash costs include payments made in the form of a check, electronic fund transfer (EFT), and debit card, in addition to physical cash. However, cash costs do not include credit card payments. On a cash accounting basis, the costs paid for by using credit would not be recorded in the general ledger until the card balance has been paid off with cash. That is one reason why many companies moved away from the cash accounting method to the accrual method. The accrual method recognizes expense for both credit transactions and cash transactions.
Businesses that borrow substantial amounts of money generally face higher taxes up front when they use cash cost instead of the accrual method.
Advantages of Cash Cost
Choosing cash cost gives a sole proprietor, partnership, limited liability company (LLC), or corporation access to the considerable advantages of cash basis accounting for small businesses. A business that uses cash cost will also be able to report its income on a cash basis. For income tax purposes, every business must keep its books on either a cash basis or an accrual basis. It is not possible to recognize income on a cash basis and recognize costs on an accrual basis.
The most significant benefit of cash accounting is that it eliminates the problem of phantom income. Suppose that a contractor completes $50,000 in renovations to a home for a client in December. Under the accrual basis of accounting, the contractor must recognize that revenue in the year the renovations were complete, even if the client does not pay until later. If the client does not pay by April, for whatever reason, the contractor will not have the actual funds to pay the taxes that are due. On a cash basis, revenue is not recognized on the books until it is received, just as cash costs are not recognized until they are paid.
Disadvantages of Cash Cost
Cash costs can understate expenses for businesses that use a significant amount of credit. Let us suppose that an entrepreneur uses $100,000 in credit to start a new business and earns $180,000 after taking any applicable tax deductions. The $100,000 in credit was not a cash cost, so the entrepreneur must pay taxes on the entire $180,000. The entrepreneur faces a higher marginal tax rate and must pay taxes on a larger amount, significantly increasing the tax burden.
If costs were recognized on an accrual basis, the entrepreneur would be able to deduct the entire $100,000 in business expenses. On an accrual basis, the entrepreneur only needs to report $80,000 in income. That would reduce the tax burden by more than 50% in this case.
The situation may not be so bad because all cash costs are eventually recognized. As a successful business pays back debts over time, the payments count as cash costs. Businesses can deduct these costs from income on a cash basis. A simple example is a sole proprietor who pays the credit card bill every month. When the proprietor pays the bill each month, the business can record the cash costs.
However, the tax disadvantages of cash cost become more apparent in extreme cases. If the entrepreneur who uses $100,000 in credit earns only $120,000 after applying tax deductions, the entrepreneur could face accounting insolvency. The $100,000 in credit was not a cash cost, so the entrepreneur has to pay taxes on $120,000 in income. The tax bill will be more than $20,000, so the entrepreneur will have less than $100,000 in assets left, while still owing $100,000 (plus interest).