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Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.

It contrasts the other major accounting method known as accrual accounting, which records income or expenses in a company’s books at the time the revenue is earned but not received, or when a cost is incurred but not necessarily paid.

For example, XYZ Construction lands a contract to build an expansion onto ABC Manufacturing’s main factory. ABC stipulates it will not pay XYZ until the new wing is complete.

XYZ uses cash basis accounting, which means the revenue it receives from the job will be recognized once it’s received. Meanwhile, the expenses XYZ pays, such as labor costs, are recognized as the project proceeds.

XYZ doesn’t complete the project and receive its payment until its next fiscal year, which creates some misleading figures in its books. Last year it recorded large losses; this year it’s recording large gains. If XYZ had used the accrual method, the transactions would have been counted when the order from ABC was received.

Many individuals and small companies use cash basis accounting, mainly because it’s simpler and less expensive than accrual accounting. It provides a clearer picture of just how much cash a business has on hand.

But it can also yield some misleading numbers, which can make financing more difficult to obtain.

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