Introduction to Cash Accounting
Cash accounting is an accounting method where payment receipts are recorded during the period in which they are received, and expenses are recorded when they are actually paid. This means revenues and expenses are documented when money is exchanged. Cash accounting is renowned for its simplicity and is often referred to as cash-basis accounting.
Key Takeaways
- Simplicity at its Best: Transactions are recorded only when money goes in or out of an account, making cash accounting straightforward and easy to manage.
- Suitability for Small Businesses: While cash accounting works well for small enterprises, larger companies or those with extensive inventory requirements may find it less ideal as it can obscure the accurate financial position.
- A Clear Alternative: Cash accounting stands in contrast to accrual accounting, where revenues and expenses are recognized when they are incurred, regardless of cash movement.
Deep Dive into Cash Accounting
Cash accounting is a method preferred by small businesses due to its simplicity. Unlike accrual accounting, which records revenues and expenses when they are earned/incurred, cash accounting records transactions when cash is exchanged. For small businesses, this method offers a clear view of actual cash on hand.
Corporations, by contrast, must follow accrual accounting according to Generally Accepted Accounting Principles (GAAP). The delay inherent in recording transactions under cash accounting can lead to less accurate financial data in the short term.
Businesses with over $25 million in annual gross receipts are mandated by the IRS to use the accrual method. The Tax Reform Act of 1986 also prohibits certain entities like C corporations, tax shelters, and specific trusts from using cash accounting for tax purposes. The accounting method chosen for tax reporting must align with the company’s internal bookkeeping system.
Cash Accounting in Action
Imagine Company X sells 10 computers to Company Y for $10,000 on November 2. Under cash accounting, Company X records the $10,000 sale on November 2 as this is the date the payment is received. The date Company Y originally placed the order, say October 5, holds no relevance as no payment was made on that date.
With accrual accounting, however, Company X would record the $10,000 sale on October 5 when the order was placed, despite no cash having been exchanged at that time.
Similarly, consider Company Z, which hires a pest control service on January 15 but pays the invoice on February 15. With cash accounting, the expense is recorded on February 15, when the payment is made. Under accrual accounting, the expense is noted on January 15 when the service was rendered.
Potential Drawbacks of Cash Accounting
A significant drawback of cash accounting is the lack of accuracy in representing incurred but unpaid liabilities. This could result in a more favorable but misleading financial outlook. Conversely, cash accounting could understate a successful project’s finances while awaiting payment.
There are additional negative tax implications under cash accounting, as businesses can only deduct expenses recognized within the same tax year. For instance, expenses incurred in December but paid in January of the following year cannot be deducted for the previous fiscal year, potentially impacting the business’s overall financial performance. Likewise, payments received in the following year for services rendered in the current year will not reflect in the business’s financials until they are actually received.
Related Terms: Accrual Accounting, GAAP, Fiscal Year.
References
- Internal Revenue Service (IRS). “IRS Issues Guidance on Small Business Accounting Method Changes Under Tax Cuts and Jobs Act”.
- Congress.gov. “H.R.3838 - Tax Reform Act of 1986”.
- Internal Revenue Service (IRS). “Publication 538: Accounting Periods and Methods”, Page 9.
