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The cash basis of accounting recognizes transactions and events only when cash (including cash equivalents) is received or paid by the entity.
Financial statements prepared under the cash basis provide readers with information about the sources of cash raised during the period, the purposes for which cash was used and the cash balances at the reporting date. To understand cash accounting easily, it is important for us to understand certain key terms explained below:
Cash accounting focuses on the measurement of balances of cash and changes therein in the financial statements.
Let’s consider an example ABC Inc. purchased a Machinery worth 10,000 Indonesian rupiahs and recorded the same in its balance sheet at its historical cost of Rs. 10,000/-. ABC Inc. paid for the machinery through a cheque drawn on the supplier's name.
In the given example two transactions have occurred
Cash accounting keeps track of these transactions where cash or cash equivalents change its form.
Cash equivalents are held for the purpose of meeting short term cash commitments rather than for investment or other purposes.
For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity let’s say, three months or less from the date of acquisition.
In the earlier example of ABC Inc., the machinery acquired qualifies as Investment (Investment in Fixed Assets) but it does not qualify to become cash equivalent. This is because the company acquiring machinery tends to reap its benefits over a longer period by carrying out production activities and certainly not to sell the machinery within 3 months of acquisition or usage.
So examples of investments that qualify as cash equivalents are Treasury bills, commercial papers, marketable securities, short term government bonds and money market funds.
A business entity should prepare and present general-purpose financial statements which include the following components:
The cash basis of accounting recognizes revenues and expenses only when cash is collected or disbursed, but the accrual basis of accounting recognizes revenues and expenses only when they occur or when they are earned.
Cash accounting can be adequate and preferred by some small businesses, government agencies, non-profit organizations, community association and small service businesses that do not deal with an inventory.
Small businesses that do not sell or buy on credit can use the cash basis of accounting for evaluating their financial performance.
Cash flow is critical to small businesses and any inefficiency in cash flow often result in the failure of businesses though they are profitable on the paper. So here cash accounting seems much more relevant than accrual basis accounting for such type of business owners. This is because cash basis accounting lets them see all their cash flow activity on their profit and loss statement.
The methodology of only having to look at one financial statement i.e., the profit and loss account statement in order to see how the business is performing and to get visibility on the cash flow is attractive. But there will almost always be some cash flow activity that does not appear on the profit and loss statement, even if accounting is done correctly.
For example, if we are making drawings from business, paying long-term debt like loans, these cash disbursements will not appear on the profit and loss statement. This is where the net income number on profit and loss statement rarely matches the bank account balance.
There are several reasons to use cash basis accounting in business but tracking cash flow accurately alone shouldn’t be one of them.
The major reason as to why one should not use cash basis accounting is when your business extends credit to customers or when it maintains open accounts with the vendors and suppliers.
Using cash accounting when a business has accounts receivables or accounts payables will have a huge impact on the business abilities to track and collect all the money owed to the debtors. Also, the possibility of missing on the payments to the vendors.
Choose an accounting method that makes the most sense considering the objective of the business and more importantly, the one which drives the business towards greater growth and profitability, regardless of tax policies to be followed.
Guide to Business Management Software for Start-ups & Small Businesses