What Is Cash Basis Accounting?

What Is Cash Basis Accounting?
| Updated on: June 17, 2022

Accounting is an essential part of running a business of any size. Most accountants maintain accounts strictly adhering to the commonly accepted accounting principles and regulations. However, within the accepted principles there is some flexibility in the methods of accounting that a business uses. One of the preferred and most popular methods is the cash basis accounting method. It is very straightforward and easy to understand and implement. The cash basis accounting method recognizes the receipt or payment of cash as it happens. This is one of the main reasons why it is easy to implement even with users and businesspeople who have little accounting knowledge.  Read on to understand what is cash basis of accounting.

Why Small Business Needs an Accounting Software?

Differences Between Cash Accounting and Accrual Accounting

What is cash basis of accounting?

Cash basis accounting is the method of accounting that records the payment and receipt of cash as it happens. It is the simplest form of accounting that is often used in small businesses and proprietorships because of its ease of use. It is especially easy to implement in a business that has no inventory.

The alternative system of accounting is the accrual basis of accounting that matches the revenue and expenses and records the expenses and revenues within the same accounting period. The recording of the revenue and expenses does not always happen when the cash is paid or received. The cash paid or received without the matching counterpart of revenue or expense is recorded as a deferred entry that is later adjusted. While smaller businesses are able to maintain accounts records easily with the cash basis of accounting, they often adopt the accrual-based accounting when they grow in size. When you work with TallyPrime to manage your business accounting, you will be able to work with either cash-based or accrual-based accounting effortlessly.

Cash basis accounting is useful because of its simplicity, but it has many drawbacks. The accrual-based system is more complex but is also widely used. The revenues or expenses are recorded only when they are matched with their counterpart and not at the time when the actual cash transaction takes place. Since the cash basis shows the actual cash position and not the revenue that has been earned, it can give a falsely positive picture of the finances of the system. The accrual system gives a more realistic picture of the company’s finances, revenue, and income. The accrual system gives a more complete balance sheet. This is because the net income for a cash basis accounting system is based only on the cash received, but that of the accrual system is based on the revenue and not the cash received. The accrual system follows the matching principle of GAAP and is a better system for large organizations and businesses with inventory.

Example of cash basis accounting

Let us take the example of a company that has been awarded a huge maintenance contract. The terms of the contract state that they will be paid in one payment after the end of the one-year contract period. In this scenario, the company would be performing the service throughout the period. By the cash basis accounting system, they will only record the payment for the service at the end of the year when they actually receive it. So, for the entire contract period, the books of accounts would show that the company is not generating revenue.

If we take the opposite, the company may receive a huge advance payment for a long contract of a year. They will record the revenue when they receive it at the beginning of the contract period. Throughout the rest of the period, the accounts will only show the expense of the project and it would appear that there is no revenue. If the cash payment falls outside the accounting year, the company’s books of accounts may show a very misleading picture of the company being idle for the year when in fact, it has been working on a lucrative contract. The books of accounts may even show a loss for the year.

Advantages of the cash basis of accounting

Easy to use: Most small businesses have limited staff. The owner of the business usually handles the accounting of the business as well. Cash basis accounting is very simple to maintain because it tells the owner exactly how much cash there is on hand, and it is a very easy method. Since cash receipts and payments are recorded as they happen, there is no need for an accountant to manage the business accounts. Many simple software programs are able to handle the easy cash basis system of accounting. TallyPrime can be used in a simple cash basis accounting application just as efficiently in a more complex accrual-based accounting system.

Tax: Some accountants prefer to use the cash basis system of accounting because it may offer tax benefits by accelerating some payments and reducing the taxable profits. So, it is applicable in cases where it can be used to defer tax liability.

Disadvantages of cash basis accounting

The cash-basis method has some inherent disadvantages.

Can be misleading: a company may have a decline in business orders for one month. But, if many customers make payments in that time period, it will give a false picture of a boom in business. The cash basis accounting system only reflects the cash status of the company and cannot be relied upon in order to judge the actual revenue and expense that the business is generating. Using such trends for analysis, projections and planning will give highly inaccurate results.

Accuracy: The timing of the cash payments and receipts may not exactly match the actual revenue generation and expense activities. So, if a company is spending toward a project that will only pay at the end of the period, the records will only show the expenses without the revenue that is being earned through the expensing activity. This is the picture that the books of accounts will present until the company finishes the project, issues the invoice, and collects the payments.

Easy to manipulate: A business can alter its results by not encashing a cheque immediately or by manipulating the cash receipt payment. The tax component of the income then gets deferred to the next accounting period.

Raising funds: Since many financial institutions do not rely on cash-basis accounting, a business following the system may find it hard to obtain a loan. However, small businesses and proprietorships may not be subject to such stringent rules.

Auditing: If a business wants to start auditing its accounts, it would have to switch to the accrual-based system of accounts. Auditors will only issue audited financial statements for companies that maintain their financial records with the accrual-based accounting system.

Reporting: The reports of the cash-based system are highly unreliable and cannot be used to track and analyze the company’s performance or finances.

These disadvantages are the reasons why most companies switch to accrual-based accounting as they grow in size. Intelligent accounting software such as TallyPrime helps even small businesses to take advantage of the cash accrual system of accounting.

Choosing between cash-basis and accrual-method accounting

To choose between the cash basis accounting and accrual-based accounting systems, we must first understand what is cash basis of accounting and its feature comparison.

Feature

Cash Basis

Accrual Based

Ease of use

Very simple and straightforward to use

More detailed and complex to understand and use

Timing

Revenues and expenses are recognized when cash is received, or paid

Revenues and expenses are recognized only when they are earned

Management of credit

Accounts receivable and payable are not maintained

There is a record of the receivable and payable which gives a complete picture of the finances

Net income calculation

Net income is calculated based on the cash that flows in and out. Can be very inaccurate

Net income is calculated by factoring the precise revenue and related expenses, which is more accurate

GAAP

Does not follow the matching principle of GAAP

Follows the GAAP matching principle

Application

Is easy to use in personal accounts, small  proprietorships, and small-scale businesses

Is used by large organizations that need to file audited financial reports, and statements

Terms similar to the cash basis of accounting

Another term that is used for cash basis accounting is cash accounting.

Can you be cash basis if you have inventory?

Cash basis accounting is best for a business that needs to track cash and record transactions simply. It is not suitable for a business that has inventory, loans, or long-term liabilities.

Who uses cash basis accounting?

Despite its shortcomings, cash basis can be used for certain applications. It is primarily suitable for small, simple businesses that do not have inventory. It is also suitable for small associations and non-profit organizations.

Cash basis accounting is best suited for businesses that have the following features:

  • Single entry accounting system
  • A proprietorship or partnership that does not publish financial statements or results
  • The buyer pays in cash or immediate bank transfer, and there is no credit that is offered
  • Small transaction volume
  • Few employees
  • No inventory

TallyPrime is the best choice of accounting software for small simple businesses and more complex accrual-based accounting systems. It allows you to grow your business and switch your method of accounting without having to reinvest in new software. The design and layout of TallyPrime easily reflects all your transaction entries in the correct books of accounts. Tally allows you to maintain your daily accounting records with minimal fuss and without the need for an accountant. It also makes auditing by an accountant easier and quicker.

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