What is cash basis accounting?
Businesses must choose one or the other of two possible approaches to financial accounting and reporting:
Cash basis accounting is the practice of recording revenues when cash is received and recording expenses when the expense is paid.
Accrual accounting is the practice of recording revenues when they are earned and recording expenses when they are owed.
On first hearing the distinction between cash accounting and accrual accounting, the difference may sound minor. When the natures of the two accounting systems are better understood however, it is clear that the choice of accounting system has a profound influence on the way the company bills its customers, collects payments, pays its bills, and meets reporting obligations to regulatory agencies and governments. The vast majority of businesses choose accrual accounting. It is almost impossible for a public company (a company that sells shares of stock to the public) to meet its reporting requirements using cash accounting alone.
Cash transactions eligible for recording in a cash basis system include actual physical transfer of coins and banknotes, of course, but also forms of transmission that will turn into cash very quickly, including written checks, credit cards, bank debit cards, and bank wire transfers. In a cash basis system, however, the receipt of a promissory note, the creation of an account receivable, or the sending of a customer invoice are not, by themselves, transactions eligible for recording.
- What is cash basis accounting?
- What are the differences between cash and accrual accounting?
- Cash basis accounting examples.
- When and where may cash basis accounting be sufficient?
- What are the advantages and disadvantages of cash basis accounting?
What are the differences between cash and accrual accounting
The difference between cash and accrual accounting stems from the fact that most business transactions involve two events and, moreover, these events can occur at different times. The seller delivers goods or services (one event) and the buyer pays for the goods and services (another event). These events may occur more or less simultaneously or there may be a time lapse between them. Either event may precede the other.
The seller may deliver goods, for instance, then invoice the customer and wait 30 days or more for payment. Or the seller may receive payment "up front," and then deliver later (e.g., when the buyer leases floor space, the payment is typically made before the occupancy period).
- Under cash basis accounting, the seller's paid expenses for delivering goods or services are recorded only when they actually occur. Similarly, the seller records cash received from the customer only when that occurs, even if time passes between the events, and even if they occur in different accounting periods.
The generally accepted accounting principles (GAAP) in most countries, however, incorporate the matching concept, the idea that reported incoming revenues should be matched (reported in the same accounting period) with the costs that bring them. Otherwise, reported margins and profits are misleading.
- In contrast to cash basis accounting, the alternative—accrual accounting with a double entry system—achieves matching by using two pairs of transactions for a single sale. For the seller, closing the sale and delivering goods or services brings two bookkeeping entries (a debit to one account and a credit to another), while receiving the customer's cash payment brings another two entries (again, a debit to one account and a credit to another). Similarly, the buyer records two transactions when the payment is owed, and another two when cash is paid. Under accrual accounting, the reported income for both buyer and seller is based on each party's first pair of transactions—i.e. entries showing the money earned (for the seller) and the money owed (for the buyer).
Cash basis accounting examples
Cash accounting works hand-in-glove with single-entry accounting, while accrual accounting works well only with double entry accounting. As a result, examples that Illustrated the differences between cash accounting and accrual accounting are very similar to illustrations showing the differences between single entry and double entry systems.
Cash accounting with a single entry approach is very similar to the check register that individuals use to keep track of checks, deposits, and balances for a single checking account: The amount of each cash inflow or outflow is recorded along with the transaction name or description. Tables 1 and 2, below, are examples showing how the cash basis single entry record might look for one day's transactions for a very small business (e.g., a small retail shop operating as a sole proprietorship).
|1 June XX||Starting balance for day||$4,520.00|
|1 June XX||Electricity bill for month||($149.80)|
|1 June XX||Postage stamps purchased||($43.00)|
|1 June XX||Inventory purchased||($624.15)|
|1 June XX||Daily product sales||$1,040.25|
|1 June XX||Sales tax paid||($83.22)|
|1 June XX||Dailyservice revenues||$592.25|
|1 June XX||Bank interest received||$180.83|
|1 June XX||Customer refund paid||($42.95)|
|1 June XX||Ending balance for day||$5,390.21|
|Table 1. The simplest form of cash basis accounting in a single entry system, showing one day's transactions for a small business. Cash funds received are positive numbers and cash funds paid out are negative (in parentheses).|
|1 June XX||Starting balance for day||$4,520.00|
|1 June XX||Electricity bill for month||($149.80)||$4,370.20|
|1 June XX||Postage stamp purchase||($43.00)||$4,327.20|
|1 June XX||Inventory purchased||($624.15)||$3,703.5|
|1 June XX||Daily product sales||$1,040.25||$4,743.30|
|1 June XX||Sales tax paid||($83.22)||$4,660.08|
|1 June XX||Dailyservice revenues||$592.25||$5,252.33|
|1 June XX||Bank interest received||$180.83||$5,433.16|
|1 June XX||Customer refund paid||($42.95)||$5,390.21|
|1 June XX||Ending balance for day||$5,390.21|
|Table 2. Cash basis transactions with a single entry system, using a running balance and separate columns for incoming cash revenues and outgoing cash expenses. Funds received are positive numbers, funds paid out are negative.|
Additional columns can be added, of course, to show different categories of revenues or expenses. The only structure required in the records is to include enough different revenue and expense categories to meet tax reporting requirements.
When and where may cash basis accounting be sufficient?
Cash accounting can be adequate for a some small businesses. The cash basis approach may, in fact, be preferred over an accrual system for small companies where all or most of these conditions apply:
- The company uses a single entry system approach for bookkeeping and accounting, not a double entry system.
- The company has relatively few financial transactions per day.
- The company does not sell on its own credit, meaning it does not deliver goods or services and then invoice customers for payment later. Customers must pay at the time of the sale either in cash, or by written check or bank transfer, or with a 3rd-party credit/debit card.
- The company has very few employees.
- The company owns few expensive business-supporting physical assets (e.g., it may own some product inventory, office supplies, and cash in a bank account, but it does not own buildings, substantial amounts of office furniture, large computer systems, production machinery, vehicles, etc.).
- The company is privately held or operates as a sole proprietorship or partnership (i.e., the company does not need to publish the income statement, balance sheet, or other financial statements that are required of publicly owned companies).
Under such conditions, a cash basis system may be adequate to meet the company's legal reporting obligations. The cash basis system may be adequate for
- Supporting he company's income tax reporting (for which the primary data are incoming revenues and outgoing expenses, in several categories, if necessary).
- Proving that the company collected and paid government sales taxes for goods or services sold.
- Proving that the company complied with minimum wage payment and employee income tax withholding requirements.
- Proving that the company pays its own income tax.
- Forecasting future budgetary needs and sales revenues.
- Providing real-time visibility and control of incoming and outgoing funds, to help prevent spending over budget or overdrawing the company checking account.
What are the advantages and disadvantages of cash basis accounting?
The advantages and disadvantages of cash basis accounting (with a single entry accounting system) are best described by comparison with the primary alternate approach, accrual accounting with a double entry system.
Cash basis accounting advantages
Cash basis accounting has the great advantage of simplicity over accrual accounting.
- The cash basis approach (and single entry bookkeeping) are readily understood by people with little or no financial or accounting background.
- For many small companies, the cash basis approach can be implemented without the involvement of a trained bookkeeper or accountant.
- The cash basis approach does not require complex accounting software. It should be clear from the examples above, for instance, that a cash basis single entry system can be created and maintained easily in a written notebook or a very simple spreadsheet.
Cash basis accounting disadvantages
Cash basis accounting provides insufficient records and i sufficient control for public companies and other organizations that are required to file audited financial statements such as the income statement or balance sheet. Nor can it—by itself—give owners and management crucial information for evaluating the company's financial position. Some of the important differences between the two approaches illustrate disadvantages of the cash basis approach:
Lack of error checking
An accrual accounting system and double entry bookkeeping provide several forms of error checking that are absent in cash accounting with a single entry system. In the accrual system, every financial transaction results in both a debit (DR) entry in one account and an equal, offsetting credit (CR) entry in another account. For any time period, the sum of all debits must equal the sum of all credits. That is:
Total DR = Total CR
Moreover, an accrual double entry system works so that the balance sheet equation always holds:
Assets = Liabilities + Equities
These equations together are known as the accounting equation. Any departure from these equalities in an accrual double entry system is a signal that a transaction entry error has been made somewhere.
This kind of error checking is not built into a cash basis single entry system. If the cash basis bookkeeper mistakenly enters, say, a revenue inflow as $10,000 when the correct value is $1,000, the error may not be detected until the company receives a bank statement with an unexpected low balance for a bank account (or an overdrawn account). In an accrual double entry system, however, the $1,000 cash deposit entry (a debit to an asset account, "cash on hand") will be accompanied by another entry recognizing the source, e.g., a credit to a liability account (e.g., "bank loan") or a credit to another asset account ("accounts receivable"). If the second entry were not made, the sums of credits and debits in the system would differ, immediately revealing the error.
Focus on revenues and expenses only
A double entry system keeps in view the company's entire chart of accounts. That is, all transactions in a double entry system result in entries in two different accounts, which may be the so-called income statement accounts (revenue accounts and expense accounts) or the so-called balance sheet accounts (asset accounts, liability accounts, and equities accounts).
When the company receives cash through a bank loan, for as mentioned, the double entry system records a debit for an asset account, e.g., "cash on hand" (for an asset account, a debit is an increase), as well as a credit to a liability account, e.g., "bank loans" (with a liability account, an increase is a credit).
With a single-entry system, the company may record cash received from a bank loan as incoming cash, but there is no easy way to record the corresponding increase in liability (bank loan to be repaid). Single entry systems do not easily track the value of assets, liabilities or equities.
Single entry systems, moreover, work hand-in-glove with cash basis accounting, where inflows and outflows are recorded only when cash actually flows. Single entry systems cannot easily support the alternative approach, accrual accounting—as used by the vast majority of businesses worldwide. When the delivery of goods and services comes at a different time from cash payment for those goods and services, for instance, accrual accounting provides the mechanisms for implementing the matching concept, the practice of recognizing revenues and the costs that brought them in the same accounting period.
If the vendor delivery and the customer payment fall in different time periods, however, the single entry system has no way of matching the two events and thus presents a misleading picture of earnings for either period.
As a result, it is extremely difficult to build a single entry system that conforms to the GAAP requirements in most countries (Generally accepted accounting principles). This lack may not concern sole proprietorships, partnerships, or very small privately held corporations—whose accounting systems must support only the company's needs to comply with tax and employment reporting requirements. It is nearly impossible to build a single entry system, however, that supports by itself the reporting needs of public corporations, or other companies that must report statements of income financial position (balance sheet), retained earnings, or cash flow (changes in financial position).