Businesses must choose one or the other of two possible approaches to financial reporting:
Firstly, they may select cash basis accounting. Firms using this approach record revenue when they receive cash and record expenses when the pay cash.
Secondly, they may choose accrual basis accounting instead. Firms using this approach record revenue when they earn it and record expenses when they owe them.
Choosing an Accounting System Impacts the Way the Firm Does Business
On first hearing the distinction between cash accounting and accrual accounting, the differences may seem minor. When the natures of the two accounting systems are better understood, however, it is clear that the accounting system choice has a profound influence on operations. Choice of system impacts the way the firm bills customers, and how it collects payments and pays its bills. And, the choice of accounting system has a profound impact on the way the firm meets reporting obligations to regulatory agencies and governments.
Most Businesses Choose Accrual Accounting
The vast majority of businesses worldwide choose accrual accounting. It is almost impossible for a public company to meet its reporting requirements using cash accounting alone. Large organizations of all kinds—public and private—will cannot meet their own record-keeping needs using cash basis accounting only. One reason, for instance, is that only accrual accounting enables the organization to track its asset base, liabilities, and equities.
Some Businesses Choose Cash Basis Accounting
By contrast with accrual accounting, some small privately-held businesses choose cash basis accounting because it is simple.
- This approach is more straightforward because it uses a single-entry system: each transaction results in just one transaction record entry. A double-entry accrual system, by contrast, requires at least two bookkeeping entries for each.
- Cash basis accounting is straightforward, also, because it recognizes only two kinds of transactions—cash inflows and cash outflows. Accrual accounting, by comparison, records debit and credit transactions in five different account categories.
And, with a cash basis system, keeping the firm's "books" does not require accounting or bookkeeping skills. Just about any person who can arrange figures in a table and manage a simple spreadsheet can create and use cash basis records. As a result, the cash basis approach enables some small firms to meet their record-keeping and reporting needs without a trained accountant or accounting software.
Cash Basis Means Cash Transactions Only
Cash transactions recorded in a cash basis system include physical transfer of coins and banknotes, of course, but also forms of transmission that turn into cash very quickly. As a result, the cash basis system also registers payments with written checks, credit cards, bank debit cards, and bank wire transfers.
A cash basis system, however, does not record receipt of a promissory note, creation of an account receivable, or the sending of a customer invoice.
Explaining Cash Basis Accounting in Context
Sections below further define and illustrate cash basis accounting. Note especially that the term appears in context with the following terms and concepts from the fields of bookkeeping, accounting, and business analysis.
Sections below further explain Cash-Basis Accounting and Bookkeeping, focusing on three themes:
- The rationale and purpose for Cash-Basis Accounting.
- Example transactions and accounts showing how to use Cash-Basis Accounting.
- Cash basis Accounting Contrasted with Accrual Accounting, and reasons that most companies and organizations choose Accrual Accounting.
- 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?
- Cash basis approach works well with single entry systems.
The difference between cash and accrual accounting stems from the fact that most business transactions involve two events.
- The seller delivers goods or services.
- The buyer pays for the purchase.
These events may occur at the same time, or there may be a time lapse between them. And, 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 be paid "up front," and then deliver later. For example, when a buyer leases floor space, the first payment is usually due before the occupancy period. For example, when a buyer leases floor space, the first payment is typically due before the occupancy period.
Under cash basis accounting, sellers record their expenses for delivering goods or services when they pay the cost. Similarly, sellers register cash receipts only when customers pay.
Cash Basis sellers record revenues and expenses, that is, only when they occur, even if time passes between the two events, events, including situations when they happen in different accounting periods
Accrual Accounting Achieves Matching While Cash Basis Accounting Does Not
The generally accepted accounting principle of "Matching" is the idea that reported incoming revenues should match (report in the same accounting period) with the expenses that bring them. Otherwise, reported margins and profits are misleading. Cash basis firms that sell "on credit" will not always achieve this kind of matching.
- In contrast to cash basis accounting, the alternative—accrual accounting—achieves matching by using two pairs of entries for a single sale.
- For accrual-basis sellers, closing the sale and delivering goods or services brings two bookkeeping entries. These are a debit to one account and a credit to another. And, receiving the customer's cash payment brings another two entries. These, again, are debit to one account and a credit to another.
- At the same time, accrual-basis buyers record two entries when they first owe the payment, and another two entries when they pay cash.
Under accrual accounting, therefore, both sellers and buyers report revenues and expenses based on each party's first pair of entries. They state, that is, entries showing income earned by the seller and cash owed by the buyer.
Cash accounting works well with single-entry accounting, while accrual accounting works only with double-entry accounting. As a result, examples comparing cash accounting and accrual accounting are very similar to examples comparing single-entry and double-entry systems.
Single-entry cash accounting is very similar to the way that individuals use a check register for checking account checks, deposits, and balances. Users directly record the amount of each cash inflow or outflow, along with a transaction name or description.
Cash Basis Transaction Record
Tables 1 and 2, below, show how the cash basis single-entry record might look for a few days transactions for a small business, such as a small retail shop operating as a sole proprietorship.
Three-Column Cash Record For a Small Business
Table 1, with three columns, is the briefest possible form of cash-basis transaction record.
Five Column Cash Basis Transaction Record For a Small Business
Table 2 with five columns is slightly more complicated than Table 1. Table 2 has separate columns for cash inflows (revenues), cash outflows (expenses), and current balance.
The record can add additional columns, of course, to show different categories of revenues or expenses. The only structure required in the register is to include enough different revenue and expense categories to meet tax reporting requirements.
Cash accounting can be adequate for some small businesses. Some small firms may, prefer the cash-basis approach over an accrual system.
When Do Firms Prefer Cash Basis Accounting?
The cash approach may be preferred where all or most of the following conditions apply. The company:
- Uses single-entry accounting, not double-entry accounting
- Has relatively few financial transactions per day
- Does not sell on credit (does not deliver goods or services and then invoice customers for payment later)
- Requires that at the time of sale, customers must pay either by cash, written check, bank transfer, or 3rd-party credit/debit card
- Has very few employees
- Owns few valuable business-supporting physical assets
- May hold some product inventory, office supplies, and cash in a bank account, but does not own buildings, substantial amounts of office furniture, large computer systems, production machinery, or vehicles
- The company is privately held or operates as a sole proprietorship or partnership. The company does not need to publish the Income statement, Balance sheet, or other financial statements required of publicly owned companies.
Meeting Legal Reporting Needs With a Cash Basis System
Under such conditions, a cash basis system may be adequate to meet the company's legal reporting obligations. The cash basis system may be sufficient for
- Supporting the company's income tax reporting (for which the primary data are incoming revenues and outgoing expenses, in several categories)
- Proving that the company collected and paid government sales taxes for goods or services sold
- Forecasting future budgetary needs and sales revenues
- Showing that the company complied with minimum wage payment and employee income tax-withholding requirements
- Proving that the company pays its income tax
- Providing real-time visibility and control of incoming and outgoing funds (to prevent spending over budget or overdrawing the company checking account)
The advantages and disadvantages of cash basis accounting with a single entry system are clearest when comparing the cash basis approach with the primary alternative approach, accrual accounting with a double-entry system.
Cash Basis accounting has the significant benefit of simplicity over accrual accounting.
- People with little or no financial or accounting understand the cash basis approach (and single-entry bookkeeping) readily.
- Many small companies can implement the cash basis approach without involving a trained bookkeeper or accountant.
- The cash basis approach does not require complicated accounting software. It should be clear from the examples above, for instance, that a firm can quickly create and maintain a cash basis single-entry system in a written notebook or a very simple spreadsheet.
Cash basis accounting cannot meet the record-keeping needs of public companies and other organizations that must file audited financial statements, such as an Income statement or Balance sheet. Nor can it—by itself—give owners and managers crucial information for evaluating the firm's financial position. Some of the essential differences between the two approaches illustrate the disadvantages of the cash basis approach.
Double-entry accrual systems provide several kinds 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 timespan, the sum of all "debits" must equal the sum of all "credits." That is:
Total DR = Total CR
Cash Basis Systems Lack Built-in Error Checking
Moreover, a double-entry accrual 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 this equality in a double-entry accrual system is evidence of a transaction entry error somewhere in the system.
Accrual Systems Build in Error Checking
This kind of error does not exist in a cash basis single-entry system. Consider the result, for instance, if the cash basis bookkeeper mistakenly enters, say, a revenue inflow as $10,000 when the correct value is $1,000.
In a single-entry cash system, the error may not be apparent until the firm receives a bank statement with an unexpected low account balance—or an overdrawn account.
In a double-entry accrual 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 (e.g., "Accounts receivable"). If the second entry is missing, the sums of credits and debits in the system will differ, thereby 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, as mentioned, the double-entry system records a debit for an asset account, e.g., "cash on hand" (for an asset account, a "debit DR" 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 register the corresponding liability increase (bank loan to repay). Single entry systems do not easily track the value of assets, liabilities or equities.
Single-entry systems, moreover, work well with cash basis accounting, which registers inflows and outflows only when cash 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.
When Product Delivery and Customer Payment Fall in Different Periods
If vendor delivery and customer payment fall in different reporting periods, however, the single-entry system has no way of matching the two events. In such cases, the single entry system, therefore, presents a misleading picture of earnings for either period.
As a result, it is challenging to build a single-entry system that conforms to the GAAP requirements for businesses in most countries (Generally accepted accounting principles). This lack may not concern sole proprietorships, partnerships, or small privately held companies. For these firms, the accounting system 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 that supports by itself the reporting needs of public companies, or other firms that must report statements of income, financial position, retained earnings, or cash flow.