Cash accounting requires the business to categorize and report income and expense transactions in terms of when they occur. Income is reported at the time it’s earned while expenses are recognized when they’re paid for. This type of accounting system works best for small businesses with straightforward financial reporting requirements.
How Does It Work?
Cash accounting is a method that records revenues and expenses on a “when received” or “when paid” basis instead of using an account balance approach. This type of accounting system works best for small businesses with straightforward financial reporting requirements. For example, a small business may have a simple income statement with two revenue and expense categories: sales and cost of goods sold. In this case, cash accounting works fine for reporting these types of transactions. However, if a company has several sources of revenue or incurs costs that are difficult to measure in terms of cash flow, using an accrual basis accounting system is more appropriate. For example, a business may have revenue from services and equipment rental contracts paid in advance or deferred into the future. This also includes costs for depreciation on assets such as trucks that were purchased by issuing a note payable. In this case, cash accounting would not accurately report these transactions because it doesn’t recognize them until payment is received.
Example of Cash Accounting
Let’s say, for example, you sell $500 worth of goods on credit but receive payment in full today. The $500 of revenue is recognized today. If the customer doesn’t pay for 90 days, you don’t record anything until they actually make payment. On the other hand, if a business uses an accrual basis accounting system, income and expenses are recorded when they occur, regardless of whether or not there’s cash in the bank to support the transaction. For example, if you sell $500 worth of goods on credit and receive payment in full today, this transaction is recorded even though the cash isn’t in your bank accounts yet.
Benefits of Using Cash Accounting
The following are some of the benefits of using cash accounting.
- It’s easy to use.
- It’s easy to understand.
- Revenue recognition is immediate, meaning there are no accruals or deferrals of income.
- The matching principle for recording expenses works well because cash basis accounting records all related costs at the same time.
- It provides more accurate forecasts of cash flow because all transactions are treated equally, regardless of when they actually get paid or billed.
- There’s a limited need for estimates and accruals — which simplifies the financial reporting process so it can be completed faster.
Limitations Using Cash Accounting
Several limitations can make cash accounting less suitable for businesses.
- This type of system doesn’t provide a complete picture of how the business is really performing because it doesn’t record all transactions in terms of when they actually occur.
- Since there’s no accrual, expenses aren’t recognized until the corresponding cash is paid for them — which could result in overstated profits and understated losses (or vice versa).
- This can lead to an understatement of taxable income and overstatement of cash flow because the company is reporting revenue before receiving payment.
- Cash basis accounting doesn’t provide a complete picture of how profitable or successful your business is at generating sales — which isn’t helpful if you want to make informed decisions.
- It may provide a misleading picture of your business because it doesn’t recognize all costs in terms of when they actually occur.
- It creates a challenge for forecasting, particularly if most of your company’s transactions are made on credit, which means it provides an incomplete picture of how profitable or successful you’ll be in generating future sales.
Cash Accounting vs. Accrual Accounting
Cash accounting is an accounting method that records transactions when cash or equivalent items change hands. Cash accounting is one type of system that businesses use to record business transactions, but it’s not the only way. Other forms of accounting can provide a more accurate picture of how profitable or successful your company is at generating sales and managing its resources. Accrual is one such alternative — and it’s the primary method used by businesses for recording their transactions. In an accrual accounting system, income and expenses are recorded when they occur, regardless of whether or not there’s cash in the bank to support the transaction. This type of system takes into account all related costs at the same time. An accrual-basis system provides a more accurate view of how profitable or successful your business is at generating sales, managing its resources, and investing in future growth — which can help you make better decisions about the direction it’s headed. On top of that, an accrual-based system creates more transparency for stakeholders and partners — which helps maintain trust and credibility with a wide range of stakeholders. Accrual accounting enables you to create more accurate forecasts because it incorporates all transactions, regardless of when they actually get paid or billed. It also allows businesses to make informed decisions about how profitable or successful their company will be at generating future sales based on the transactions that have already occurred.
The Bottom Line
The benefits of using cash accounting outweigh the limitations. However, it’s not a complete picture of your business because you aren’t recording all transactions in terms of when they actually occur, and several other limitations can make it unsuitable for most businesses. Nonetheless, it’s the primary method businesses use for recording their transactions, and it provides more transparency for stakeholders — which is helpful when trying to maintain trust with a wide range of partners.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.