written by | November 1, 2022

Importance of Cash Basis Accounting | Advantages and Disadvantages

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Table of Content


Cash basis accounting is a method in which revenues and expenses are recorded at the time of cash received or payments made. Under this method, revenue is recorded while receiving the cash, and expenses are recorded at the time of payment. This process is popular with individuals and small businesses as it is a simple and easy accounting method. 

Did you Know? Cash basis accounting is the simplest method to record cash transactions. 

Overview of Cash Basis Accounting

Cash basis accounting recognizes revenue and expenses only when cash is exchanged. Businesses account for income and expenses while receiving payment or when they actually pay for an expense.

Also Read: Basis of Accounting - What Is the Difference Between Cash and Accrual Basis of Accounting

Features of Cash Basis Accounting 

The features of cash basis accounting are provided below: 

  • Cash basis accounting is a simple process and does not require any extra skills.
  • It follows a single-entry system.
  • It records only the cash payments made and the cash received.
  • It does not have a built-in error-checking tool.
  • It focuses only on expenses and revenues at large.

Applications of Cash System of Accounting

Businesses like micro or small enterprises dealing primarily in cash use this cash-based accounting method. This method is popular with small-scale enterprises because it is a simple way to maintain cash transactions.

Types of businesses where a cash system of accounting is applied are:

  • Sole proprietorship/ partnership businesses that do not require publishing financial statements.
  • Businesses that deal only in cash and do not deal in credit.
  • Businesses employing a very small number of workers.
  • Any business which does not maintain stock.

Advantages of Cash Method of Accounting

The cash basis of accounting has the following advantages:

  • This method of accounting is easy to use.
  • Cash transactions are simpler to record.
  • No extra skill is required to manage the cash transactions when compared to the accrual basis of accounting which is rather complex.
  • The tax liability can be reduced using basic cash accounting.
  • It provides a lucid picture of the financial status of the business.

Disadvantages of the Cash Basis Accounting

The cash basis of accounting has the following disadvantages: 

Accuracy

Cash-based accounting does not give accurate results compared to the accrual basis of accounting. This happens because, often, the timing of cash flow does not match the timing of changes in the business's financial status.  

Manipulation

A business can manage to change its reported status by deferring the encashment of cheques or changing the timing of liability payments. This is used to transfer the tax liability to a later reporting period. 

Lending

Since lenders realize that cash basis accounting does not provide accurate financial statements, businesses following the cash basis accounting method often refuse to lend.

Audited financial statements

Auditors do not approve of financial statements compiled under cash basis accounting. A business desirous of having audited financial statements will have to convert to the accrual basis of accounting.

Management reporting

Since the results of the financial statements created using the cash basis accounting method are inaccurate, it is not advisable to issue management reports. With so many problems attached to the cash basis accounting, the businesses, once they come out of the start-up phase, do not continue. 

Also Read: Learn the Difference Between Bookkeeping and Accounting - Changing Faces of Accounting and Bookkeeping

Who Uses Cash Basis Accounting?

The businesses which use cash basis accounting are:

  • Certain Government agencies.
  • Small businesses.
  • Non-profit organizations.
  • Small service businesses that do not maintain inventory.
  • Community associations.
  • Businesses that do not deal in credit for their purchases and sales.

Reasons for using Cash Basis Accounting by Businesses

  • Under this, businesses use simple single-entry accounting instead of double-entry accounting.
  • The business is a partnership or a sole proprietorship.
  • The business does not sell goods or deliver services on credit.
  • There are limited financial transactions every day.
  • The business has only a few employees.

Calculation of Net Income in Cash Basis Accounting.

Since only the expenses or revenues are recorded when cash is exchanged, it becomes easy to calculate the net income. 

The formula for net income is mentioned below:

Net Income = Revenue - Expenses

For example:

Your revenue is at ₹50,000/- and your expenses include:

Rent - ₹ 8,000/- 

Utilities - ₹ 5,000

Now, use the formula

Net Income = Revenue – Expenses

Net income = 50,000 - 13,000 = ₹47,000/- 

Your net income would then be ₹ 47,000/

Also Read: What Is Accounting Equation - A Complete Overview | Khatabook

Cash Basis and Accrual Basis of Accounting

The difference between the cash basis and accrual basis of accounting is given below:

Definition

In the cash basis of accounting the expense and income are considered only when there is an outflow and inflow of cash whereas in the accrual basis of accounting income and expense are recorded when it is incurred, not considering the time when it is paid or collected.

Nature

The cash basis is simple in nature as compared to the accrual basis of accounting which is complex in nature.

System of Accounting

In cash basis accounting the single-entry system is used to record the inflow and outflow of cash. The accrual basis of accounting follows the double-entry system of debit and credit. 

Variation in the Income Statement

Under the cash basis of accounting, the income statement shows a comparatively lower income. The income statement will show higher income on an accrual basis of bookkeeping.

Accuracy

The cash basis accounting shows low accuracy whereas the accrual basis is more accurate.

Auditing of Financial Statements

Under the cash basis, accounting financial statements cannot be audited. Only those financial statements can be audited which are prepared using the double-entry system of accrual basis accounting.

Suitability

Cash basis accounting is suitable for small and micro businesses whereas accrual basis is suitable for big businesses. 

Conclusion:

Cash basis accounting is a simple method to maintain cash transactions for revenue and expenses. It uses the single-entry system of accounting. Cash Basis Accounting could be adequate and is preferred by a few small businesses, government agencies, Non-profit organisations, community associations and small businesses which do not deal with an inventory. 

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FAQs

Q: What is the difference between cash and accrual basis of accounting?

Ans:

In the cash basis of accounting, the expense and income are considered only when there is an outflow and inflow of cash. In the accrual basis of accounting, income and expense are recorded when it is incurred, not considering when it is paid or collected. In cash basis accounting, the single-entry system records the inflow and outflow of cash. The accrual basis of accounting follows the double-entry system of debit and credit.

Q: Which are the businesses that use cash basis accounting methods?

Ans:

The businesses which use cash basis accounting are:

  • Certain Govt. agencies
  • Small businesses
  • Non-profit organizations
  • Small service businesses that do not maintain inventory
  • Community associations
  • Businesses that do not deal in credit for their purchases and sales

Q: What are the features of cash basis accounting?

Ans:

The features are mentioned below:

  • Cash basis accounting is a simple process and does not require any extra skills
  • It follows a single-entry system
  • It records only the cash payments made and the cash received
  • Does not have a built-in error-checking tool
  • It focuses only on expenses

Q: Where is the Cash System of Accounting used?

Ans:

Types of businesses where the cash system of accounting is applied are:

  • Sole proprietorship/ partnership businesses that do not require publishing financial statements
  • Businesses that deal only in cash and do not deal in credit
  • Businesses employing a very small number of workers
  • Any business which does not maintain stock

Q: What are the advantages of cash basis accounting?

Ans:

The advantages are mentioned below:

  • This method of accounting is easy to use
  • The cash transactions are simpler to record
  • No extra skill is required to manage the cash transactions when compared to the accrual basis of accounting which is rather complex.
  • The tax liability can be reduced using basic cash accounting.
  • It provides a lucid picture of the financial status of the business.

Q: What is cash basis accounting?

Ans:

Under the cash basis of accounting, expenses are recorded when the payments are made. Under this method, revenue is recorded while receiving the cash, and expenses are recorded at the time of payment.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.