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.
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:
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.
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.
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.
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.
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
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/
Cash Basis and Accrual Basis of Accounting
The difference between the cash basis and accrual basis of accounting is given below:
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.
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.
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.
Cash basis accounting is suitable for small and micro businesses whereas accrual basis is suitable for big businesses.
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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