Cash basis accounting is the method of accounting that records the payment and receipt of cash as it happens. It is the simplest form of accounting that is often used in small businesses and proprietorships because of its ease of use. It is especially easy to implement in a business that has no inventory.
The alternative system of accounting is the accrual basis of accounting that matches the revenue and expenses and records the expenses and revenues within the same accounting period. The recording of the revenue and expenses does not always happen when the cash is paid or received. The cash paid or received without the matching counterpart of revenue or expense is recorded as a deferred entry that is later adjusted. While smaller businesses are able to maintain accounts records easily with the cash basis of accounting, they often adopt the accrual-based accounting when they grow in size. When you work with TallyPrime to manage your business accounting, you will be able to work with either cash-based or accrual-based accounting effortlessly.
Cash basis accounting is useful because of its simplicity, but it has many drawbacks. The accrual-based system is more complex but is also widely used. The revenues or expenses are recorded only when they are matched with their counterpart and not at the time when the actual cash transaction takes place. Since the cash basis shows the actual cash position and not the revenue that has been earned, it can give a falsely positive picture of the finances of the system. The accrual system gives a more realistic picture of the company’s finances, revenue, and income. The accrual system gives a more complete balance sheet. This is because the net income for a cash basis accounting system is based only on the cash received, but that of the accrual system is based on the revenue and not the cash received. The accrual system follows the matching principle of GAAP and is a better system for large organizations and businesses with inventory.
Example of cash basis accounting
Let us take the example of a company that has been awarded a huge maintenance contract. The terms of the contract state that they will be paid in one payment after the end of the one-year contract period. In this scenario, the company would be performing the service throughout the period. By the cash basis accounting system, they will only record the payment for the service at the end of the year when they actually receive it. So, for the entire contract period, the books of accounts would show that the company is not generating revenue.
If we take the opposite, the company may receive a huge advance payment for a long contract of a year. They will record the revenue when they receive it at the beginning of the contract period. Throughout the rest of the period, the accounts will only show the expense of the project and it would appear that there is no revenue. If the cash payment falls outside the accounting year, the company’s books of accounts may show a very misleading picture of the company being idle for the year when in fact, it has been working on a lucrative contract. The books of accounts may even show a loss for the year.
Advantages of the cash basis of accounting
Easy to use: Most small businesses have limited staff. The owner of the business usually handles the accounting of the business as well. Cash basis accounting is very simple to maintain because it tells the owner exactly how much cash there is on hand, and it is a very easy method. Since cash receipts and payments are recorded as they happen, there is no need for an accountant to manage the business accounts. Many simple software programs are able to handle the easy cash basis system of accounting. TallyPrime can be used in a simple cash basis accounting application just as efficiently in a more complex accrual-based accounting system.
Tax: Some accountants prefer to use the cash basis system of accounting because it may offer tax benefits by accelerating some payments and reducing the taxable profits. So, it is applicable in cases where it can be used to defer tax liability.
Disadvantages of cash basis accounting
The cash-basis method has some inherent disadvantages.
Can be misleading: a company may have a decline in business orders for one month. But, if many customers make payments in that time period, it will give a false picture of a boom in business. The cash basis accounting system only reflects the cash status of the company and cannot be relied upon in order to judge the actual revenue and expense that the business is generating. Using such trends for analysis, projections and planning will give highly inaccurate results.
Accuracy: The timing of the cash payments and receipts may not exactly match the actual revenue generation and expense activities. So, if a company is spending toward a project that will only pay at the end of the period, the records will only show the expenses without the revenue that is being earned through the expensing activity. This is the picture that the books of accounts will present until the company finishes the project, issues the invoice, and collects the payments.
Easy to manipulate: A business can alter its results by not encashing a cheque immediately or by manipulating the cash receipt payment. The tax component of the income then gets deferred to the next accounting period.
Raising funds: Since many financial institutions do not rely on cash-basis accounting, a business following the system may find it hard to obtain a loan. However, small businesses and proprietorships may not be subject to such stringent rules.
Auditing: If a business wants to start auditing its accounts, it would have to switch to the accrual-based system of accounts. Auditors will only issue audited financial statements for companies that maintain their financial records with the accrual-based accounting system.
Reporting: The reports of the cash-based system are highly unreliable and cannot be used to track and analyze the company’s performance or finances.
These disadvantages are the reasons why most companies switch to accrual-based accounting as they grow in size. Intelligent accounting software such as TallyPrime helps even small businesses to take advantage of the cash accrual system of accounting.
