Definition of Cash Accounting
Cash Accounting records cash transactions in business when the cash is received or paid. The date or time of these records can differ from when the company delivers its services. That is, the transaction gets recorded only when payment clears and is deposited into the account or an expense payment is made. So, the cash balance always reflects actual bank data. Cash Accounting uses this data to create financial reports, and you can track your finances. Small businesses and freelancers can benefit from using this simple accounting method.
2. Understanding Cash Accounting
Cash Accounting is one of the simplest forms of accounting. It tracks the revenue of a business by tracking the payments made and received at the time they are made. It gives businesses an easy view of the cash flow and balance of the company at any given time. This is crucial in creating financial statements and making intelligent business decisions.
Small businesses and entrepreneurs use Cash-based accounting owing to its simplicity and usefulness. However, large companies avoid using cash accounting since it can obscure the underlying financial position.
Since all the transactions are recorded based on the inflow and outflow of cash, the recorded transaction dates can differ from when the actual transaction occurred. In a company with a large volume of inventory, this difference can cause issues.
To resolve this issue, large companies go with Accrual accounting. This accounting method records the revenue and expenses when they are incurred and not when they are made.
Read more about expense accounting.
Cash Accounting effects occur only on a single account, i.e., it is single-entry accounting.
3. Pros and Cons of Cash Accounting Method
- The simplicity and efficiency of Cash Accounting are what attract small businesses to it. It is easy to understand and use, so there is no need for significant investments in training personnel.
- Cash Accounting is cheaper than Accrual Accounting, and you do not need to hire an accounting firm.
- Maintenance of a Cash Accounting System is much easier than other methods. It simply tracks the cash inflow and outflow as it happens.
- You always have access to the real-time cash balance in cash accounting. Unlike accrual accounting, you do not have to factor in pending payments to see the current cash balance.
- You can lower your tax liability using the cash accounting method. Since cash accounting only records the cash transactions when it incurs, you can control the timing of the transactions in the tax year to manage your tax liabilities.
- Cash Accounting is not suitable for large companies with an extensive inventory. Since it only records the cash flow when it happens, you cannot estimate the future liability. It does not include pending transactions, making the data unreliable for large companies. It can give an erroneous image of the company’s performance.
- The Companies Act does not recognize Cash Accounting, another reason large companies avoid it.
- There can be adverse tax repercussions while using cash accounting. For example, if a company incurred an expense in the last fiscal year and was not paid until the following fiscal period, the company would be unable to claim a deduction for the year the expenditure occurred.
- Cash accounting is usually a short-term solution. This is because eventually, your company will grow, and with it, its accounting demands. This growth cannot be accommodated by cash accounting.
- The transition from cash accounting to accrual is not an easy process. You need to add the accrued expenses, prepaid expenses, and accounts receivable and subtract the cash payments, cash receipts, and customer prepayments.
4. Examples of Cash Accounting
Let’s try to understand Cash Accounting better using some examples.
- A hardware company sells ₹5,000 worth of units in December, but the payment is cleared and hits the account in the following month, i.e., January. Even though its sales occurred in December, they would not be reported until January because that is the month the company received its money in cash for the transaction.
- Company X hired company ABC to employ their services valued at ₹200,000. But Company X paid ₹100,000 in cash and the remaining ₹100,000 in credit. Your revenue reported by cash accounting would only include cash, i.e., ₹100,000, and not the ₹100,000 on credit.
5. Limitations and problems of Cash Accounting
Cash-based accounting only includes cash expenses and revenues and does not include accounts receivable or accounts payable. It does not consider pending expenses or invoiced income that has not been received. So, it cannot give an accurate picture of the profitability and performance of the business. While beneficial in the short term, it is not a viable solution for the long term.
The Companies Act does not recognize Cash Accounting. IRS maintains that companies whose average annual gross receipts exceed $25 million and businesses that are a corporation or maintain inventory cannot use cash accounting. They prefer accrual accounting for gaining accurate financial data of the company.
Cash accounting is a single-entry system, meaning it affects only one account. While this offers simplicity to the method, it also tends to introduce errors during transaction posting.
Issues with Tax Liability
Cash accounting records the time the expense is paid. Due to the mismatch between the time an expense incurs and the time the expense is paid, there can be issues when deciding the company’s tax liability.
6. Cash Basis Accounting Method vs. Accrual Accounting Method
What it does
|Financial transactions are recorded when the expenses are paid, and revenue is received in the bank account.||Financial transactions are recorded when the expenses and revenue are incurred.|
Who uses it
|Small businesses or entrepreneurs opt for cash accounting.||Large companies with a massive volume of inventories benefit from accrual accounting. IRS requires accrual accounting for many companies whose average annual revenues exceed $25 million|
|Easy to understand and use||Complex and comparatively difficult to use|
|Cash accounting does not include all transactions, so its accuracy is doubtful.||It is a more accurate method of accounting.|
What is it used for
|We can see the total cash balance the business has generated at the moment.||We can check a business’s profit or loss during a particular period.|
What it includes
|Only cash expenses and revenue||All expenses and revenues, including cash, credit, etc.|
|If the owed revenue is not received yet, the tax is not paid on that money.||Irrespective of the payment’s receipt status, tax is also paid on the owed amount.|
7. How Software Can Help with Cash Accounting
Accounting software will help your business deal with cash accounting more efficiently.
- It can help automate and streamline accounting processes.
- It improves the accuracy of accounting activities.
- It takes care of compliance on your behalf.
- Accounting software can create basic financial reports that provide insight into the financial health of your business. It helps in analyzing and building a business budget.
- You can create customized invoices and export them to PDF or other formats.
- Accounting software lets you sync your bank account to software, so all the transactions are updated in real-time.
1. What Is a Cash Accounting Example?
Company Y sold stationery worth $200,000 to Company X in December 2020.
But Company X paid ₹100,000 in cash and the remaining ₹100,000 in credit. Since cash accounting only records cash flows, your revenue reported would only include cash, i.e., ₹100,000, and not the ₹100,000 on credit.
Consider the same scenario, but here Company X paid the whole ₹200,000 to Company Y in cash in January 2021. Since the revenue was received in 2021, it will be reported in 2021 and not the year the sale occurred, i.e., 2020.
2. What Is Cash Accounting vs. Accrual?
Cash and Accrual accounting are accounting methods businesses use to help with their daily accounting needs. The main difference between cash and accrual accounting is when the financial transactions are recorded.
In Cash Accounting, the transactions are recorded when the incurred expenses are paid, and the invoiced incomes are received. That is, the transaction gets recorded only when the cash exchanges hands. This gives us the total cash balance of the business at the time.
In Accrual Accounting, the transactions are recorded when the expenses and revenue are incurred. Irrespective of the receipt status of the cash, the transactions are logged when incurred. This method gives a more accurate picture of the performance of the company.
4. How Do You Record Cash In Accounting?
Cash is recorded in accounting using cash accounting software. It records the income when it is received in the bank and the expenses when they are paid. In short, the cash flow is recorded when the payments are made.
5. Who Uses Cash Accounting?
Small businesses, freelancers, and entrepreneurs with new businesses are the ones who would benefit from Cash Accounting. Revenue procedure 2000-22 allows any company that meets a sales test to use the cash method of accounting for tax purposes.
Large businesses use Accrual Accounting for better efficiency.
6. What are the Components of a Cash Flow Statement?
The three main components of a cash flow statement are
- Cash flow from operations
- Cash flow from investing
- Cash flow from financing
7. What is Cash in Accounting Terms?
The cash mentioned in accounting refers to the tangible bills and coins, checks, bank balances, and money orders exchanged for goods or services. It can also refer to the value of assets that can be liquidated immediately.