Accounting consists of many methodologies and systems that can be confusing or overwhelming, especially to those who have only begun dipping their toes into the world of finance. One of these accounting systems is known as cash basis accounting, which is what we’ll be explaining thoroughly and in simple terms in this article.
What Is Cash Basis Accounting?
Cash basis accounting is one of the many accounting systems present in finance, and it only recognizes revenues and expenses when cash payment has already been exchanged and confirmed. In other words, cash basis accounting doesn’t recognize income received from credit accounts, and both expenses and income will only be considered once actual payment is paid for or received.
This method is usually used by small businesses or individual sellers who only transact in cash. That being said, if you’re interested in using this particular accounting system for your business, you need to know that cash basis accounting is not acceptable under the International Financial Reporting Standards (IFRS) as well as the Generally Acceptable Accounting Principles (GAAP).
Cash Accounting vs. Accrual Accounting
Asides from cash basis accounting, you’ve probably heard of accrual basis accounting, too. However, how do these two accounting systems differ from one another? Well, as you now know, cash basis accounting only considers revenues and expenses once actual payment is made or received. Accrual basis accounting, on the other hand, recognizes revenues and expenses when they’re earned, which means it can still consider income from credit accounts.
If you’re running a business, then you need to know that the accounting system you choose to use plays a major role in how your business progresses. To give you a better comparison between these two methods, we’ve made a simple guide containing the key differences:
|Basis Method||Cash Basis||Accrual Basis|
|How easy is it to use?||Simple and straightforward. It doesn’t require a lot of effort to understand and use||A bit more complex, but it’s more commonly used by businesses|
|Definition||Revenues and expenses are only recognized and recorded as soon as actual money has been exchanged||Revenues and expenses are recognized and recorded at the time when the sale or purchase was made|
|Does it have credit accounts?||You won’t find any records of receivable or payable accounts because all transactions are done in cash||You’ll find accounts receivables and account payables, which allows you to see a clearer picture of the company’s profits|
|What’s the net income?||This method bases its net income on the actual money received and disbursed||This method bases its net income on the earned revenues and incurred expenses|
|What does the balance sheet look like?||There are certain assets and liabilities that won’t be included in the balance sheet||The balance sheet is fairly complete, and you’ll find reports of liabilities, assets, and more|
|Accounting Standards||Not accepted by GAAP and IFRS||GAAP and IFRS requires it|
|Who uses this method?||Mostly used by non-profit organizations, small service-based businesses, and the like||Mostly used by public companies or any other organization where they have to file audits and financial statements|
Choosing What’s Right For You
Most businesses change and morph as they age. Their accounting requirements will differ. It’s why a lot of business owners end up doing their own accounts for the first year or so, but need to hire an accountant afterward. Try to forecast what you think your business will need. For example, if you’re going to be looking at a right of use asset and using leased items you’d be better off settling on accounting on an accrual basis because lease accounting is generally covered by covenants under GAAP and GASB 87. Remember, cash-based accounting isn’t accepted by IFRS or GAAP accounting standards. Knowing this at the outset can save you a lot of bother later on. You can change from one to the other, but it’s better to pick the right accounting basis from the start.
Without a doubt, some businesses prefer to use cash basis accounting it’s easy and straightforward. This is a great method to use for those individuals who don’t have a lot of knowledge relevant to financial accounting just yet and don’t want to hire the help of an accountant. But it does have a downside, which is the fact that it can be difficult to have an accurate picture of how your business is doing financially.