Cash basis refers to a major accounting method that recognizes revenues and expenses at the time cash is received or paid out. This contrasts accrual accounting, which recognizes income at the time the revenue is earned and records expenses when liabilities are incurred regardless of when cash is received or paid.
What Is Cash Basis Accounting?
Under the cash method of accounting, transactions are recorded when cash is received or paid. In other words, revenue is recorded when cash payment is received for the sale of products or services, and expenses are recorded when cash is paid to vendors for purchases of products or services. Most small businesses and individuals operate on a cash basis and prepare their income taxes using this method.
Cash Basis Explained
When transactions are recorded on a cash basis, they affect a company’s books upon exchange of consideration; therefore, cash basis accounting is less accurate than accrual accounting in the short term. The Tax Reform Act of 1986 prohibits the cash basis accounting method from being used for C corporations, tax shelters, certain types of trusts, and partnerships that have C Corporation partners.
Example of Cash Basis Accounting
A construction company secures a major contract but will only receive compensation upon completion of the project. Using cash-basis accounting, the company is only able to recognize the revenue upon project completion, which is when cash is received. However, during the project, it records the project’s expenses as they are being paid. If the project’s time span is greater than one year, the company’s income statements will appear misleading as they show the company incurring large losses one year followed by great gains the next.
Benefits of Cash Basis Accounting
Cash basis accounting is advantageous because it is simpler and less expensive than accrual accounting. For some small business owners and independent contractors who carry no inventory, it is a suitable accounting practice. Many small businesses avoid employing accountants and using complex accounting systems when using this method because of its ease of use. It also gives an accurate picture of how much cash is on hand.
FAQs
What Is the Difference Between Cash Basis and Accrual Basis?
The main difference between the cash basis and accrual basis of accounting is the timing of when expenses and income are recorded in your financial statements. With the cash basis, you record transactions when the payment is exchanged. Accrual basis accounting records income as it’s earned and expenses when they are incurred. For example, if you pay for a business insurance policy in one lump sum at the beginning of the year, you would record this entire transaction on the cash basis when it’s paid. Using the accrual basis, you would record a portion of the cost each month over the entire year.
What Is Accrual Accounting?
Under the accrual method of accounting, rather than recording revenues and expenses when cash changes hands, revenues are recorded when earned and expenses are recorded when incurred. The IRS requires businesses that hold merchandise in inventory to use the accrual method.
An exception to this rule are those businesses that meet the definition of a “small business taxpayer” with an average annual gross receipts figure over the last three years of $26 million or less; these businesses are not required to use the accrual method.