Cash Accounting

What exactly is Cash Accounting?

Cash accounting typically refers to a way of accounting in which payment receipts are recorded in the period in which they are received, and expenses are recorded in the period in which they are paid. In other words, revenues and expenses are recorded when cash is received or given.

Cash accounting, also known as cash-basis accounting, differs from accrual accounting in that it recognizes income when revenue is produced and when obligations are recorded, regardless of whether cash is received or paid. However, cash accounting records the entry only after cash has been transacted.

In-Depth Understanding of Cash Accounting

Cash accounting is popular among small firms because it is simpler and more valuable and offers a clear view of the company's financial situation. When transactions are recorded on a cash basis, the firm's records are delayed from completion. This is why cash accounting is much less accurate than accrual accounting in a short period.

The majority of small firms have the option of using either cash or accrual accounting procedures. Nonetheless, the IRS mandates corporations with yearly gross sales of more than $25 million to employ the accrual approach. The Tax Reform Act of 1986 restricts C companies, tax shelters, certain trusts, and partnerships with C Corporations partners from using cash accounting. For tax reporting, businesses must use the same accounting approach that they usually follow for internal bookkeeping.

What are its Advantages/Disadvantages?

As we often see, there are always two sides to a coin, and that is also true for cash accounting. This accounting offers both advantages and disadvantages. Let's start with the advantages:

Advantages

• Simple: One must select one of the simplest accounting procedures as a business. This accounting method is the easiest since it will just record monetary transactions. However, additional transactions have to be taken into account.
• Maintenance is Easy: The upkeep of cash accounting is rather simple. As cash is received from clients, revenue is recorded, and expenditures are recorded when cash is given to suppliers.
• Liquidity:Potential investors who want to invest in the firm do not need to go through any liquidity ratio because it is solely about cash transactions. One may simply look at the accounting system, the cash inflow, and outflow and then calculate the net cash flow for the firm.
• Single-Entry Accounting: This is referred to as single-entry accounting. That is, the effect happens solely on one account. That simplifies things for the business and eliminates the necessity for the matching concept.

Disadvantages

There are some drawbacks as well. Here they are:

• Not very Accurate: As said earlier, it only includes recorded cash transactions and does not include all transactions. As a result, we cannot claim that it is highly reliable. Moreover, income and costs are recorded when the corporation gets or pays cash, regardless of the accounting period.
• Not Recognized by Companies Act: While only some organizations use this way of accounting, it is not recognized by the Companies Act. As a result, large corporations do not practice this.
• Chances of Discrepancies: Because it exclusively records monetary transactions, the company may engage in unethical tactics such as concealing revenue or exaggerating expenditures.

Cash Accounting Example

Suppose Company X receives ₹1,00,000 from selling ten computers to Company Y on November 2 and reports the transaction as having occurred that day. Company Y purchased the computers on October 5 but only paid for them once they were physically delivered on November 2.

In this case, following the cash accounting, Company X would simply record the ₹1,00,000 transaction on November 2 after receiving the payment. In contrast, under accrual accounting, Company X would have recorded the ₹1,00,000 transaction on October 5, even though no money changed hands.

As said above, costs are recorded in cash accounting when paid rather than incurred. In cash accounting, if Company Y hires Company Z for pest treatment on January 15 but does not pay the invoice until February 15, the expense is not recorded until February 15. Yet, the expenditure would be recorded in the books on January 15, the date it was incurred, under accrual accounting.

When is Cash Accounting considered ideal?

While there may be many reasons that one may choose cash accounting, we discuss some ideal use cases for this accounting to be an adequate approach. The cash accounting can be a good option:

• When someone owns a small business that is either a sole proprietorship or a partnership.
• When only a few financial transactions need to be recorded.
• When a company has a small number of employees.
• When a company does not need to record income statements, balance sheets, or any other financial statements.
• When someone never does business on credit as a company. Every transaction is made in cash.
• When someone has very little fixed capital.

The Bottom Line

The advantages of utilizing cash accounting exceed the disadvantages. Nevertheless, it does not provide a comprehensive picture of the firm since it only records some transactions regardless of when they occur. Numerous additional constraints make it inappropriate for most businesses. However, it is the primary mechanism through which organizations record their transactions. It gives more transparency to stakeholders, which is beneficial when attempting to retain confidence with a diverse set of partners.