cash basis accounting

cash basis accounting

Benefits of Cash Basis Accounting

1. Introduction to Cash Basis Accounting

Under the cash-basis of accounting, the accounting process begins with the recognition of cash as the primary means of measurement and the basis for recording all business transactions during an accounting period. The other major elements of the cash-basis of accounting include an emphasis on the accounting equation (Assets = Liabilities + Equity), income measurement based on cash receipts and cash payments (revenue is recognized when cash is received and expenses are recognized when cash is paid), and updating account balances (providing the accounting and business information) at the close of each accounting period by closing out the revenue and expense accounts to the income summary account and subsequently posting the associated account balances to the balance sheet accounts.

This article is a high-level overview and analysis of the differences and benefits of using cash-basis accounting instead of traditional accrual accounting standards as taught in most business schools. It is not meant to be an in-depth study of Generally Accepted Accounting Principles (GAAP), nor a complete representation of accrual accounting. Instead, it serves to challenge the status quo of the accounting industry, the educational system, and the falsity that cash-basis accounting is somehow superior to traditional GAAP, especially for small, non-public, and non-publicly traded businesses. Most small business owners may want to keep it simple and use the cash basis; it’ll help them stay organized, keep the money flowing, and get paid without too much hassle or the need to understand the intricate details of GAAP.

2. Advantages of Cash Basis Accounting

Businesses with less than $25 million in gross receipts during the three-year period are eligible to use the cash basis method. The Internal Revenue Code allows businesses that meet the revenue test to utilize the cash basis method exempting them from the elaborate rules generally associated with the accrual method of accounting. Corporations can also use the cash basis method of accounting if it meets the $25 million gross receipts test. Post-lobbying activities typically associated with any new tax legislation, this test would revert back to the current $5 million gross receipts level beginning in the year 2005. With the massive changes experienced in the record keeping requirements affecting individual and corporate taxpayers, it is inconceivable that a new tax act would regard the lower threshold as representing a tenable basis for a growth plateau. While the business requirements were debated at length and were ultimately resolved with a compromise, the decision was made to take real estate developers well beyond the $25 million threshold and out of the reach of the simple record keeping that is enjoyed with the cash basis methods.

The cash basis method of accounting for income tax purposes is the methodology with which most real estate investors are generally familiar. Real estate developers and other real estate professionals are generally required to use the accrual basis method of accounting. This discussion is intended to take an in-depth look at the cash basis method of accounting. The cash basis method offers many advantages for those taxpayers entitled to utilize this form of accounting. These points go beyond the obvious benefits that are inherent in cash basis accounting. There is the notion on the part of some real estate professionals that the cash basis method is audited more frequently and consequently requires greater vigilance in the substantiation of expenses.

3. Limitations of Cash Basis Accounting

(d) No Realization Concept: The concept of realization is not considered as a basis of recognition of revenues as the transactions are recognized as revenues when cash is received and not when the sale of goods or services is made or services have actually rendered. Or to say when products are produced. Thus, the cash basis does not comply with the accounting principle of realization of revenues and recording of expenses.

(c) Inflating Income: At the time when transactions relating to the receipt of income in advance, like interest on securities, rent on buildings, commission, etc., are not recorded in the cash basis of accounting, these are treated as cash payments made. As a result of this, overestimations of actual income will occur if not taken as revenue in the subsequent years.

(b) Omission of Transactions: Many times, transactions are not recorded in the cash basis of accounting, like transactions dealing with the purchase of machinery and other fixed assets, payment of salaries for employees, revenues that have to be paid in advance, etc. These transactions are not recorded in the cash basis of accounting. It leads to less information and sometimes may become misleading.

(a) Relevance: Usually, all transactions which occur in the life of a business are not recorded primarily in the cash basis of accounting. As a result of this, the financial statements prepared under this basis ignore those expenses which are to be paid in the future and call those revenues earned in advance as income which are yet to be received in cash. This leads to a descent in the truth and fairness of the profit of concern.

Cash basis of accounting, like any other thing in the world, is not free from limitations. There are some major limitations of it, and they are explained below:

4. Factors to Consider when Choosing Cash Basis Accounting

Cash basis accounting is particularly helpful in tracking whether or not you have enough money to pay your bills. This is especially the case if your business can be cyclical and doesn’t have regular income. You won’t have to estimate large inflows of sales or other revenue until the money is actually in the bank. Plus, you won’t report revenue until it’s received, reducing the chance of having to pay income taxes on money you may never receive. This also lets you simplify your revenue tracking for income taxes. In a down economy, cash flow can be a major problem for a growing small business. Generating revenue isn’t a problem with most companies; collecting the revenue can be. Cash basis accounting helps you see how much cash you actually have and when you expect to have more coming.

One of the benefits of cash basis accounting is that it’s simple to understand and use. You don’t need as much accounting knowledge as you would if you were using generally accepted accounting principles, or GAAP. You simply track when money enters and leaves your business and that’s it. Every small business owner has limited time and money to spend. Because cash basis accounting is relatively simple, you don’t need to spend as much time on it. You don’t have to prepare complicated financial statements or learn as many rules. As an entrepreneur, the time you save on accounting can be used to serve your customers, develop marketing campaigns, or improve your products and services. Plus, if your business is very small with few transactions, you can prepare the statements yourself each accounting period.

When running a small business, you have the option of using the cash basis of accounting for your financial statements. This method recognizes expenses when you pay them and revenue when you receive it. It’s a simpler method that many entrepreneurs prefer. Consider the factors when choosing cash basis accounting.

5. Conclusion

Transaction processes and recording under cash basis can also help develop business management. The company can better understand how it actually buys goods, collects money, and settles its liabilities. Better management certainly leads to better performance. Although cash basis accounting has been relegated by generally accepted accounting principles as a reporting process, cash basis accounting remains available for tax reporting purposes. As long as the requirements are fulfilled, accounting standards actually allow companies to report their financial conditions using cash basis. There has been questioning about the fairness and reliability of cash basis accounting. However, the method actually provides some benefits that every business can take advantage of.

Cash basis accounting is a simple method, and as a result, it is relatively cheaper than its counterpart, accrual accounting. It is easy to maintain and requires no extensive knowledge about accounting. Even though most of the time, cash basis accounting produces a relatively lower net income number than what it should be under accrual basis accounting, the method actually allows the business to have a solid insight into its liquid assets and expenses since these records are required for basis calculation and tax purposes.