By recording income as soon as money is received and expenses as soon as money is paid out, cash-based accounting allows businesses to keep tabs on their financial situation. To put it briefly, cash-based accounting only records transactions that involve the exchange of money. There are benefits and drawbacks to using cash-based accounting. The suitability of the cash basis method will depend on the specific facts and circumstances of the firm.
Cash Basis Accounting: What Is It?
With an emphasis on cash-on-hand, cash-based accounting is an accounting technique used to monitor a company's inflow and outflow of cash. The cash method of accounting is a streamlined approach that is helpful for small firms because it merely records income received and money paid out, regardless of when goods and services are sold or received.
Important Cash Basis of Accounting Financial Statements
When employing this accounting approach, three essential financial statements should be used:
1. Cash Flow Statement
The cash flow statement of your business provides information on all incoming and existing funds for a specific period. In addition to monitoring the inflow and outflow of funds, it can serve as a summary of the company's revenue generation performance.
Also read: Fund Flows Explained: Importance, Benefits, and Limitations
2. Income Statement
As a snapshot of the company's financial situation as of a specific date in a fiscal year, your income statement is also referred to as a profit and loss statement since it examines the revenue and expenses your business is reporting over a given period.
3. Balance Sheet
A statement that lists all of your company's assets and liabilities is called a balance sheet. Revenues are recorded in cash accounting only when money is received, while expenses are recorded only after money has been disbursed.
Example of Cash Basis Accounting
Let's say you own a small bakery that specializes in making personalized cakes. On April 5, a $1,000 wedding cake is ordered by a customer, and on April 10, the cake is delivered. But on April 15, the client makes the payment for the cake. The $1,000 sale would be recorded using cash basis accounting on April 15th, when the payment is received, rather than on April 5th, when the order was placed, or April 10th, when the cake was delivered.
In a similar vein, you would record the $200 spent on April 20, the day the payment was made, if you had bought $200 worth of baking supplies on April 7 but hadn't paid the supplier until then.
Benefits of Cash Basis Accounting
These are a few of the main benefits of employing the cash accounting approach.
1. Simple to Understand
Compared to other accounting techniques, cash-based accounting is typically easier to comprehend. Since revenue and costs are recorded as soon as they are received and do not need to be broken out over longer periods, recordkeeping is simple. You might not need to hire a professional accountant if you decide to use the cash method for your small business.
2. It Needs Fewer Employees
You probably won't need to engage a full-time accountant if you choose to use a cash-based accounting system. It is a straightforward procedure that does not call for an intricate accounting system. To track cash flow, all you'll need is bookkeeping software.
3. A System of One Entry
A sophisticated accounting program isn't necessarily required when using the cash technique because it can be done using a straightforward single-entry system. When accruals are not booked, month-end bank reconciliations ought to be simpler. However, there are disadvantages to single-entry systems as well, which are listed below.
Drawbacks of Cash Basis Accounting
These are some of the disadvantages of employing the cash method of accounting.
1. One-Entry Method
Although the cash method's single-entry system's ease of use can be advantageous, there are drawbacks as well. The double-entry system, which is based on accounting equations, is required when using the accrual approach. The goal of these traditional accounting principles is to give a more consistent and accurate picture of profit and loss so that company analysis may be conducted.
2. It's Just a Temporary Measurement
The overall financial status of your business could not be accurately depicted by cash accounting. It is extremely binary and ignores subtleties such as transaction processing time, inventory levels, and incurred costs.
3. It might mislead investors.
Accounts payable are not reported by cash accounting, which could make the business appear far more lucrative than it is over a given time frame. If there are numerous outstanding bills, investors may subsequently make assumptions about the company's profitability when, in reality, it is experiencing financial difficulties.
In Conclusion
A straightforward and useful choice for small enterprises, cash-based accounting provides a clear picture of cash flow and ease of use. It is less appropriate for companies with intricate financial requirements, nevertheless, due to its drawbacks, which include a limited financial viewpoint and the possibility of deceiving investors. The particular needs of your company will determine which approach is best.
FAQ'S
1. What Distinguishes accrual accounting from cash-based accounting?
Accrual accounting documents income and expenses as earned or incurred, regardless of actual payment, whereas cash basis records transactions only when money exchanges hands.
2. Does GAAP compliance apply to cash basis accounting?
Cash-based accounting does not adhere to GAAP as it does not take the all-encompassing approach that these rules need.
3. For whom is cash basis accounting appropriate?
The ideal candidates are small firms, sole proprietorships, or independent contractors with simple financial activities and little funding for intricate accounting.
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