| Cash basis Cash-basis accounting is a method | | | | bookkeeping. |
| of bookkeeping that records financial events | | | | |
| based on cash flows and cash position. | | | | Comparison Using cash-basis accounting, |
| | | | income and expenses are recognized only when |
| Revenue is recognized when cash is received | | | | cash is received or paid out. |
| and expense is recognized when cash is paid. | | | | |
| In cash-basis accounting, revenues and | | | | Using accrual-basis accounting, receivables |
| expenses are also called cash receipts and | | | | and payables are recognized when a sale is |
| cash payments. | | | | agreed to, even though as yet, no cash has |
| | | | been received or paid out. |
| Cash-basis accounting does not recognize | | | | |
| promises to pay or expectations to receive | | | | Cash-basis accounting defers all credit |
| money or service in the future, such as | | | | transactions to a later date. It is more |
| payables, receivables, and prepaid expenses. | | | | conservative for the seller in that it does |
| | | | not record revenue until cash receipt. In a |
| This is simpler for individuals and | | | | growing company, this results in a lower |
| organizations that do not have significant | | | | income compared to accrual-basis accounting. |
| amounts of these transactions, or when the | | | | |
| time lag between the initiation of the | | | | A simple example A small business such as a |
| transaction and the cash flow is very short. | | | | fruit stand, which buys its inventory daily |
| | | | for cash at a wholesale market, sells the |
| Two types of cash-basis accounting exist: | | | | inventory for cash, and throws away what |
| strict and modified. Strict cash-basis | | | | didn't sell, can get an accurate picture of |
| follows the cash flow exactly. | | | | its profits or losses using cash-basis |
| | | | accounting. |
| Modified cash-basis includes some elements | | | | |
| from accrual-basis accounting such as | | | | A remodeling business that gives customers 90 |
| inventory and property capitalization. | | | | days to pay and that procures materials on |
| | | | account at the lumber yard, must use the |
| Issues with cash basis Cash-basis accounting | | | | accrual method to gain an accurate picture of |
| fails to meet GAAP requirements because it | | | | its financial condition. |
| does not adhere to the following two GAAP | | | | |
| principles: Revenue recognition principle - | | | | Either business will probably get a |
| revenue should be recognized when it is | | | | relatively accurate picture using either |
| realized (e.g. a credit sale) Matching | | | | method over a long period of time, except for |
| principle - revenue should be matched to the | | | | the transactions that have already begun that |
| expense if possible (e.g. | | | | are not yet closed. |
| | | | |
| sales to COGS) Additionally, cash-basis | | | | Other considerations Standard accrual-basis |
| accounting is not viable for cost accounting | | | | financial statements (profit statements and |
| in manufacturing operations because expenses | | | | balance sheets) do not indicate the cash |
| cannot always be correctly associated with | | | | inflows and outflows of a company. The |
| product costs. | | | | Statement of Cash Flows is created to |
| | | | indicate that information for accrual-basis |
| Example When you pay your rent, your landlord | | | | accounting. |
| would record an income event at the time he | | | | |
| receives your payment. The landlord would | | | | Accrual-basis accounting is more costly to |
| subsequently record an expense event when he | | | | maintain, because it requires the bookkeeper |
| pays the rental agent their fee for your | | | | to record a lot more transactions. However, |
| apartment. It is the accounting method used | | | | the advent of accounting software has made |
| by most individuals, and by some businesses, | | | | the difference between the reporting methods |
| that have limited payables or receivables or | | | | less significant. |
| whose income and expense cash flows are | | | | |
| closely associated with each other in time. | | | | Companies that have extended or used credit |
| | | | significantly should use (and in the United |
| Accrual basis Accrual-basis accounting | | | | States may be required by the Internal |
| records financial events based on events that | | | | Revenue Service to use) the accrual-basis |
| change your net worth (the amount owed to you | | | | method of accounting. The U.S. Securities and |
| minus the amount you owe others). | | | | Exchange Commission requires that all |
| | | | publicly traded companies follow GAAP, thus |
| Standard practice is to record and recognize | | | | all publicly traded companies publish their |
| revenues in the period which they incur and | | | | financial statements using accrual-basis |
| to match them with related expenses in a | | | | method. |
| process known as matching or expense | | | | |
| matching. Even though cash is not received or | | | | Three kind of external stakeholders should be |
| paid in a credit transaction, they are | | | | considered when deciding the reporting |
| recorded because they are consequential in | | | | method: creditors stockholders taxation |
| the future income and cash flow of the | | | | authorities For the creditors and |
| company. | | | | stockholders of large enterprises, cash basis |
| | | | accounting is financially inadequate. It does |
| Accrual-basis is GAAP compliant. | | | | not project the future cash flow of the |
| | | | company. |
| Example Your landlord would record an income | | | | |
| event on the day your rent comes due (you owe | | | | For tax purposes, cash basis accounting is |
| it to him). He records an expense event when | | | | highly favored because it defers tax burdens |
| the fee owed to the rental agent comes due | | | | until the cash is received. It is often used |
| for your apartment that month (he owes it to | | | | by small businesses and organizations that |
| the agent). The details of the actual cash | | | | are not required to use the accrual method, |
| flows and their timing are tracked by | | | | both for tax reasons and for its simplicity. |