What is Cash Basis Accounting?
Cash basis accounting is the recognizing of cash only when received and not when earned. Income from credit accounts is not included in cash basis accounting until in the businesses account. The accounting for expenses paid is when the business pays them, not when incurred.
Who Uses Cash Basis Accounting in Business?
Cash basis accounting is normally only used by individuals, very small companies or firms that deal almost exclusively in cash. If a firm or individual is cash rich, with high, positive cash flow then cash basis accounting is easy to manage and is a suitable accounting method to use.
How does Cash Basis Accounting Work for Business?
With cash basis accounting the sales involving cash only are the ones appearing on the firm’s books, as are any expenses paid in that accounting period. If, for example, a store selling sneakers uses cash basis accounting, the storeowner may only account for sales when receiving the cash for any pair of sneakers sold. The owner does not include sales done via credit card or from a credit account, only when the payment hits the account. Expenses too are from when the store pays them. At the end of an accounting period, the storeowner calculates cash flow from that in the account and from any expenses paid during the time.
Drawbacks in Cash Basis Accounting
A company or individual using cash basis accounting risks having a misleading account of their business. If the owner pays expenses such as bills and wages while not including all the sales, the balance may look poor in the accounting books. It may appear that the business has a poor or negative cash flow, which may lead to problems with credit facilities. On the other side, the store may look cash rich if there are few expenses in the accounting period. This is particularly dangerous if expenses occur, such as stock purchased on credit, but not accounted for in the store’s accounts. The storeowner may invest elsewhere or take a higher salary, though in fact the business cannot afford it at that time.
Due to the inaccuracies in cash basis accounting a business may not look good to potential investors as cash flow is poor or many expenses are outstanding. As these problems can lead to many other difficulties, such as financing and banking ones, most companies prefer not to use cash basis accounting, opting instead for the more accurate accrual accounting method of keeping the business accounts.