What is the Cash Basis of Accounting?

The cash basis of accounting is the practice of recording revenue when cash has been received, and recording expenses when cash has been paid out. The cash basis is commonly used by individuals and small businesses (especially those with no inventory), since it involves the simplest accounting.

An alternative method for recording transactions is the accrual basis of accounting, under which revenue is recorded when earned and expenses are recorded when liabilities are incurred or assets consumed, irrespective of any inflows or outflows of cash. The accrual basis is most commonly used by larger businesses. A start-up company will frequently begin keeping its books under the cash basis, and then switch to the accrual basis when it has grown to a sufficient size. Accounting software can be configured to work under either the cash basis or the accrual basis of accounting, usually by setting a flag in a setup table.

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Example of Cash Basis Accounting

Grouch Electronics installs home theater systems. The owner, Bubba, completes a major install for a rich client in February. He bills the client $25,000, but is not paid until June, because the client turns out not to be so rich. He cashes the client’s check in June, and records $25,000 of revenue in his accounting records at that time. He does not record the $25,000 in February, when he completed the work, because he operates under the cash basis of accounting.

Advantages of the Cash Basis of Accounting

The cash basis of accounting has the following advantages:

Taxation. The method is commonly used to record financial results for tax purposes, since a business can accelerate some payments in order to reduce its taxable profits, thereby deferring its tax liability.
Ease of use. A person requires a reduced knowledge of accounting to keep records under the cash basis. Several accounting software packages are designed for the cash basis of accounting, to make them easier to use.

Disadvantages of the Cash Basis of Accounting

The cash basis of accounting also suffers from a number of problems, as outlined below:

Accuracy. The cash basis of accounting yields less accurate results than the accrual basis of accounting, since the timing of cash flows do not necessarily reflect the proper timing of changes in the financial condition of a business. For example, if a contract with a customer does not allow a business to issue an invoice until the end of a project, the company will be unable to report any revenue until the invoice has been issued and cash received.
Manipulation. A business can alter its reported results by not cashing received checks or altering the payment timing for its liabilities. This is commonly used to defer the recognition of taxable income to a later reporting period.
Lending. Lenders do not feel that the cash basis generates overly accurate financial statements, and so may refuse to lend money to a business reporting under the cash basis. However, this may not be the case for a small business that cannot afford the services of a CPA to prepare its books.
Audited financial statements. Auditors will not approve financial statements that were compiled under the cash basis of accounting, so a business will need to convert to the accrual basis if it wants to have audited financial statements.
Management reporting. Since the results of cash basis financial statements can be inaccurate, management reports should not be issued that are based upon it.

In short, the numerous problems with the cash basis of accounting usually cause businesses to abandon it after they move beyond their initial startup phases.