Is Cash a Basic Accounting Method?
Cash is a recognized method of accounting used by many small businesses. It's based on cash transactions and usually doesn't involve the recognition of accounts receivable and payable. On a cash basis, when a firm receives money, it recognizes revenue and when it pays a bill, it recognizes an expense. In this context, the word "cash" means cash, credit cards and checks.
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Benefits
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Accounting using the cash basis is simple and easy to understand. A small-business owner can gauge if his firm is doing well by reviewing money going in and out of the business bank account. It's straightforward. Many businesses start using the cash method and then, as they grow, switch to the accrual method.
Another benefit of the cash basis is that business owners can manipulate income and expenses, potentially saving taxes. He can decide to pay certain bills ahead of time or ask customers to pay him a bit late, allowing him flexibility on the timing of income and expenses.
Types
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Cash-basis accounting can be classified as two types: Pure cash and modified cash. Pure cash accounting only considers money coming in and out. Financial statements compiled under the pure cash basis basically show summaries of receipts and disbursements..
The modified cash basis of accounting follows the same idea for cash receipts and disbursements, but it adds some of the accrual items, such as capitalization and depreciation. Modified cash basis is also known as a hybrid method.
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Disadvantages
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A main disadvantage of cash is that is not accepted by the generally accepted accounting principles (GAAP) in the U.S. Publicly owned companies cannot use this method and must employ the accrual basis of accounting.
The cash basis of accounting doesn't match revenue with expenses properly. While this method provides flexibility that may minimize taxes, it also can skew revenues and expenses. For example, a firm pays sales commissions in January for sales that happened in the prior year. Under the cash basis, the expense will happen in January even though the actual revenue related to the expense transaction happened the year before.
Warning
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Specific situations prevent a business from using the cash method of accounting; instead they must use the accrual basis. These situations are: a firm is a C corporation or a partnership with a C corporation as a partner or a tax shelter. Exceptions to these situations are businesses with less than $5,000,000 in average annual gross receipts, farms, and qualified personal-service corporations. Furthermore, all public companies in the U.S. must be on the accrual basis -- cash basis is not acceptable.
Considerations
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Many businesses use cash basis throughout the year and then they convert to accrual basis at year-end. In order to convert to accrual, accountants look at bills not yet paid and revenue not yet received. They may also look for prepaid expenses -- expenses paid related to future periods, such as insurance policies paid for two years. Accountants could make adjusting entries for revenue received but services not yet performed. They may also make adjustments for inventory numbers and cost of goods sold.
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