What is Cash Accounting?
Cash accounting is a type of accounting which focuses on cash inflow and cash outflow. And at the end of the day, cash accounting helps us find out how much net cash a business has earned during a particular period of time.
Cash basis of accounting would consider cash received as revenue and cash expended (paid) as expenses.
Even if this method is not recognized under Companies Act, many companies maintain cash basis of accounting; because it’s easy to understand and easy to maintain.
Cash basis of accounting is so easy to maintain because one can simply track the expenses and the revenue quickly just by looking at the cash balance.
Another characteristic of cash basis accounting is that the business doesn’t need to show forth the taxes. Since everything happens in cash, there is no proof of earning and as a result, the company doesn’t need to pay any taxes until the cash is put into the bank. This also enhances the chances of discrepancies.
Example of Cash Accounting
Let’s look at an example of cash accounting.
Let’s say that Company ABC has sold finished products of $200,000 in cash. According to cash accounting, this entry will come under cash revenue since the business is selling its finished products in cash.
But what if Company ABC would sell its finished products of $100,000 in cash and another $100,000 in credit! According to cash basis accounting, only $100,000 would be recorded as cash revenue and not another $100,000 which was sold on credit. If we look at the accrual basis of accounting, $200,000 would be recorded as the revenue of the company.
Let’s look at another example.
Let’s say that Company MNC has large machinery which has been used for few years now. Every year, the company assumes depreciation of $4000 on this machinery as wear and tear so that after few years of use this machinery can be replaced by a new one.
According to cash basis accounting, this depreciation wouldn’t be counted as expenses and wouldn’t be recorded because there’s no cash involved in the depreciation expenses and it’s totally non-cash expenses.
Advantages of Cash Accounting
As you can understand cash accounting has few benefits and few demerits. Let’s first look at the benefits –
- Simple: As a business, you have to choose one of the accounting methods. If you choose cash accounting, it’s the simplest because you will only record transactions that are related to cash. Other transactions won’t be taken into consideration.
- Maintenance is easy: Maintaining an accrual system of accounting is tough. Compared to that maintenance of cash accounting is pretty easy. You will record revenue when cash is received from customers and you will record expenses when cash is paid to suppliers.
- Liquidity: Since cash accounting is all about only cash transactions, the potential investors who would like to invest in the business doesn’t need to go through any liquidity ratio. S/he can look at the accounting system, look at the cash inflow and cash outflow and then find out for herself/himself the net cash flow of the business.
- Single-entry accounting: Cash accounting is single entry accounting. That means the effect occurs only on one account. It makes things easier for the business and the business also doesn’t need to follow the matching concept.
Disadvantages of cash accounting
There are also few demerits of cash accounting. Here are they –
- Not very accurate: Since cash accounting only records cash transactions, cash accounting doesn’t include all the transactions. As a result, we can’t say that cash accounting is very accurate. Plus under cash accounting revenue or expenses is recorded when the company receives or pays cash, even in the different accounting period.
- Not recognized by Companies Act: Few businesses follow cash accounting, but it is not a recognized method under Companies Act. As a result, cash accounting isn’t practiced by big companies.
- Chances of discrepancies: Since cash accounting only records cash transactions, the business can be involved in unfair practices by hiding the revenue or inflating the expenses.
When is cash accounting sufficient?
A big company can’t follow cash basis accounting. But what sort of companies can follow cash accounting? In simple terms, when cash accounting would be sufficient? Here are few conditions which need to be fulfilled for cash accounting to be sufficient –
- When you have a very small business and the business is either sole-proprietorship or partnership.
- When you only need to record few financial transactions.
- When you have very few employees.
- As a company, you don’t need to record income statement, balance sheet or any other financial statements.
- As a company, you never do business with credit. Every transaction (most of it) is in cash.
- You also have very limited fixed capital.
This has been a guide to what is Cash Accounting, their examples, advantages, and disadvantages etc. You may also have a look at these accounting articles to enhance your knowledge
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