What Is Cash Accounting?
Cash accounting focuses on cash inflow and outflows. Accordingly, it considers only the cash received during an accounting period as revenue and cash paid during the same period as expenses and accordingly prepares its Financial Statements.
It is so easy to maintain because one can quickly track the expenses and revenue by looking at the cash balance. Also, 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.
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Cash Accounting Explained
The cash accounting basis is an accounting method is which the recognition of income and expenses take place only when the actual cash inflow and outflow happens. Wjen the payment is received by the business, it is recorded as revenue and when payment is made it is recorded as expense.
Small business usually use it because it is simple to maintain and easy to record. However, it may not always show the actual financial condition of the business. This is due to the fact that this kind of accounting does not take into consideration the revenues or expenses that may happen in future.
In some countries, it is compulsory to use the The cash accounting basis to record transaction if the business turnover is less than a certain level.
A big company can’t follow cash accounting method. But what sort of companies can follow this accounting? In simple terms, when would this accounting be sufficient? Here are a few conditions which need to be fulfilled for this accounting to be adequate.
- When it is a very small business and the business is either sole-proprietorship or partnership.
- When there is only need to record a few financial transactions.
- When the business has very few employees.
- Owner does not need to record income statementRecord Income StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., balance sheets, or any other financial statements as a company.
- As a company, it never does business with credit. Every transaction (most of it) is in cash.
- The business also has very limited fixed capitalFixed CapitalFixed capital refers to the investment made by the business for acquiring long term assets. These long term assets don’t directly produce anything but help the company with long-term benefits..
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 sells its finished products in cash.
But what if Company ABC would sell its finished products for $100,000 in cash and another $100,000 in credit! According to cash accounting method, only $100,000 would be recorded as cash revenue and not another $100,000, sold on credit. However, if we look at the accrual basis of accountingAccrual Basis Of AccountingAccrual Accounting is an accounting method that instantly records revenues & expenditures after a transaction occurs, irrespective of when the payment is received or made. , $200,000 would be recorded as the company’s revenue.
Let’s look at another example.
Let’s say that Company MNC has used large machinery for a few years now. Every year, the company assumes depreciation of $4000 on this machinery as wear and tear so that after a few years of use, this machinery can be replaced by a new one.
This depreciation wouldn’t be counted as expenses according to cash basis accounting. It wouldn’t be recorded because there’s no cash involved in the depreciation expenses Depreciation Expenses Depreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. and non-cash expenses.
As we can understand, cash accounting rules have few benefits and a few demerits. Let’s first look at the benefits –
- Simple: As a business, it has to choose one of the accounting methodsAccounting MethodsAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.. If the business selects this accounting, it’s the simplest because it will only record transactions 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, the maintenance of cash accounting is pretty straightforward. It will record revenue when cash is received from customers, andl record expenses when cash is paid to suppliers.
- Liquidity: Since it is only about cash transactions, the potential investors who would like to invest in the business don’t need to go through any liquidity ratio. S/he can look at the accounting systemAccounting SystemAccounting systems are used by organizations to record financial information such as income, expenses, and other accounting activities. They serve as a key tool for monitoring and tracking the company's performance and ensuring the smooth operation of the firm., look at the cash inflow and cash outflow, and then find out for herself/the business’s net cash flow.
- Single-entry accounting: This 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.
There are also a few demerits to the cash accounting system. Here are they –
- Not very accurate: Since it is only recorded cash transactions and doesn’t include all the transactions. As a result, we can’t say it is very reliable. Plus, under this accounting, revenue or expenses are recorded when the company receives or pays cash, even during the different accounting periods.
- Not recognized by Companies Act: Few businesses follow this accounting, but it is not a recognized method under the Companies Act. As a result, This isn’t practiced by big companies.
- Chances of discrepancies: The cash accounting rules only records cash transactions, the business can be involved in unfair practices by hiding the revenue or inflating the expenses.
Cash Accounting Vs Accrual Accounting
Let us look at the basic differences between the two topics given above.
Under the former, revenue and expense is recognized as and when they are received and paid, whereas for the latter, the revenue and expense is recognized as and when they are earned or earned.
The cash accounting system may not provide the actual or true picture of the financial health of the business because many transactions are not recorded in the books which have already happened but the cash has not changed hands but the latter shows the true picture of the business because transactions are immediately recorded as and when they happen.The former is easy and simple to record whereas the latter is complex due to the fact that each and every transaction is recorded even though cash has not ben exchanged.
The former is suitable for small businesses but for bigger business houses the latter is better because it will help in keeping a clear track of transactions.
Cash Accounting Video
This has Guide to what is Cash Accounting. We explain its differences with accrual accounting, along with example, advantages & disadvantages. You may also have a look at these accounting articles to enhance your knowledge.