Did you know that there are two different approaches to accounting for the income and costs of your company? Cash accounting and accrual accounting are the two approaches that can be used. The cash accounting approach is the more straightforward of the two, but the accrual accounting method is more difficult to implement but has the potential to present a more accurate picture of the financial health of your organisation.
Are you just getting started with cash accounting? If this is the case, continue reading for an explanation of this strategy as well as some pointers on how to get started. Cash accounting is a common kind of bookkeeping used by sole proprietors and other persons operating their own enterprises.
One of the factors contributing to its widespread adoption is the ease with which it can be comprehended and put into practise. In this article, we'll go over what cash accounting is, when it's useful, and how to get started utilising it right away.
The practise of tracking and reporting a company's income and expenses is referred to as cash accounting. Businesses employ this method. This method is not the same as accrual accounting, which is the approach that is most frequently employed in commercial enterprises. Small firms who are looking for a less complicated approach to keeping track of their money may find that cash accounting is beneficial.
In this piece, we'll go over the fundamentals of cash accounting, including how the method operates and some of the advantages associated with using it. In addition to that, we will offer a few suggestions for getting started with cash accounting.
Cash Accounting
Owners of businesses have the option of selecting between the cash basis accounting method or the accrual accounting method when making decisions regarding how to record income and costs. In addition to having an effect on the manner in which a firm maintains its records, the various techniques offer a variety of viewpoints regarding the financial success of the company.
The cash basis of accounting, as its name suggests, tends to present an accurate image of the cash reserves held by a corporation. In addition to this, picking it up won't take too much effort.
However, due to the fact that cash basis accounting does not represent incoming payments or commitments coming due, it can provide an incomplete picture of how healthy a company is. For example, it would not display forthcoming lease payments or the anticipated revenue from orders that have been booked but have not yet been shipped.
Additionally, because cash basis accounting does not match expenses with the income that is tied to them, it can create a picture of a company's performance that is deceptive and misleading. Because the timing of the income and expenses recorded depend, at least in part, on when companies and their customers issue invoices or pay their bills, the performance of a company may appear to fluctuate more under cash basis accounting than it does under accrual accounting. This is because the timing of the income and expenses recorded depends on the cash flow of the business.
Accrual accounting, on the other hand, records earnings and expenditures at the time they are earned or incurred, which results in a more "smooth" presentation of the company's financial position. For example, if a company uses the accrual method of accounting, it will record its payroll expense as the employees put in time on the job rather than when it actually transfers the money into their bank accounts.
A more complete picture of a company's profitability can often be obtained through the use of accrual accounting. It indicates revenue when the company offers items or services to a consumer in the expectation that money will be received. This could be in the form of a sale or a service rendered. Accrual accounting makes allowances for write-offs of uncollected monies in the (ideally infrequent) event that payments are not received.
Accounting on a Cash Basis versus Accounting on an Accrual Basis: A Brief History
It's possible that people have been trying to keep track of their income and expenditures for as long as they've been running businesses. In Mesopotamia, researchers have uncovered what appear to be ancient accounting documents that date back thousands of years.
In the 15th century, the Franciscan friar and mathematician Luca Pacioli published a book in which he described a method of record-keeping that was utilised by Venetian merchants. The accounting method that we now refer to as accrual accounting was largely influenced by Pacioli's writings.
During the intervening centuries, commercial enterprises expanded and became more technically advanced. And as a direct result of this, the academic field of accounting followed suit. Accounting became more important throughout the Industrial Revolution, which took place roughly between the 18th and 19th centuries, when a greater number of companies sought outside investors.
It should come as no surprise that many potential investors desired some sort of guarantee that they would make a profit from their investment in a company before doing so. In the midst of these events, in the year 1854, the Institute of Chartered Accountants of Scotland became the first accounting professional organisation anywhere in the globe. As time went on, several countries and regions all over the world began to organise themselves into professional organisations.
What exactly is accounting on a cash basis?
Companies that use cash basis accounting report income at the time it is really received, such as when a check is deposited, cleared, and cash is paid into the account. Expenses are recorded at the time a payment is issued by the company.
These dates may be different from the dates on which the company actually carries out an activity or incurs a cost.
When using the cash method, revenue is recognised when it is received, and expenses are recognised when they are paid. It is frequently utilised by sole proprietors and other small service organisations whose accounts are able to function on the basis of a straightforward cash in and cash out system.
Let's start with accounting based on the cash flow. Using this approach, you will record income and costs when they are received and paid for respectively. However, if you use cash basis accounting, your expenses will only be recorded when money is transferred out of your account and paid to third parties like as suppliers and vendors.
To put it another way, if you own a small stationery business and made a purchase of paper supplies in June using a credit card but didn't pay the account in full until July, you should count the cost of those materials as an expense for the month of July.
It is vital to remember that this strategy does not take into account any accounts receivable or accounts payable. This is something that should be kept in mind. This is due to the fact that it only applies to payments received from customers—whether they be in the form of cash, cheques, receipts for credit card purchases, or gross receipts—when payment is actually received.
For instance, a consultant might hand over completed work and submit an invoice right away, but the money might not clear their account for another month. Even if the labour was already done, under the cash foundation of accounting, they wouldn't be able to record the money until it was actually deposited into their account.
In the same vein, if they purchased some office furniture but chose to delay payment, they would only record the expense of the outbound item when the money was actually sent out of their account, not when the transaction was actually made.
Knowledge of Cash Accounting
One of the two types of accounting is known as cash accounting. The second method is known as accrual accounting, and it involves recording income and expenses as soon as they are incurred. Cash accounting is typically used by smaller companies since it is not only easier and more straight-forward, but it also paints a more accurate image of the amount of money that is actually available to the company.
When transactions are recorded on a cash basis, the effects of those transactions on a company's books do not occur immediately after the transaction has been completed. As a direct consequence of this, cash accounting is typically not as precise as accrual accounting in the short term.
Who Makes Use of a Cash Accounting System?
The cash basis of accounting is used frequently by self-employed professionals and owners of small businesses. What is the cause? In most cases, this is the most straightforward approach to accounting. The amount of money that is actually available to the company is also presented in a concise manner through the use of cash basis accounting. That metric is extremely important for any business.
Although cash basis accounting is ideal for many younger and smaller businesses, it is not appropriate for all businesses. Accrual accounting is something that the majority of smaller businesses who carry inventory will need to employ because it will help them to track changes in the inventory levels. Accrual accounting is something that must be used by the vast majority of companies who sell their services on credit.
Companies that utilise an accounting method known as cash basis only record income and costs when there is a monetary transaction. They wait until the invoices and bills have been paid before considering them to have been paid before counting them as income or expenses.
Cash basis accounting, despite its misleading name, has nothing to do with the method of payment that is received. You can still undertake cash accounting even if you choose to get paid electronically.
Examples of Accounting Done on a Cash Basis
Take, for example, a residential painting company that finishes a job in April, sends the homeowner an invoice, and then receives payment from the homeowner through credit card in May. In accordance with the cash basis accounting technique, the company records the income whenever payment is received, regardless of whether or not this occurs within a few weeks of the task being finished. There is a lag period between the moment the so-called "economic event" took place and the moment it was recorded.
On the other hand, suppose the house painter is responsible for the payment of an energy bill totalling $175 that covers the month of April. When using the cash method of accounting, the $175 is recorded as an expense for the month of May, despite the fact that it paid for services that were performed in April.
Suppose that, in accordance with the cash accounting technique, Company A realises a profit of $10,000 from the sale of 10 computers to Company B on November 2, and reports this transaction as having taken place on that date. The fact that Company B really placed the order for the computers on October 5 is disregarded as immaterial because the company did not pay for them until November 2, when they were physically delivered.
Accrual accounting, on the other hand, would have required Company A to record the sale of $10,000 on October 5 despite the fact that no cash had been exchanged at that point in time.
In a similar fashion, cash accounting requires businesses to record their expenses after they have actually paid for them, rather than when the expenses were incurred. In the case where Company C contracts Company D for pest treatment on January 15, but does not pay the invoice for the work completed until February 15, cash accounting dictates that the expense will not be recognised until February 15. However, if accrual accounting was used, the item would have been recorded in the books on January 15—the date it was first incurred—rather than later.
Cash Basis Accounting Benefits
The ease of use of accounting on a cash basis is something that many owners of small businesses find appealing. Even while it does not require as much bookkeeping to maintain as accrual accounting does, it nevertheless provides sufficient information for a large number of small businesses to be able to reasonably track their performance. It is a method that is very simple to train workers in finance to utilise. In addition, because it does not take into account future revenue or payments, it provides an accurate picture of the company's financial position at the present time.
Accounting on a cash basis is widely used in the world of small businesses since it is simple to understand and straightforward to keep up to date. When expenses are paid and income is received, it is abundantly clear that there is no requirement to keep track of accounts receivable and accounts payable.
This might be a significant benefit for companies who do not have their own accountants working for them on the premises. Nevertheless, the accrual technique has the potential to become overly complex in a short amount of time, particularly in situations in which some bills are paid in advance while others are paid in arrears. When determining whether or not it is time to record income, owners of businesses need to exercise caution because of the frequent need to transfer funds between their various accounts.
It should come as no surprise that using the cash technique also makes it considerably simpler for a corporation to keep track of its immediate financial situation. A fast glance at the bank account makes it very clear how things are currently standing. It is essential for owners of small businesses to be aware of the amount of cash that is currently available. When you use cash accounting, it is much simpler to ensure that there is always enough money in the bank to keep the business afloat.
Cash Basis Accounting Drawbacks
On the other hand, cash basis accounting might present an erroneous image of the performance of the organisation because it does not connect expenses with the income that they assist generate. Take for example a corporation that buys T-shirts in August for the price of $500 but then resells them in September for $700. Using the cash basis of accounting, it would show a loss of $500 in August (with the assumption that there were no other revenues or expenses), but it would show a profit of $700 in September. On its own, neither of these numbers can accurately portray how well the company is doing.
The fact that cash basis accounting is so straightforward is also one of its biggest weaknesses. Although it is helpful for giving business owners an immediate impression of the health of their bank balance, it may fail to demonstrate the wider picture in some cases.
When it comes to one's financial obligations, this might be an especially risky move. For instance, if a company decides to delay some costs in order to take advantage of a "buy now, pay later" offer, such costs won't be recorded in the company's books until the actual payment has been completed. This indicates that owners of businesses who use the cash method must be aware of future expenses and ensure that they have the finances available to cover them.
When comparing the effectiveness of different time periods, the cash basis method can also make things more complicated. A company might have a very busy January but not receive money until March, which is a month in which the company had very little activity to speak of. This is just one example of how this could happen. If one were to use cash accounting, the month of March would appear to be the more favourable option on paper because that is when the income was recorded.
After doing some research, it became obvious that January was the best month overall. However, keeping a clear image of busy and quiet moments during the course of a corporation that has a large number of income and spending items on the books is not always an easy task. This is especially the case when there is a significant time lapse between the period in which money is earned and the period in which it is recorded.
A lack of transparency on this scale can be detrimental for businesses for a wide variety of different reasons. To begin, business owners who run their companies utilising a cash basis method run the risk of being understaffed during times of high customer volume and overstaffed during times of low customer volume if they are not vigilant.
The accrual foundation of accounting may provide a more accurate representation of the company's performance than other methods of accounting since it takes into account both accounts payable and accounts receivable. This indicates that it may provide a stronger basis for planning over a longer period of time. Accrual accounting may be a prerequisite for working with certain lenders for businesses seeking financing.
How To Pick The Best Alternative For Your Business
The cash accounting method can be a convenient and reliable way to keep track of revenue and expenses without the need for a great deal of bookkeeping for small businesses that do business primarily through cash transactions and do not maintain large inventories of products. This method is ideal for businesses that do not maintain large inventories of products.
On the other hand, if you want an accounting view of your financial health that is both accurate and up to date. There are also some other considerations that must be taken into account.
The Complicated Nature Of Your Organisation
It's possible that one accounting approach is more tenable than the other, but that will depend on the nature of your business and how complicated your accounts are. For instance, a company that has multiple accounts, hundreds of employees, and various LLCs will probably want to steer clear of cash basis accounting because it won't give the company the big picture view it's looking for when it comes to the financials on the income statement, balance sheet, or cash flow statement. This is because cash basis accounting is based on the idea that all transactions are recorded immediately as they occur.
Sales income
The amount of money you would make from each sale is another consideration to take into account while making your decision. If your yearly sales is greater than $25 million, then you are required to adopt the accrual method in accordance with GAAP. This isn't a problem for the majority of small businesses right now, but it could become one in the near future, so it's important to keep that in mind.
Open to the Public Market
Another requirement of the GAAP standards is that the company must be publicly traded or have the potential to become publicly traded. Companies that are traded publicly have a responsibility to their shareholders to provide truthful information regarding the state of their finances. The accrual system of accounting is the most effective approach for doing this.
Continued Progress
Before continuing on with the rest of the items on your small business accounting checklist, it is absolutely necessary for your company to make the choice of which accounting method to utilise. That is not to imply that it cannot be altered at a later time; all that this means is that it will be more difficult to switch once you have become accustomed to one approach or the other. Accounting software and tools such as QuickBooks Live can be of assistance with either approach, and virtual accountants are available to guide you through each stage of the process.
Cash accounting is an accounting method where payment receipts are recorded during the period in which they are received, and expenses are recorded in the period in which they are actually paid. In other words, revenues and expenses are recorded when cash is received and paid, respectively.