Cash basis accounting refers to an accounting system where the firm recognizes sales when it receives cash from customers and recognizes expenses when it pays cash to vendors. Thus, with cash basis accounting, income more closely approximates the firm’s operating cash flow.
The Internal Revenue Service (IRS) allows firms under a certain size to report their business income on a cash basis. This has two benefits to a small firm. First, cash basis accounting is significantly easier to use than a method based on accruals (where the firm recognizes revenues and expenses at the time of occurrence, regardless of when cash changes hands). Second, cash basis accounting may yield significant tax savings over accrual basis accounting. This is especially true for a growing business, where accrual accounting could lead to reported earnings in excess of actual operating cash flow.
There are, conversely, two major drawbacks to using cash basis accounting.
First, cash basis accounting can lead to a significant mismatch of revenues and expenses on the income statement. For example, a firm may offer payment terms to customers and may have payment terms from suppliers. In such a case, a given period’s cash-based income statement will mostly reflect payments and receipts from transactions made in prior periods. This makes the cash-based income statement ineffective for determining a current period’s operating performance.
The second problem with cash-based accounting is that it leads to an inaccurate balance sheet. Under a cash-based system, sales and expenses lack any corresponding receivables and payables. Thus, the balance sheet will not accurately reflect the firm’s true financial position.
When deciding whether to use a cash-based system, business operators should consult a tax professional and weigh the costs and benefits of using a cash-based accounting system.
