In the world of accounting, there are two methods used to record financial transactions: the cash basis and the accrual basis. In this article, we will explore the cash basis of accounting, including what it is, how it works, its advantages and disadvantages, and its relevance to small businesses.
What is the Cash Basis of Accounting?
The cash basis of accounting is a method of recording financial transactions based on when cash is received or paid out. Under this method, revenue is recognized when cash is received, and expenses are recognized when cash is paid out.
How Does the Cash Basis of Accounting Work?
Under the cash basis of accounting, the recording of financial transactions is straightforward. For example, if a small business sells a product or service and receives payment immediately, the revenue is recognized at the time of the sale. On the other hand, if the business purchases supplies and pays for them immediately, the expense is recognized at the time of the purchase.
Advantages of the Cash Basis of Accounting
One of the main advantages of the cash basis of accounting is its simplicity. It is easy to understand and apply, which makes it a popular choice for small businesses that do not have complex financial transactions. Additionally, this method can help businesses manage their cash flow better since it records income when it is received, and expenses when they are paid.
Disadvantages of the Cash Basis of Accounting
Despite its simplicity, the cash basis of accounting has several disadvantages. Firstly, it does not provide an accurate picture of a company’s financial performance since it does not take into account revenue earned but not yet received or expenses incurred but not yet paid. Secondly, it is not in compliance with Generally Accepted Accounting Principles (GAAP), which may be required by some lenders, investors, or regulatory agencies.
Relevance of the Cash Basis of Accounting to Small Businesses
The cash basis of accounting is particularly relevant to small businesses that have simple financial transactions and do not need to produce financial statements that comply with GAAP. Additionally, it is a suitable method for businesses that want to manage their cash flow better and have a more accurate understanding of their available funds.
A(Cash Basis Accounting)–>B(Revenue is recognized when cash is received);
A(Cash Basis Accounting)–>C(Expenses are recognized when cash is paid out);
B–>D(Sell Product or Service);
The cash basis of accounting is a straightforward and easy-to-use method for recording financial transactions based on when cash is received or paid out. While it has advantages such as simplicity and improved cash flow management, it also has disadvantages such as a lack of compliance with GAAP and an incomplete picture of a company’s financial performance. Despite its limitations, it remains a relevant method for small businesses with simple financial transactions.