Understanding the Basics of Cash Accounting
When managing your business finances, one of the crucial decisions you must make is choosing the right accounting method. In this blog, we’ll review the pros and cons of cash accounting and offer tips for determining if it’s right for your company.
What Is Cash Accounting?
Cash accounting is an accounting method where revenue is recorded when cash is received, and expenses are recorded when money is paid out. This differs from accrual accounting, where revenue is recorded when earned, and expenses are recorded when they are incurred.
With cash accounting, income statements report cash collected and cash spent during a period. Cash accounting is easier than accrual accounting because no receivables, payables, or inventory accounts are used.
This method best suits small businesses and freelancers with relatively simple finances who want to minimize accounting work. It can also be useful for new companies without established income and expenses. However, it does not provide as accurate a picture of the business as accrual accounting.
What Are the Pros of Cash Accounting
Utilizing cash accounting offers businesses the following advantages:
Cash accounting is straightforward to implement for a small business owner or individual. There’s no need to track accounts receivable or accounts payable, accrue estimated expenses, or deal with complex depreciation schedules. Expenses are recorded when paid and income when received, keeping the bookkeeping uncomplicated. For a freelancer or small business owner focused on their trade, this simplicity in accounting can be a major benefit over accrual methods.
Minimal Record Keeping
This method requires less onerous recordkeeping compared to accruals. Other than tracking income and expenses when cash exchanges hands, there’s little paperwork needed. No adjusting entries have to be made at the end of accounting periods to bring revenues and expenses into alignment. The minimal recordkeeping makes tax time easier as well.
Tax Timing Advantages
By controlling when invoices go out, a business owner can decide when income gets reported. Delaying billing so payment is received in the next tax year is a legal way to manage tax expenses. Likewise, accelerating year-end expenses reduces taxable income in the current year.
Eliminated Bad Debt Expenses
Bad debt is not recorded as an expense with cash accounting like it is with accruals. Only cash received gets counted as income, so there’s no hit from uncollectible accounts receivable. This avoids expenses from nonpaying customers, reducing profitability measures. While less conservative than accrual methods, it’s one less bookkeeping headache for small businesses.
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Cons of Cash Accounting
Cash basis accounting has some notable disadvantages that can make it problematic for many businesses. Some of the main challenges and issues include:
Reduced Financial Clarity
Cash basis only records income when cash is received and expenses when cash is paid out. This means key assets like accounts receivable and liabilities like accounts payable are excluded from the balance sheet. So, the balance sheet fails to provide an accurate snapshot of what the business owns and owes.
Increased Exposure to Manipulation
With this technique, invoices can strategically be sent out and paid at certain times to impact the financials and income statement. This makes it easier for dishonest businesses to manipulate earnings and misrepresent performance. Expenses and revenues can be shifted to different periods through the strategic sending of bills and customer payments.
Can Impact Financing
Since cash basis may be viewed as less accurate, lenders and creditors often require accrual-based financial statements to make informed lending decisions. This can create challenges in obtaining financing for businesses only using a cash-based method.
How to Determine if Cash Accounting Is Right for Your Business
Determining the best accounting method can be challenging for many business owners. Here are some indications that cash accounting is right for your company:
You’re a Small Business
Cash accounting is particularly well-suited for small businesses. If you’re just getting your business off the ground, you probably don’t want to be bogged down by complex accounting systems. Cash accounting is easy to set up, making it an excellent choice for those with limited accounting knowledge and resources.
You Want a Simple Method
Cash accounting is all about simplicity. With this method, you record your income and expenses when money changes hands. This straightforward approach means you won’t have to deal with complex accruals or estimate uncollected revenues. If you prefer a clear and easily understandable way of tracking your business finances, cash accounting may be your best option.
Your Business Experiences Seasonal Revenue Fluctuations
For businesses with seasonal revenue fluctuations, cash accounting offers a significant advantage. With cash accounting, you only recognize income when you receive payments, making it a valuable tool for managing your cash flow. This method can help smooth out your tax obligations, aligning them with your revenue receipts.
Having Trouble With Cash Basis Accounting? Outsource to the Devine Team
As a business owner, taking time to complete cash accounting distracts you from other vital responsibilities. Partnering with Devine Consulting gives you access to our knowledge and expertise in accounting processes.
We offer industry-leading services and the latest software to track your company’s finances and allow you to focus on growing your business. Partnering with us provides peace of mind, knowing the financial components of your organization are handled properly.
Contact us to learn more about what the Devine Consulting team offers.