Cash Accounting Definition
The accepted cash accounting definition is an accounting method wherein sales are recorded at the time of payment and expenses are recorded at the time they are paid. Only when cash actually changes hands is the payment or expense recorded; this is in contrast to accrual basis accounting, which records credits when they are earned, rather than received, and debits when they are owed, rather than when they are actually paid.
The cash accounting method can significantly reduce bookkeeping costs, since it is simpler and less time-consuming than accrual methods. Additionally, companies that utilize a cash accounting system can easily determine their current profitability. By keeping a current cash accounting balance sheet, corporate finance managers can assess the company’s financial situation at a glance.
Advantages to the Cash Accounting Method
For tax purposes, there are definite advantages to the cash accounting basis for accounting. Cash accounting ensures that taxes are not paid on monies that have not yet been received; this improves cash flow and ensures that funds are available for tax expenditures. This can be especially important for individuals and small businesses where cash flow may be restricted at certain times. For companies that do a great deal of cash business and do not maintain large inventories, cash accounting is a convenient and reliable way of tracking expenses and profits without necessitating a great deal of bookkeeping.
Disadvantages to Cash Accounting
Because cash accounting is so simple, it does not allow for tracking the actual dates of sales and purchases. Additionally, it usually does not provide a means of matching these transactions to specific items of inventory. There are no accounts receivable or accounts payable records; this can create difficulties for businesses that do not receive payment for goods immediately, or have outstanding bills that have yet to be paid. Additionally, since partial payments are not recorded as such in a cash accounting system, the cash accounting balance sheet may not reflect all monies due. If meticulous records are not kept of these outstanding balances due or owing, then companies may not receive or make payments in a timely fashion, if at all.
Cash Accounting System Applications
For companies that are paid in advance for their services and must pay for their inventory at the time of delivery, cash accounting systems are sufficient and provide enough detail for accurate recordkeeping. For instance, a tanning salon provides services to the public, for which it expects payment in advance. Its expenses include tanning oil, which is purchased on a cash basis, and utilities, which are also due upon receipt of the bills. A cash accounting basis would be suitable for the tanning salon, since all of its financial income and outlays are already transacted on a cash basis.
By contrast, most large companies carry balances with their suppliers and must wait for payment for their deliveries. An accrual basis method is more suited to this situation, since it allows for better control of delayed payments and receipts, and provides tracking for partial payments, accounts receivable, and accounts payable, even when no cash has yet changed hands for the transaction. While some large companies still employ a cash accounting system for tax purposes, this is usually supplemented by an accrual system in order to maintain better control over expenses and revenues and to allow more complete and accurate financial reports for shareholders.