Cash Based Accounting

Cash based accounting refers to the method used to report earnings and income over the fiscal accounting reporting period.  For many legal entities, such as C corporations and governments, that year ends on September 30th of each year.  For the rest of us, those years ends as the physical year ends, on December 31st each year.

What do we mean when we use the term "cash" basis for accounting?  Cash-based accounting means that sales are recorded when you receive the money, and expenses are recorded when they are actually paid.  Many government entities use the cash based accounting methods, but are being heavily encouraged to move to the accrual based methods, in order to provide more accurate private versus public sector comparisons and to encourage greater government accountability.

There are basically two forms of accounting methods: cash and accrual.  Cash based systems are great if your income is below one million, and you don't have problems collecting for your products or services.  Well, by that definition alone, many of today's businesses should not even consider the cash based accounting methods.  You might find it odd here, that our government that records income and revenues into the trillions of dollars is still using the cash based method; commonsense dictates that the accrual based method should be used; but of course, commonsense and government do not always go hand in hand.

What benefit does cash based accounting provide?  There are actually only a couple of benefits from using the cash based method accounting, however if this method fits your business, it will save you money in bookkeeping expenses.  If most of your sales are cash sales, you don't maintain an inventory, and you don't have customer accounts or returns, then the cash based method is a much better choice, because it's much easier and it's much cheaper to maintain.

What benefit does the government hope to gain when changing from cash based to accrual based accounting, since profitability isn't an issue?  The accrual based method of accounting provides the government with a better perspective of management performance and results.  What does that mean for government?  It's a new viewpoint in comparing how our government measures up against private sector businesses, and will hopefully produce better management and efficiency from the public sector of the business world.

The greatest advantage to cash based accounting, allows an information manager, or if you're a small business, the business owner to quickly assess if the business is operating profitably, but only if the business is for the most part a cash business; with little or no inventory and cash sales.  You can better assess profit levels when you use the accrual based method because you match income to expenses more accurately.

Compare this to the use of your credit card.  Suppose you use your credit card to purchase an item.  You don't actually have a deduction of your personal checking account until you pay for the credit card debt; this is cash accounting methods.  If you use your credit card, and then write a check immediately to satisfy that debt on your credit card, regardless of the due date of the bill, you're using accrual based accounting.  Can you see how accrual forces accountability, and also makes you aware of your spending limits?

For some businesses, there is a need to be able to view finances from both pictures.  Access to both methods provides information managers with a better view of actual cash flows, and keeps CEOs and CFOs more aware of the actual state of the business.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.