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Encyclopedia > Accounting methods


Cash basis

Cash-basis accounting is a method of bookkeeping that records financial events based on cash flows and cash position. Revenue is recognized when cash is received and expense is recognized when cash is paid. In cash-basis accounting, revenues and expenses are also called cash receipts and cash payments. It has been suggested that Accounting scholarship be merged into this article or section. ... It has been suggested that Online bookkeeping be merged into this article or section. ... This article does not cite any references or sources. ... For the tax agency in the United Kingdom of the same name, see HM Revenue and Customs. ... In accounting, an expense represents an event in which an asset is used up or a liability is incurred. ...

Cash-basis accounting does not recognize promises to pay or expectations to receive money or service in the future, such as payables, receivables, and prepaid expenses. Accounts payable is a file or account that contains money that a person or company owes to suppliers, but hasnt paid yet. ... Accounts receivable is one of a series of accounting transactions dealing with the billing of customers who owe money to a person, company or organization for goods and services that have been provided to the customer. ...

This is simpler for individuals and organizations that do not have significant amounts of these transactions, or when the time lag between the initiation of the transaction and the cash flow is very short.

Two types of cash-basis accounting exist: strict and modified. Strict cash-basis follows the cash flow exactly. Modified cash-basis includes some elements from accrual-basis accounting such as inventory and property capitalization.

Issues with cash basis

Cash-basis accounting fails to meet GAAP requirements because it does not adhere to the following two GAAP principles: Image File history File links Gnome-globe. ... Generally accepted accounting principles (GAAP) are the accounting rules used to prepare financial statements for publicly traded companies and many private companies in the United States. ...

  • Revenue recognition principle - revenue should be recognized when it is realized (e.g. a credit sale)
  • Matching principle - revenue should be matched to the expense if possible (e.g. sales to COGS)

Additionally, cash-basis accounting is not viable for cost accounting in manufacturing operations because expenses cannot always be correctly associated with product costs. In accounting, the cost of goods sold (also, cost of sales or cost of revenue) describes the direct expenses incurred in producing a particular good for sale, including the actual cost of materials that comprise the good, and direct labor expense in putting the good in salable condition. ... Cost accounting is the process of tracking, recording and analyzing costs associated with the products or activities of an organization. ...


When you pay your rent, your landlord would record an income event at the time he receives your payment. The landlord would subsequently record an expense event when he pays the rental agent their fee for your apartment. It is the accounting method used by most individuals, and by some businesses, that have limited payables or receivables or whose income and expense cash flows are closely associated with each other in time.

A simplified Income Statement and Balance Sheet for cash basis accounting might look like the following:

 Vandalay Industries Income Statement For the financial year ended 30 June 2004 Revenue ............................ $1,000 Expense ............................ 800 ------ Net income ......................... $ 200 ====== 
 Vandalay Industries Balance Sheet As at 30 June 2004 Assets Cash .............................. $5,500 ------ Total assets ..................... $5,500 ====== Liabilities and Stockholders' Equity Common stock ...................... 5,500 ------ Total liabilities and Equity ..... $5,500 ====== 

Accrual basis

Accrual-basis accounting records financial events based on events that change your net worth (the amount owed to you minus the amount you owe others). Standard practice is to record and recognize revenues in the period in which they incur and to match them with related expenses in a process known as matching or expense matching. Even though cash is not received or paid in a credit transaction, they are recorded because they are consequential in the future income and cash flow of the company. Accrual-basis is GAAP compliant. Net worth (sometimes net assets) is the total assets minus total liabilities of an individual or company. ... In accounting, the matching principle indicates that when it is reasonable to do so, expenses should be matched with revenues. ... Generally accepted accounting principles (GAAP) are the accounting rules used to prepare financial statements for publicly traded companies and many private companies in the United States. ...


  • Using cash-basis accounting, income and expenses are recognized only when cash is received or paid out.
  • Using accrual-basis accounting, receivables and payables are recognized when a sale is agreed to, even though as yet, no cash has been received or paid out.
  • Cash-basis accounting defers all credit transactions to a later date. It is more conservative for the seller in that it does not record revenue until cash receipt. In a growing company, this results in a lower income compared to accrual-basis accounting.

Accrual is derived from the verb accrue, which describes the gathering or clustering of things together over time, as atoms, or it describes a general increase in number, as in interest. ...

A simple example

  • A small business such as a fruit stand, which buys its inventory daily for cash at a wholesale market, sells the inventory for cash, and throws away what didn't sell, can get an accurate picture of its profits or losses using cash-basis accounting.
  • A remodeling business that gives customers 90 days to pay and that procures materials on account at the lumber yard, must use the accrual method to gain an accurate picture of its financial condition.
  • Either business will probably get a relatively accurate picture using either method over a long period of time, except for the transactions that have already begun that are not yet closed.

A small business may be defined as a business with a small number of employees. ... For other uses, see Cash (disambiguation). ...

Other considerations

Standard accrual-basis financial statements (profit statements and balance sheets) do not indicate the cash inflows and outflows of a company. The Statement of Cash Flows is created to indicate that information for accrual-basis accounting. In financial accounting, a cash flow statement is a financial statement that shows incoming and outgoing money during a particular period (often monthly or quarterly). ...

Accrual-basis accounting is more costly to maintain, because it requires the bookkeeper to record many more transactions. However, the advent of accounting software has made the difference between the reporting methods less significant. Accounting software is computer software that records and processes accounting transactions within functional modules such as accounts payable, accounts receivable, payroll and trial balance. ...

Companies that have extended or used credit significantly should use (and in the United States may be required by the Internal Revenue Service to use) the accrual-basis method of accounting. The U.S. Securities and Exchange Commission requires that all publicly traded companies follow GAAP, thus all publicly traded companies publish their financial statements using accrual-basis method. Three kind of external stakeholders should be considered when deciding the reporting method: Credit as a financial term, used in such terms as credit card, refers to the granting of a loan and the creation of debt. ... Seal of the Internal Revenue Service Tax rates around the world Tax revenue as % of GDP Part of the Taxation series        “IRS” redirects here. ... The U.S. Securities and Exchange Commission, commonly referred to as the SEC, is the United States governing body which has primary responsibility for overseeing the regulation of the securities industry. ... A public company usually refers to a company which is permitted to offer its securities (stock, bonds, etc. ...

  • creditors
  • stockholders
  • taxation authorities

For the creditors and stockholders of large enterprises, cash basis accounting is financially inadequate. It does not project the future cash flow of the company.

For tax purposes, cash basis accounting is highly favored because it defers tax burdens until the cash is received. It is often used by small businesses and organizations that are not required to use the accrual method, both for tax reasons and for its simplicity.

  Results from FactBites:
Revised procedures for changing accounting methods. (2382 words)
Changes in accounting methods do not include corrections for mathematical or posting errors, computational mistakes, and non-timing adjustments, such as the correction of items deducted as business expenses that are really dividends and personal expenses.
In addition, a change in the method of accounting does not include adjustments to an addition to a reserve for bad debts or to the useful life or basis of an asset.
Examples of Category A methods would include the use of direct costing in valuing manufacturing inventories or the use of the cash method of accounting for sales and purchases when inventory is a material factor.
  More results at FactBites »



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