Business, Legal & Accounting Glossary
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.
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.
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.
Cash-basis accounting fails to meet GAAP requirements because it does not adhere to the following two GAAP principles:
Additionally, cash-basis accounting is not viable for cost accounting in manufacturing operations because expenses cannot always be correctly associated with product costs.
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.
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.
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.
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.
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 the accrual-basis method.
Three kinds of external stakeholders should be considered when deciding the reporting method:
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 favoured 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.
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This glossary post was last updated: 18th April, 2020 | 2 Views.