July 12, 2022
Cash basis accounting has been around for a long time, and it's still the favorite form of accounting for many people. It's easy to use, and you can do it yourself without hiring any help. But there are a number of significant problems with this cash basis accounting, and for that reason, it has fallen out of favor with professional accountants.
In this article, we will explain the basics of cash basis accounting, including what it is, how it works, the difference between cash basis accounting and accrual basis accounting, and we’ll explain why you should avoid using cash basis accounting whenever possible.
A simple cash basis accounting definition is a method of accounting that records income and expenses when they are actually paid or received. It's also known as cash basis reporting. Cash basis accounting is used for tax purposes only; this means it's not the form of accounting that businesses use to keep track of their finances.
Unlike accrual basis accounting, which records financial transactions when they take place regardless of whether or not they're paid in full at that time, cash basis only considers money received or spent (and thus counts toward your total revenue).
This means that you don't account for sales until after you've collected payment from customers. Similarly, as soon as you receive payments from clients or suppliers, those amounts are recorded under "revenue."
Cash basis accounting is the opposite of accrual basis accounting. With the cash basis method, you only record income when you actually receive payment, and you only record your expenses when you actually pay for something.
Accrual basis accounting records income when it's earned, not when it is received. So, if your business sells items on credit and collects payment later in the month or even next month, accrual basis accounting lets you record those sales in your cash base as revenue at the time of sale, even though the customer hasn't paid yet!
There are a number of problems with using the cash basis method of accounting. Let’s look at three of the biggest drawbacks with cash basis, so that you can understand why accrual basis accounting is preferred.
1. Cash basis accounting is not useful for tax purposes because the Internal Revenue Service (IRS) does not recognize cash basis as an acceptable form of accounting. This means that you won't be able to use your business's cash-based records to prepare your annual tax return.
2. Cash basis isn't that great for financial planning either because it doesn't capture all of your company's transactions and expenses; in other words, it doesn't provide a complete picture of how much money is coming into the business and where it's going out.
3. Cash basis accounting requires that you estimate future revenues when preparing forecasts; this can lead to incorrect predictions because they're based on past performance rather than actual results over time.
4. Cash basis also fails when used by businesses with multiple departments: a restaurant owner may have multiple restaurants within their organization but only one bank account under each restaurant name; since transactions are recorded by department there is no way for managers to access info about each restaurant individually.
Whether you're starting a small business or just want to know how your preferred method of accounting works, it's important to understand the basics of cash basis and accrual basis accounting. The two methods for tracking income and expenses differ based on when transactions are entered into accounts rather than how much profit or loss has been made during a period.
All things considered, accrual basis accounting is the preferred method used by serious accountants and the only method accepted by the IRS. So, if you plan on learning only one method of accounting, you would be wise to learn accrual basis accounting rather than cash basis accounting.
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