The cash method of accounting is a well-known and widely used technique which has some advantages and disadvantages. In this article, we shall know about this accounting technique in detail.
Maintaining high accounting standards is essential for business firms. The company management should focus on maintaining proper books of accounts not just to satisfy the Federal government’s requirements, but doing so can help them understand the financial position of their company perfectly. This analysis is useful in chalking out expansion policies to make sure smooth and steady growth for the corporation.
When we think of the principal methods of accounting, the following three names come to our mind:
- Cash accounting method or cash basis
- Cost method of accounting
- Accrual accounting method or accrual basis
These two methods are very useful in keeping track of the cash generated and expenses incurred by the firm. Accounting done with these methods by after the generally accepted accounting principles and conventions of accounting can be helpful for company management and institutions and people interested in the company’s financial matters like creditors and shareholders.
About the Cash Accounting Method
In the cash method of accounting, income is not counted unless the company receives cash/check payment for the goods sold. Similarly, there is also a rule for counting the expenses made by the firm. Expenses are not counted unless the amount of expense is actually paid by the company. So, in simple words, we can say that this is a realistic approach towards accounting. Accounting done with the help of cash accounting method gives exact details about the cash balance of the company. The problem of display of exaggerated earnings and profits will not occur in the books of companies which are maintained using this method.
On the other hand, a company following cash accounting will not show expenses on taxes unless they are paid. So, in some quarters, when the expenses are not paid, the profits of the company may be higher than the expectations of most analysts. But, in the quarter when the company actually pays the tax, net profits will be squeezed. Financially weak firms may even report quarterly losses as against profits in the preceding quarters. So, shareholders tracking the performance of these companies should consider these facts before they calculate or estimate profits of the company and decide on making investment in their stocks.
The cash method for tax purposes is the most simplest to understand. It is just according to the normal human tendency of reporting money earned only after receiving it. Such kind of accounting is ideal for small businesses, enterprises and start-up firms. One of the major advantages of cash method is its simplicity for use and getting realistic financial details of the company. Another advantage is that at times, the enterprise owner might not have to shell out more in taxes as he does not declare income until he receives the payment from the other party. So, if he gets the payment in the next financial year, he saves money in taxes in the current year.
Assume that a firm sells stock worth $10,000 to a client in the current financial year. Due to some reason, the client is unable to pay the firm immediately and can pay only in the next financial year. Now, if this firm uses cash accounting method, then it will not report profits unless they are actually credited in its bank. So, the profit earned on income of $10,000 sale of stock won’t be included in the total net income of the firm for the current financial year. The benefit of this is that the firm will get some relief in tax payment at least till it files taxes for next year, where it will have to shell out taxes for this particular sale.
Comparison With Accrual Accounting Method
Cash method of accounting is often compared with the accrual accounting method. Accrual accounting method is considered to be better than cash accounting provided you have a very large business enterprise with a large turnover and are dealing in inventories. Inventory record becomes simpler with the accrual method. In the accrual method, income is registered after the sale of goods; even before the company receives the payment or the same. Also, expenses are deducted in the same fiscal period irrespective of whether the firm has actually paid them or not.
Finally, we conclude that if you are an owner of a small firm, then you should go with cash method of accounting. Accounting practices have undergone a vast change with the changing business environment and hence as the head of a business, you should keep yourself acquainted with them. Hiring qualified and talented auditors/accountants can help to avoid any errors in company accounts.