Cash Accounting: How it Works & Should You Use It?

In the “Cash Accounting: How it Works & Should You Use It?” video by Accounting Stuff, you’ll dive into the world of cash accounting and explore its advantages and disadvantages. This informative video aims to help small business owners understand the concept of cash accounting, how it works, and when it is suitable to apply. You’ll learn about the definition of cash accounting, along with real-life examples to help illustrate the concept. Additionally, the video covers the pros and cons of cash accounting and provides insights on who should and shouldn’t use this method of accounting. Whether you’re new to accounting or looking to enhance your understanding, this video is a valuable resource in exploring the cash basis of accounting.

In this video, James from Accounting Stuff introduces the topic of cash accounting, emphasizing its relevance for small business owners. He explains the fundamental principles of cash accounting, including only recording transactions when cash actually changes hands. Using a practical example of a baking business, James walks you through the steps of recording expenses and revenue under the cash basis. He also highlights two scenarios – one where the customer pays in cash and another where payment is on account – to demonstrate how timing impacts recording transactions. Additionally, James covers the pros and cons of cash accounting, shedding light on its suitability for businesses mainly dealing with cash. If you’re looking to deepen your understanding of cash accounting and evaluate whether it is the right method for your business, this video is a must-watch.

What is Cash Accounting?

Cash accounting is a method of recording financial transactions in which revenue is recognized when cash is received and expenses are recognized when cash is paid out. It is a simple and straightforward way of tracking finances, particularly for small businesses that mainly deal with cash transactions. In this article, we will explore how cash accounting works, its advantages and disadvantages, and determine which businesses would benefit from using this method.

How does Cash Accounting work?

Cash accounting operates on the principle of recording transactions only when cash changes hands. When cash is received from a customer, the revenue is recorded, and when cash is paid out for expenses, the expenses are recorded. This method does not take into account any unpaid bills or receivables, focusing solely on cash transactions.

To better understand how cash accounting works, let’s consider an example. Imagine you own a baking business and a customer places an order for a birthday cake. The cost of ingredients for the cake is $10, and you sell it for $25, resulting in a $15 profit. When the customer pays you $25 in cash, you record $10 as an expense for the ingredients and $25 as revenue.

Advantages of Cash Accounting

1. Simple and easy to understand: Cash accounting is straightforward and requires minimal accounting knowledge. Small business owners can easily handle their finances without the need for complex accounting methods or professional accountants.

2. Cost-effective for small businesses: Since cash accounting does not involve complex calculations or the need for specialized software, it is a cost-effective option for small businesses with limited resources. You can avoid expenses associated with hiring an accountant or investing in expensive accounting software.

3. Accepted for tax purposes in many countries: Cash accounting is accepted by tax authorities in many countries for small businesses whose earnings fall below a specific threshold. This makes it a viable option for businesses looking to simplify their tax reporting process.

Disadvantages of Cash Accounting

1. Inaccurate way of recording profits: Cash accounting does not accurately reflect the true profitability of a business. By recording revenue only when cash is received, there can be significant fluctuations in reported profits, especially if there are delays in receiving payments or making payments for expenses.

2. Fluctuations in results: Due to the timing of cash inflows and outflows, cash accounting may result in inconsistent financial results from one accounting period to another. This can make it challenging to analyze the financial performance of a business or compare it with previous periods.

3. No recording of payables and receivables: Cash accounting does not include the recording of payables (amounts owed to suppliers or creditors) or receivables (amounts owed by customers). This can make it difficult to track outstanding invoices, monitor cash flow, or assess the financial health of the business.

4. Not allowed under GAAP or IFRS: Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) do not permit cash accounting for financial reporting. If a business follows these accounting standards, they are required to use accrual accounting, which recognizes revenue and expenses when they are earned or incurred, regardless of cash flow.

Who should use Cash Accounting?

Cash accounting is most suitable for small businesses that primarily operate in cash. If your business deals mainly with cash transactions and has limited complexity in terms of payables and receivables, cash accounting can be a practical and cost-effective method of managing your finances. Additionally, if your country’s tax regulations allow for cash accounting for businesses below a certain earnings threshold, it may be a viable option for simplifying tax reporting.

Who shouldn’t use Cash Accounting?

Businesses that have significant payables and receivables should not use cash accounting. If your business relies on credit sales, has outstanding invoices, or receives payments on account, cash accounting may not accurately reflect the financial position and profitability of your business. In such cases, using accrual accounting, which records revenues and expenses when they are earned or incurred, would be more appropriate.

Comparison: Cash Basis vs Accrual Basis

To better understand the differences between cash accounting and accrual accounting, let’s compare the pros and cons of both methods.

Cash Basis Accounting:

• Pros: Simple, easy to understand, cost-effective, accepted for tax purposes in many countries.
• Cons: Inaccurate recording of profits, fluctuations in results, no recording of payables and receivables, not allowed under GAAP or IFRS.

Accrual Basis Accounting:

• Pros: Provides a more accurate picture of profits, consistent financial results, includes recording of payables and receivables, compliant with GAAP and IFRS.
• Cons: More complex, requires accounting expertise or professional assistance, may require additional accounting software.

The choice between cash basis and accrual basis accounting depends on the specific needs and characteristics of your business. If your business has complexities such as outstanding invoices, credit sales, or the need to comply with GAAP or IFRS, accrual accounting is the preferred method. However, if your business primarily deals with cash transactions, has minimal complexity, and is not subject to GAAP or IFRS requirements, cash accounting can be a simple and efficient option.

Conclusion

Cash accounting is a method of recording financial transactions that focuses on tracking cash inflows and outflows. It is simple, cost-effective, and suitable for small businesses that mainly operate in cash. However, it has limitations in accurately reflecting profitability, can result in fluctuating financial results, and does not include the recording of payables and receivables. If your business primarily deals with credit sales, has outstanding invoices, or needs to comply with accounting standards like GAAP or IFRS, accrual accounting is recommended. Consider the specific needs of your business and consult with an accountant or financial advisor to determine the most appropriate accounting method for you.