The cash method of accounting is one the straightforward techniques of recording business transactions. It entails recording transactions based on actual cash flows. While income is recognized when a company receives payment from clients, expenses are recorded when cash is paid to suppliers or other entities. The approach offers a clear and immediate view of an organization’s cash position and cash flow, making it appropriate for small enterprises and sole proprietors with less complex financial operations. The simplicity of the cash method of accounting enables easy implementation without the need for complex accounting systems or professional expertise, making it cost-effective for developing enterprises. However, one of the drawbacks of the approach is that it does not help businesses to match revenue and expenses with the time they were actually earned or incurred. The disadvantage can distort analysis of a firm’s long-term financial performance. Despite the shortcoming, the cash method helps organizations to maintain clear records of their financial flows.
A Summary of the Cash Accounting Method
The cash accounting method is used to record financial transactions when cash is received or paid, which helps to determine when expenditures, financing, and income are recognized in an organization. For instance, income from a sale is only recorded when payment is received, omitting revenue if a payment is delayed (Beaver, 2020). Based on the cash accounting method, sales made on credit are not recognized until when the payment is made to the organization. The cash-based accounting technique influences the financial status of a business since financial records do not change when cash is not received or paid out.
Advantages of the Cash Accounting Method
Most enterprises prefer the cash accounting approach because it accurately reflects their cash flows, which is crucial for small businesses without complex transactions. Since it is less complex, it lowers bookkeeping costs and difficulties. For instance, the cash-based accounting technique allows firms to defer taxes until they receive cash, which is beneficial as it helps to minimize expenses (ACCA, 2013). Small enterprises often experience financial difficulties, and deferring taxes helps them to minimize costs. By deferring taxes, they are able to retain more cash in the short term and can sustain key operations such as acquiring additional stock, investing in growth plans, and mitigating unforeseen expenses. For example, if accounts receivable are higher than accounts payable and accrued expenses, the taxpayer can defer paying taxes on the net taxable revenues to a period when the cash is actually received and expenses are paid (Clark, 2019). Furthermore, small businesses can experience income fluctuations from one month to another or between financial periods. More liquidity is essential for sustaining stability and business continuity. Deferring taxes helps firms to match their tax payments with their actual cash receipts, which enables them to reflect a more accurate status of their cash flows.
Disadvantages of the Cash Accounting Method
However, the main shortcoming of cash accounting lies in the possibility of distorting financial reports during specific periods, which can affect planning and forecasting in organizations. The cash accounting approach diverges from Generally Accepted Accounting Principles (GAAP) since the resulting financial records may be insufficient for many lenders and inappropriate for publicly traded companies (Beaver, 2020). The fact that the cash accounting approach does not conform to GAAP rules, which are widely recognized standards for financial reporting, is disadvantageous to businesses. For instance, financial records prepared based on the method may not meet the requirements set by external parties such as investors, lenders, or regulatory agencies. Limited access to credit hinders implementation of business growth plans.
Since revenues and expenses are recorded when a business receives cash or makes a payment, the method can misrepresent a firm’s financial health. For example, an enterprise can experience growth in sales but encounter delays in receiving payments, resulting in an understatement of its revenue in its financial records (Cudia, 2008). The inconsistency can cause inaccurate financial assessment, business planning, and estimation of future activities. For example, enterprises using the cash accounting approach may struggle with managing tax liabilities effectively. Since revenue is recognized upon receipt of cash, deferred tax obligations can lead to cash flow challenges when taxes become due. Overall, the practice of recognizing revenue when cash is received can cause financial difficulties when all deferred payments are due.
Changes to the Use of the Cash Accounting Method Over Time
Various changes to the use of the cash accounting method have been undertaken over the years, affecting business practices. Initially, the cash method was permitted for specific organizations. For example, a C corporation taxpayer or a partnership with a C corporation partner was not allowed to use the cash accounting method to record financial transactions if it did not meet the $5 million gross receipts test of Section 448(c) under the Tax Cuts and Jobs Act (TCJA) (Clark, 2019). Other taxpayers were prohibited from using the cash accounting method for various reasons. For instance, those who met the $5 million gross receipts test were prohibited from applying the cash accounting method if they were supposed to account for their inventories under Section 47(a) under the TCJA (Clark, 2019). However, new provisions of the TCJA allow more businesses to utilize the method to record their financial transactions. For example, taxpayers with less than $25 million in gross receipts are permitted to use the cash accounting method (Clark, 2019). The regulations also permit the enterprises not to capitalize additional uniform capitalization (UNICAP) to costs inventory. Furthermore, the businesses are permitted to classify inventories as supplies or non-incidental items or apply the inventory approach that conforms to their financial accosting method for inventories. Except for small businesses that lacked inventory, it was difficult for firms to use the cash accounting to record their financial transactions under previous regulations. The TCJA allows more organizations to use the cash method of accounting.
Other exceptions before the TCJA amendments also allowed taxpayers to use the cash accounting method despite restrictions in other codes. For example, a taxpayer that was required to account for inventories with average yearly receipts below $1 million was allowed to use the cash accounting technique under Rev. Proc. 2001-10 (“Rev. Proc. 2001-10,” n.d.). The exception implied that businesses with relatively low income were permitted to use the cash accounting technique in their financial statements. A second exception in Rev. Proc. 2002-28 permitted taxpayers with gross yearly receipts of $10 million to use the cash accounting method regardless of whether they had inventories. However, such taxpayers had to meet certain conditions. Clark (2019) indicates that they should not have been barred from using the cash approach under Section 448 and did not engage in a prohibited business operation under Section 4.01 of Rev. Proc 2002-28 (“Rev. Proc. 2002-28,” n.d.). Despite various exceptions, firms had to meet specific conditions to use the cash accounting method.
Current Issues
The main issue about the cash method of accounting is that it offers a limited representation of organizational performance. Firms only recognize income and expenses when they receive funds or make payments (Bank of America, 2023). However, other transactions such as accounts receivables and accounts payables are major factors that indicate the financial status or performance of a business. Thus, financial statements prepared based on the cash accounting method may not accurately indicate a firm’s financial status. For organizations that have to persuade external stakeholders such as lenders, investors, and suppliers, it may be difficult to rely on the cash accounting method to portray an accurate status of their financial position. Therefore, it is important to support the approach with other techniques that can precisely illustrate an entity’s financial transactions.
Conclusion
The cash accounting method is advantageous to small businesses because of its simplicity and straightforwardness. As a result, it does not entail costly processes that can increase organizational expenses. It also enables tax deferring, enabling small firms to pay due taxes when their cash flows improve. However, the main concern about the cash accounting method is that it disregards key transactions that reflect a firm’s financial position. Accounts receivables and accounts payable are not reflected in financial statements when the cash accounting approach is used. The transactions are instrumental in determining the correct financial position of an organization. Deferred tax payments can also be due when an entity is experiencing financial difficulties, resulting in liquidity problems.
References
ACCA. (2013, July). Cash accounting-pros and cons. https://www.accaglobal.com/gb/en/technical-activities/technical-resources-search/2013/july/cash-accounting.html
Bank of America. (2023, November 1). Cash vs. accrual-basis accounting: What’s best for my small business? https://business.bankofamerica.com/resources/cash-vs-accrual-accounting.html
Beaver, S. (2020, October 29). Cash-basis vs accrual-basis accounting: what’s the difference? What’s best? Oracle Suite. https://www.netsuite.com/portal/resource/articles/financial-management/cash-basis-accrual-basis.shtml
Clark, N. (2019, January 1). Relief for small business tax accounting methods. Journal of Accountancy. https://www.journalofaccountancy.com/issues/2019/jan/small-business-tax-accounting-methods.html
Cudia, C. P. (2008). Application of Accrual and Cash Accounting: Implications for Small and Medium Enterprises Implications for Small and Medium Enterprises. DLSU Business & Economics Review, 17(1), 23-40. https://www.dlsu.edu.ph/wp-content/uploads/2019/10/ApplicationofAccrualandCashAccounting_ImplicationsforSmallandMediumEnterprisesinMetroManila.pdf
Rev. Proc. 2001-10. (n.d.). https://www.irs.gov/pub/irs-drop/rp-01-10.pdf
Rev. Proc. 2002-28. (n.d.). https://www.irs.gov/pub/irs-drop/rp-02-28.pdf
Sa’diyah, D. S., & Yuhertiana, I. (2021). Changes in the recording of cash-based accounting methods to accrual base. International Journal of Community Service & Engagement, 2(2), 24-31. https://journal.jis-institute.org/index.php/ijcse/article/download/248/185
