Cash Basis of accounting is the method of accounting which involves recording the accounting entries in the books of accounts when the cash is actually received and paid against the revenues & expenses and asset & liabilities and not at the time when the revenues and expenses are incurred and becomes due for receipt/payment.
Explanation with Example:
Cash basis of accounting is the accounting method in which the revenues and expenses are recognized as and when the cash is received against revenue and paid against the expenses and not at the time when the payment and receipt becomes due such as at the time of credit sales the revenue is recorded in the financial records when the organizations receive money for that and not at the time of credit purchase, the purchases are recorded only when the business pay off the amount against such purchase. This method is easy to incorporate but it is usually followed by small businesses because it is considered inappropriate for many businesses as it is not compatible with matching concept and profit is ascertained as the difference between the receipts and payments rather than by matching the revenues with the expenses as per their occurrence.
The example of cash basis of accounting is explained below:
Suppose there is a company named Multifunctional Inc. which deals with the mobile, laptops and related accessories. Following transactions happened in the accounting year 2019-20.
|Salary paid in cash||$4,000|
|Stationery purchased on credit||$1,000|
|other income received in cash||$5,000|
We need to analyze what transactions are recorded in financial year 2019-20.
Calculation of Profit as per cash basis of accounting
|Add: Other income received in cash||$5,000|
|Less: Cash purchases||$3,000|
|Less: Salary paid in cash||$4,000|
|Profit for the year 2019-20||$6,000|
From the above transactions only those transactions that are received and paid in cash are recorded in the books. Therefore, credit sales, credit purchases and the stationery purchased on credit are not taken into account.
Advantages of Cash Basis:
Some of the advantages are as under:
1. Simple and cost effective:
Cash basis of accounting is easy to incorporate and does not require any trained professional or accountant thereby making this method inexpensive.
2. Deferment of taxes:
The cash basis of accounting may help in the deferment of taxes as the businesses may slow down the recovery against the sales and may pay off expenses very fast to get tax benefit by increasing expenses and lowering sales.
3. Less time consuming:
The cash basis of accounting is less time consuming as the number of transactions recorded as per cash basis is less as compared to the other method.
Disadvantages of Cash basis:
Some of the disadvantages are as under:
1. Lacks Accuracy:
The cash basis of accounting involves only reporting of transactions that are made in cash and ignores other important transaction that have an impact on the financial performance of the business. Therefore, this method is not considered accurate.
2. High Discrepancies :
The chances of discrepancies under cash basis of accounting are high as the cash payment and receipts can be manipulated easily resulting in the unfair trade practices.
3. Not acceptable everywhere:
Some laws and regulations do not consider the financial statements based on cash basis of accounting like Indian Company law and even the lenders require the financial statements based on accrual basis of accounting. Therefore in such cases cash basis does not work and accrual basis is mandatory.