Accounting exists to provide companies with a comprehensive understanding of their finances. When most people hear accounting, they think of taxes. But accounting also works to organize recorded finances and monitor a business’ financial health.
There currently exist two main accounting methods used by companies for financial tracking, each with its own rules and procedures for reporting. Whereas the accrual basis records transactions first upon the transfer of goods/services and then reconciled upon transfer of funds, the cash basis accounting method only records transactions upon the transfer of funds.
Pros & Cons of Cash Basis
The main benefit of cash basis accounting is that it allows companies to view how much money is actually on hand because transactions are only recorded when a transfer of funds occurs. For example, if a check is received in July but not cashed until September, it will not be recorded until September, upon cashing the check.
The cash basis method can be used advantageously for tax purposes because it speeds up expenses while slowing down revenue in a company’s book by managing the timing of transactions. By doing this, a business is able to push some tax obligations from one year to the next.
In the same vein, cash basis can also disadvantage a company that holds inventory or offers services on credit; the ability to hold money from an inventory can appear as a temporary loss.
Who Can Use Cash Basis?
Cash basis accounting, the more straightforward of the two methods, is primarily utilized by small-to-medium-sized businesses for its simplicity. The IRS regulates accounting methods to prevent businesses from misrepresenting income; as businesses grow, they are eventually required to transition to accrual basis. A company must meet the following criteria to utilize cash basis accounting:
- Not publicly traded
- C corporation or Partnership with average annual gross receipts less than $5 million
- Sole proprietorship or S corporation with average annual gross receipts less than $1 million
- Personal service business with at least 95% of business activities related to the services provided
- Family-owned farm with average annual gross receipts less than $25 million
While cash accounting is a simple and straightforward way to track finances, it often is not complex enough to give a company an accurate depiction of its finances. The alternate method to cash basis, accrual accounting, is better suited for companies that require complex calculations and are seeking a holistic view of their financial health.
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