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HomeAccounting and InventoryCash Accounting: Definitions, Terms, Statements and Example

Cash Accounting: Definitions, Terms, Statements and Example

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Cash accounting is quite a handy tool for small businesses when it comes to the accounting of receipts and expenditures. As small businesses in their growing period need careful management of funds and resources, cash accounting comes to their rescue. Cash accounting is easy to understand, implement and take care of by not engaging in complex accounting set-ups in small businesses and start-ups.

Did you know?

Cash accounting methodology is generally used by sole proprietors engaged in small, cash-based businesses, customer service providers, etc.

Also Read: A Simple Guide on the Basis of Accounting

What Is Cash Accounting?

Cash accounting is an accounting process wherein revenue is accepted, and expenditure is acknowledged when the cash amount is paid. The cash accounting procedure is generally handy for small businesses as it is less challenging to understand, and complex accounting knowledge is not required.

An example of cash accounting could be:

A company sends an invoice to a customer for services provided on July 20 worth ₹30,000 and, in return, receives payment on August 20. In this case, the sale is recorded on August 20, which is called the receipt date.

Difference Between Cash Accounting and Accrual Accounting

Cash Accounting

Accrual Accounting

  1. Cash accounting refers to a method of accounting wherein any income or expenditure is acknowledged when there is a receipt or giving away of cash. 
  1. Accrual accounting refers to a method of granting wherein any income or expenditure is acknowledged when it is earned, irrespective of the time when the payment is made. 
  1. Cash accounting is simple in nature.

      2.   Accrual accounting is complex in nature.

  1. This procedure is based on a single entry method that takes into account either receipt or expenditure of cash. 

3.   This procedure is based on the double-entry method of accounting, wherein every agreement has two upshots – debit and credit. 

  1. Cash accounting has a low level of accuracy. 

4.   Accrual accounting has a greater level of accounting than cash accounting.

  1. Cash accounting is used by micro and small businesses. 

5.   Accrual accounting is used by larger enterprises. 

  1. This method of accounting shows a lower income level in its income assertion. 

6.   This method of accounting shows a higher income level in its income assertion. 

Also Read: What is the Definition of Financial Accounting and What Does it Deal With?

The Advantages of Cash Accounting

The following are the advantages of the cash accounting method:

  • Ease of Use

Cash accounting is an easy method that facilitates small businesses’ learning, implementation and maintenance. The procedure is also quite cost-effective. Cash accounting also has a lower learning curve than accrual accounting. A lesser amount of planning is needed in cash accounting which leads to a greater amount of time left for conducting business and less wastage of time in going into minute details of the business.

  • Helps Assess the Present Situation

The cash accounting method helps a business person to maintain details of how much cash he has in reserve for further spending. This method only deals with fixed funds that go and come out in the present.

  • Prospective Tax Advantages

Some businesses greatly benefit from the cash accounting method’s tax advantages. Only income and expenditure are recorded when money shifts hands, and thus, the timing of the transaction is monitored and controlled. And when a business person can track transaction timings and manage them, he can speed up expenditure and slow down on receipts. This process helps legally increment expenditure and decrease income, allowing lower tax liability.

The Limitations of Cash Accounting

The following are the disadvantages of cash accounting:

  • Vague Overall Picture

Cash accounting does not give a clear and complete picture of a business’s income and expenditure. It also does not show a business’s liabilities properly, leading to a false idea about the spending limit. It also does not show the customer’s disabilities to the business, which can lead to the businessman forgetting about the unpaid debts of the customer.

Now, cash accounting is just a snippet of a business’s finance, and businesses do not get a clear picture of their finances in the long run, which could influence their growth.

  • Limited Use

The cash accounting method cannot be used in varied places:

  • Sale of products or sale of service upon credit.
  • Gross receipts are higher than the IRS needs.
  • There is a need for inventory to account for receipts.

So when credit is offered to customers, accrual accounting comes to the rescue as credit-available customers do not pay in a short time. This needs recording of the transaction, which is done using accrual accounting. The IRS itself also sets regulations on which businesses can use cash accounting. In this regard, C entrepreneurship or partnerships having an average annual gross receipt above the threshold of ₹191 crores for the last three tax years are barred from cash accounting transactions.

Apart from the above restrictions, a business cannot use cash accounting if it produces, buys or sells goods and relies on inventory. Cash accounting cannot be used for producing, purchasing or selling goods and depends on inventory. An exception exists in this regard wherein small business taxpayers choose not to keep an inventory because of average annual gross receipts being less than ₹191 crores or less in the last three tax years.

  • Difficult Switch-Over Method

Cash accounting is a method that makes shifting to other forms of accounting difficult. As a business grows, accounting processes need to be shifted and adjusted accordingly. 

When business transitions from cash accounting to accrual accounting, the following things need to be taken care of: 

  1. Addition of accrued and prepaid expenditure.
  2. Addition of accounts receivable.
  3. Deduct cash payments, cash receipts and customer prepayments.

What Is Modified Cash Accounting and Its Advantages?

A modified cash-based method facilitates the recording of short-term assets and financial liabilities, such as accounts outstanding and inventory, using the procedure of cash accounting. This record is made on the income statement. On the other hand, long-term assets and financial liabilities, such as fixed assets and liabilities and long-term debt, are noted on the balance sheet.

Just as in the accrual accounting method, degradation and remuneration are recorded on the income statement.

The following are the advantages of modified cash accounting:

  1. The method helps balance short-term and long-term accounting units by taking in elements from both procedures.
  2. The accrual accounting method gives a picture with clarity of business performance. On the other hand, using the cash account method helps keep records for other items and keep costs under margin where possible.

Conclusion

Cash accounting as an important accounting feature is essential for macro and small businesses as it helps them in accounting for their receipts and expenditures. It is an easy tool to use and facilitates business for startups and growing companies. Unlike accrual accounting, cash accounting is cost-effective for smaller businesses and helps them manage their resources efficiently.
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