Which of the following statements about the cash basis of accounting is correct?

What is the Cash Basis of Accounting?

The cash basis of accounting is the practice of recording revenue when cash has been received, and recording expenses when cash has been paid out. The cash basis is commonly used by individuals and small businesses (especially those with no inventory), since it involves the simplest accounting.

An alternative method for recording transactions is the accrual basis of accounting, under which revenue is recorded when earned and expenses are recorded when liabilities are incurred or assets consumed, irrespective of any inflows or outflows of cash. The accrual basis is most commonly used by larger businesses. A start-up company will frequently begin keeping its books under the cash basis, and then switch to the accrual basis when it has grown to a sufficient size. Accounting software can be configured to work under either the cash basis or the accrual basis of accounting, usually by setting a flag in a setup table.

Advantages of the Cash Basis of Accounting

The cash basis of accounting has the following advantages:

• Taxation. The method is commonly used to record financial results for tax purposes, since a business can accelerate some payments in order to reduce its taxable profits, thereby deferring its tax liability.

• Ease of use. A person requires a reduced knowledge of accounting to keep records under the cash basis. Several accounting software packages are designed for the cash basis of accounting, to make them easier to use.

Disadvantages of the Cash Basis of Accounting

The cash basis of accounting also suffers from a number of problems, as outlined below:

• Accuracy. The cash basis of accounting yields less accurate results than the accrual basis of accounting, since the timing of cash flows do not necessarily reflect the proper timing of changes in the financial condition of a business. For example, if a contract with a customer does not allow a business to issue an invoice until the end of a project, the company will be unable to report any revenue until the invoice has been issued and cash received.

• Manipulation. A business can alter its reported results by not cashing received checks or altering the payment timing for its liabilities. This is commonly used to defer the recognition of taxable income to a later reporting period.

• Lending. Lenders do not feel that the cash basis generates overly accurate financial statements, and so may refuse to lend money to a business reporting under the cash basis. However, this may not be the case for a small business that cannot afford the services of a CPA to prepare its books.

• Audited financial statements. Auditors will not approve financial statements that were compiled under the cash basis of accounting, so a business will need to convert to the accrual basis if it wants to have audited financial statements.

• Management reporting. Since the results of cash basis financial statements can be inaccurate, management reports should not be issued that are based upon it.

In short, the numerous problems with the cash basis of accounting usually cause businesses to abandon it after they move beyond their initial startup phases.

Terms Similar to the Cash Basis of Accounting

The cash basis of accounting is also known as cash accounting.

Accrual Accounting vs. Cash Basis Accounting: An Overview

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method provides an immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.

Key Takeaways

• Accrual accounting records revenue and expenses when transactions occur but before money is received or dispensed.
• Cash basis accounting records revenue and expenses when cash related to those transactions actually is received or dispensed.
• Accrual accounting provides a more accurate view of a company's health by including accounts payable and accounts receivable.
• The accrual method is the more commonly used method by large companies, especially by publicly-traded companies, as it smooths out earnings over time.
• The cash basis method typically is used by sole proprietors and smaller businesses.

Accrual Accounting

Under this method, revenue is accounted for when it is earned. Unlike the cash method, the accrual method records revenue when a product or service is delivered to a customer with the expectation that money will be paid in the future. In other words, money is accounted for before it's received. Likewise, expenses for goods and services are recorded before any cash is paid out for them.

Cash Basis Accounting

Under this method, revenue is reported on the income statement only when cash is received. Expenses are recorded only when cash is paid out. The cash method is typically used by small businesses and for personal finances.

Key Differences

Accrual Method

The accrual method records accounts receivables and payables and, as a result, can provide a more accurate picture of the profitability of a company, particularly in the long term.

For example, a company might have sales in the current quarter that wouldn't be recorded under the cash method. The related revenue is expected in the following quarter. An investor might think the company is unprofitable when, in reality, the company is doing well.  

The accrual method doesn't track cash flow. A company might look profitable in the long term but actually have a challenging, major cash shortage in the short term.

Another disadvantage of the accrual method is that it can be more complicated to use since it's necessary to account for items like unearned revenue and prepaid expenses. It also may require added staff.

The accrual method typically is required for companies that file audited financial statements and is accepted under the generally accepted accounting principles (GAAP) issued by the Financial Accounting Standards Boards (FASB).

Cash Basis Method

The key advantage of the cash method is its simplicity—it only accounts for cash paid or received. Tracking the cash flow of a company is also easier.

It's beneficial to sole proprietorships and small businesses because, most likely, it won't require added staff (and the related expenses) to use.

However, the cash basis method might overstate the health of a company that is cash-rich. That's because it doesn't record accounts payables that might exceed the cash on the books and the company's current revenue stream. 

As a result, an investor might conclude the company is making a profit when, in reality, the company might be facing financial difficulties.

The cash basis method is not acceptable under GAAP.

Tax Law Change

The Tax Cuts and Jobs Act increased the number of small business taxpayers who were entitled to use the cash basis accounting method. As of January 2018, small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period could use it.

Special Considerations

The accrual method is the more commonly used method, particularly by publicly-traded companies. One reason for the accrual method's popularity is that it smooths out earnings over time since it accounts for all revenues and expenses as they're generated. The cash basis method records these only when cash changes hands and can present more frequently changing views of profitability.

For example, under the cash basis method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season. However, they'd look unprofitable in the next year's Q1 as consumer spending declines following the holiday rush.

Both methods have their advantages and disadvantages. Each provides different views of the financial health of a company. For investors, it's important to understand the impact of both methods when making investment decisions. 

Accrual Accounting vs. Cash Basis Accounting Example

Let's say you own a business that sells machinery. If you sell $5,000 worth of machinery, under the cash method, that amount is not recorded in the books until the customer hands you the money or you receive the check.

Under the accrual method, the $5,000 is recorded as revenue as of the day the sale was made, though you may receive the money a few days, weeks, or even months later.

The same principle applies to expenses. If the company receives an electric bill for $1,700, under the cash method, the amount is not recorded until the company actually pays the bill. However, under the accrual method, the $1,700 is recorded as an expense the day the company receives the bill.

What Is Accrual Accounting?

Accrual accounting is an accounting method that records revenues and expenses before payments are received or issued. In other words, it records revenue when a sales transaction occurs. It records expenses when a transaction for the purchase of goods or services occurs.

What Is the Difference Between Cash and Accrual Accounting?

Cash basis accounting records revenue and expenses when actual payments are received or disbursed. It doesn't account for either when the transactions that create them occur. On the other hand, accrual accounting records revenue and expenses when those transactions occur and before any money is received or paid out.

When Does a Company Account for Revenue If It Uses Cash Basis Accounting?

Under the cash basis accounting method, a company accounts for revenue only when it receives payment for the products or service it provided a customer.

Which statement about cash basis accounting is true?

Which statement about cash basis accounting is true quizlet?

Which statement is prepared on cash basis of accounting?

Which of the following is a correct statement about the two basis of accounting?