Many businesses are effectively endangering their cash flow management by using cash basis accounting as their primary method of tracking their day to day financial dealings. This can develop into a serious problem. Cash basis accounting doesn’t comply with GAAP principles.
Source: www.accountingdepartment.com
If you’re surprised to learn that, keep reading. Even though there are businesses to whom a cash accounting method makes perfect sense, the big gaps in time between recording profit and recording expense can create chaos — especially when it involves bigger projects. A small business can appear to be earning a good profit one year, resulting in unnecessarily higher tax liabilities. In order to combat this, many companies spend those revenues elsewhere to reduce their tax liability, but inadvertently put themselves in the position of having short cash flow when the time comes to foot the bill to complete a job.
So why do many small companies still operate using the cash basis method? In a word, simplicity. Far more straightforward than the method of accrual basis accounting, where income is recorded when it’s earned and expenses are recorded when they’re incurred, a cash accounting method is just simpler. But simple doesn’t always mean better.
The Benefits of Cash Basis Accounting
If it seems like extolling the virtues of cash basis accounting at the same time as discussing its equally profound problems is a bit schizophrenic, welcome to the wonderful world of accounting. Here, one company’s liability can be another company’s saving grace. And although cash basis accounting fails to meet basic GAAP principles, there are some companies that can benefit.
The problem is, those companies might be few and far between with respect to the commercial landscape. If your company falls into any of the categories below, cash basis accounting might be for you:
Does not have the ability to take credit card payments
Pays all expenses in cash
Requires a simplistic accounting system
If your company doesn’t fit the description above, a cash accounting method is something you should steer far and clear of.
The bottom line: accrual basis accounting gives a company the ability to take an accurate financial snapshot at any given time. With a cash accounting method, that picture is not as clear. Its outcome depends on at what point the snapshot is taken, once again proving that the path of least resistance is not always the best path to take.
{ 3 comments }
Thank you for clearing up my confusion about accrual versus cash accounting!
Cash vs accrual accounting – the great debate is over!
Thank you so much for clearing this up. I have been thinking about this for a while now. My current CFO just moved, and I have been looking for a new one. In the meantime, I have hired someone temporary to do outsourced accounting. He has really helped the company out a lot and I want to continue to do what he does after he leaves. I was talking about this, and I was a little confused so I looked it up. Thanks again for explaining this.
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