Cash Method of Accounting
The cash method of accounting, also known as the cash basis of accounting, is a financial reporting method that recognizes revenues and expenses only when cash is received or paid, respectively. In other words, under the cash method, income is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers, employees, or other parties.
The cash method of accounting is simple and straightforward, making it a popular choice for small businesses, sole proprietors, and individuals who do not have complex financial transactions. It provides an immediate picture of the cash inflows and outflows of a business and is easier to understand compared to other accounting methods, such as the accrual method.
However, the cash method has some limitations. It does not provide an accurate representation of a company’s financial performance over a specific period, as it does not match revenues and expenses to the period in which they were incurred. This can lead to inconsistencies and distortions in financial reporting, especially for businesses with significant variations in their cash flows or with long-term projects.
For example, suppose a company provides services to a customer in December 2022 but receives payment for those services in January 2023. Under the cash method, the company would record the revenue in January 2023, even though the services were provided in December 2022. This can make it difficult for business owners, investors, and other stakeholders to assess the company’s true financial performance during a specific period.
Due to these limitations, the cash method of accounting is generally not allowed under Generally Accepted Accounting Principles (GAAP) for most businesses, and the accrual method is preferred.
Example of the Cash Method of Accounting
Let’s consider a small freelance graphic design business that uses the cash method of accounting. Here’s an example of how the cash method would work for this business:
- In January, the graphic designer completes a project for a client and sends an invoice for $2,000. However, the client doesn’t pay the invoice until February. Under the cash method of accounting, the revenue of $2,000 would be recorded in February, when the payment is actually received.
- In March, the graphic designer purchases a new computer for $1,500 and pays for it immediately. Under the cash method, the expense of $1,500 would be recorded in March, when the cash payment was made.
- In April, the graphic designer pays $300 for a software subscription covering the next six months (April to September). The entire $300 expense would be recorded in April under the cash method, even though the subscription will provide benefits over six months.
By using the cash method of accounting, the graphic design business records revenue and expenses only when cash is received or paid, which makes it easier to track cash inflows and outflows. However, it’s important to note that this method does not provide an accurate picture of the company’s financial performance over time, as it does not match revenues and expenses to the period in which they were incurred.
In contrast, using the accrual method, the graphic designer would record the $2,000 revenue in January (when the work was completed) and the $300 software subscription expense would be spread out over six months ($50 per month) to reflect the actual period the subscription covers.