Cash Basis Accounting

Simple cash basis accounting is more frequently used by small businesses and those that do not use or extend credit. Similar to making entries in a checkbook ledger, accounting in hard cash gives owners a running tally of monies received and funds paid out the moment the transactions occur. Money receipts are recorded one transaction at a time and there are no expectations of future dates of payment. Business owners operating on a strict cash basis can track cash flow and assess on a daily basis whether an enterprise is making a profit or not. Similar to making entries in a checkbook ledger, cash basis accounting lists each sale and each expense, adding and subtracting transactions from a total operating budget. The process is the same even when owners use popular accounting software rather than antiquated ledger books.

Mom and Pop enterprises, shoestring startups, and sole proprietorships generally operate with cash basis accounting. These businesses depend on paying customers to stay afloat and provide sufficient revenue to purchase inventory and stock store shelves. Smaller businesses invest a significant amount of startup capital in new businesses, and are usually extended a certain amount of credit through bankers and lending institutions. But small businesses cannot operate for very long on credit or limited capital. Every dollar counts and every customer must be a paying customer in order for small owners to pay suppliers, repay bank loans, and keep up with overhead expenses.

Most businesses fail in the first five years of operation largely due to a lack of capital or insufficient cash flow. Smaller businesses simply cannot compete with larger entities that can afford to extend credit or run an enterprise from the interest consumers pay for the privilege of delaying installment payments. A small entrepreneur can quickly get into trouble extending credit for which payments fall into default. The resulting lack of cash flow can spell bankruptcy if owners don't watch the bottom line. Consumers have a moral obligation to creditors who depend on timely payments to stay in business. Ecclesiastes 5:4-5 admonishes, "When thou vowest a vow unto God, defer not to pay it; for He hath no pleasure in fools: pay that which thou hast vowed. Better is it that thou shouldest not vow, than that thou shouldest vow and not pay."

Businesses that extend credit, or promises to pay at a later date, use accrual based accounting, a more sophisticated method of tracking profitability. Instead of recording monies that are actually received, revenue is entered when it is earned, although payment may actually be received at a much later date. Credit card issuers, lending institutions, building contractors, and other businesses that allow consumers to pay on time or via installments operate on an accrual basis. These businesses deal with account payables and account receivables, instead of cold hard currency. Accurately determining cash flow in an accrual based business can be more difficult, because transactions are open ended. Customer accounts, while recorded as revenue, are outstanding until payments are actually received. Companies that extend credit run the risk of "counting the proverbial chickens before the eggs hatch." On the books, a business can look like it is in the black, but if customers routinely default on payments, what appears to be assets can easily turn into liabilities. Yet, in spite of the potential precariousness of accrual-based bookkeeping, the Internal Revenue Service (IRS) and the U.S. Securities and Exchange Commission (SEC) require that publicly traded companies follow Generally Accepted Accounting Practices (GAAP), which specifies accrual based accounting.

Unlike the Mom and Pop grocery around the corner, the global monetary system, or money market, operates on accrual based accounting. Corporations, conglomerates, mutual funds, lending institutions, and credit unions depend on interest accumulated from credit extended to consumers. Rather than getting paid at face value at the time of a purchase, businesses can realize significant earnings from interest payments on credit purchases extended 90 days, five years, and more. Accrual-based bookkeeping records principal payments as assets, regardless of when consumers actually pay the balance of purchases made over a period of time. Companies that use cash basis accounting may not have sufficient capital reserves to extend credit and wait on payments. For smaller firms and start-ups, dollar-for-dollar bookkeeping is the safer method of keeping track of cash flow and net profits.

Companies that file federal income tax returns must indicate the bookkeeping method used during the tax year on Schedule C, Profit or Loss from Business, along with Form 1040. Whether cash- or accrual-based, the method must accurately reflect income. IRS guidelines require businesses to use the accrual method for sales and purchases of inventory items. Entrepreneurs using money-based bookkeeping must show all taxable income received when it was credited to accounts, less actual expenses paid. Accrual-basis taxpayers report income in the fiscal year it was earned, regardless of whether monies have been collected. Expenses are deducted even if they have not been paid in the year in which taxes are filed. Bookkeeping methods can be changed in order to reflect accrued sales in one tax year which may not have been received until the following year. Owners may consult the Internal Revenue Service website to determine when to use accrual based accounting or cash basis accounting, or the procedure for making adjustments due to changes in bookkeeping methods. Bankers, certified public accountants, and tax preparers may also be helpful in determining the best method of recording income and expenses and complying with IRS and SEC regulations.

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