Cash accounting is the method where a business records revenue and expenses at the time they are actually received or paid, not in the period in which they were incurred.
Here’s a simple example of how cash accounting works. A business sells 500 widgets in December for $100 each. It allows customers to take 60 days to pay for their purchases. Using the cash accounting method, the business records the revenue only when it receives payment from a customer. So, it could record some or none of the revenue in December, some or none in January, and some or all the revenue in February. The same is true for expenses. The company may buy $10,000 worth of materials in December but not pay for it until February. So, it would record zero expenses in December and January and the entire $5000 in February.
If the business uses the accrual accounting method instead, it would record those revenues and expenses when they were incurred. That is, it would record $5000 in revenue and $10,000 in expenses in December.
Why does Cash Accounting matter?
Cash and accrual accounting differ not on how much is recorded, but when it is recorded. Both methods of accounting have their advantages and disadvantages, with accrual accounting tending to reflect a business’s activities better but giving less information about the business’ cash situation. For example, accrual accounting would show the company had $5000 in sales, but it may not have actually received any funds.
There are also tax ramifications to cash accounting. Generally, a business may only deduct expenses that are recorded during the tax year. So, if an expense is incurred in one year but paid in the next year, the business may not deduct the expense until taxes are due for the year it was paid, which can be up to 16 months later. This can seriously affect a business’ net income.