Definition: A method of accounting for a business’ activities that recognizes revenue when it is paid (and not when it is earned) and expenses when they are paid (and not when they are actually incurred).
Example: In December, LoPiccolo’s restaurant hires a marketing firm to mail 5,000 holiday-special postcards to homeowners in the local area. The marketing firm bills LoPiccolo’s $2,000 for this service. The restaurant pays the bill in January. For a small business like LoPiccolo’s, it’s easier to count the advertising expense as having occurred when the bill is paid.
Investeach explains: Cash basis accounting is not as accurate as accrual accounting, which calls for businesses to record expenses when they actually occur. In this case it would be when the marketing firm prints the post cards, mails them, and bills the restaurant.
Cash basis accounting is also used on the revenue side. If the restaurant provided hot trays for a party, it would count the sale when the party’s host paid for it.
Because cash basis accounting is not as accurate as accrual basis accounting, the Internal Revenue Service (the government’s tax collection department) only lets small companies elect to use cash basis accounting. Small businesses have less ability to keep up with the more-complicated accrual accounting. Notice that cash basis accounting requires little more than looking at the company’s checkbook for the money that came in and went out. In addition, small businesses are unlikely to have investors who might be misled by the financial results that cash basis accounting produces.
Finally, by “small” business, the Internal Revenue Service (IRS) means those that take in less than $5 million per year. The actual rules are very complex and with many restrictions and exceptions. Would you expect anything less from the government? They are contained in IRS Publication 538.
Riddle me this:
1. Why is cash basis accounting not as accurate a reflection of what is really happening in a business as accrual accounting?
2. Explain why the government allows only small businesses to use cash basis accounting.
3. Where can a company find a record of the money going in and out of its bank account?
4. What is generally the upper limit that a business can take in and still use cash basis accounting?
Opposite of: Accrual accounting.