Cash Basis Accounting means income and expenses are only recorded when paid.
In the strictest sense, this means no accounts receivableComing Soon to a Browser Near You! and no accounts payableComing Soon to a Browser Near You exist.
In theory, this means you would only record deposits posted to an income account when you were paid. And you would only record expenses by paying them. You would not create invoices or bills.
Cash Basis Accounting Reports
Of course, this is impractical for most small businesses, so your accounting software will allow you to record these kinds of transactions and then run cash basis reports. These cash basis reports will attempt to eliminate any unpaid income and expenses. When you have partially paid invoices or bills, your accounting software will attempt to prorate the paid amount across the line items in that transaction.
Another implication of cash basis accounting reports is when you (eg invoiceComing Soon to a Browser Near You! for a customer deposit). In a case like this, there is no income to eliminate. You have accounts receivableComing Soon to a Browser Near You! linked to a liability (Unearned RevenueThere are 5 major account types in a company’s Chart of Accounts: • Assets • Liabilities • Equity • Revenue • Expenses The first 3 make up the Balance… ). This confuses accounting software. The effect might be that you get some weird numbers on a cash basis balance sheetComing Soon to a Browser Near You, like negative accounts receivableComing Soon to a Browser Near You! or negative accounts payableComing Soon to a Browser Near You.
In some cases, it’s better to run accrual basis reports and post your own elimination entries. Accounts PayableComing Soon to a Browser Near You against expenses. Accounts receivableComing Soon to a Browser Near You! against income, and unearned revenueThere are 5 major account types in a company’s Chart of Accounts: • Assets • Liabilities • Equity • Revenue • Expenses The first 3 make up the Balance… against income. Also if applicable, prepaid expensesComing Soon to a Web Browser Near You! against expenses. You don’t need to get specific about which expense. The goal is to get the total right, not the individual categories. You could even create contra-incomeThere are 5 major account types in a company’s Chart of Accounts: • Assets • Liabilities • Equity • Revenue • Expenses The first 3 make up the Balance… and expense accounts for this purpose.
The only use case for cash basis books is for filing tax returns on a cash basis. Other than that, you might want to see a cash basis profit and loss statement just to analyze what that looks like.
In general, the only way to run a business (regardless of how you file taxes) is on an accrual basis. Cash basis leaves out important pieces of the picture.
Writing off uncollected receivables on a cash basis
Some people go so far as to not write off uncollected receivables in a cash basis business. The leaves these uncollected receivables permanently on the books. The theory is that since receivables don’t exist on a cash basis they can’t be written off (even though you have to record them so you know who owes you money).
This is an extremist point of you. The reality is that if you write off your receivables in a cash basis business, both the income and the bad debt expense will show up in the same period and it’s a wash.
What some people do in this case is instead of bad debt as an expense, they will classify the bad debt as a contra-incomeThere are 5 major account types in a company’s Chart of Accounts: • Assets • Liabilities • Equity • Revenue • Expenses The first 3 make up the Balance… account so the revenues net to the proper cash basis number.
Modified Cash Basis
This is not applicable to publicly traded companies (GAAP), but for smaller businesses, you can elect “modified cash basis” which lets you report your short terms assets like Accounts ReceivableComing Soon to a Browser Near You!, and InventoryAny business that buys and sells products has inventory. eCommerce businesses by definition have inventory. If you look at a simple retail business, they buy products from a wholesaler or… on a cash basis, and long-term assets like fixed assetsComing Soon to a Browser Near You! (and the related depreciation) on an accrual basis.
In a manner of speaking this is the “best of both worlds” but in reality there are both advantages and disadvantages to Modified Cash Basis.
The main advantage is as stated above, that you can pick up your income and expenses based on when they were paid (so you don’t pay taxes on the income you haven’t received).
The main disadvantage is that this method will not fly if you need an audit or if your financial statementsComing Soon to a Browser Near You! are subjected to any kind of scrutiny for lending or investing purposes.
For most small businesses the best way to keep the books is on an accrual basis and use cash basis reporting for tax filing purposes only.
