Oct 21, 2021Pros and Cons of the Cash Method
One of the most important decisions that a company makes in its formative years is the method of accounting that it will use. The method of accounting dictates month-end procedures and certain liability and asset balances. The method of accounting chosen by a company may also create additional book-to-tax adjustments if the financial and tax accounting methods are not the same.
As you can imagine, the decision for which method of accounting should be adopted is an important one. There are three main accounting methods: cash, accrual, and hybrid. In this article, we’ll focus on the cash method of accounting.
What is the Cash Method?
The cash method involved recording transactions when actual cash is given or received. All transactions are recorded on a “cash” basis. This means that cash method companies do not recognize income/loss on month end accruals, accounts payable, or accounts receivable. It is important to note that even though these transactions are not reported on a company’s books, they still exist. It is essential for companies that adopt the cash method of accounting to keep track of amounts owed to suppliers and amounts outstanding from customers. However, these companies don’t recognize any income or expense for financial or tax purposes until the cash actually changes hands.
Pros and Cons to Using the Cash Method
As discussed above, determining which method of accounting to use is an important decision. If a company wants to change its method in the future, it is required to calculate and make large adjustments on both their financial statements and tax returns. These calculations can be increasingly complex and difficult depending on the size and nature of the adjustment. Either way, this is an important decision to get right. So, lets discuss the pros and cons of the cash method of accounting.
The biggest pro for using the cash method of accounting is that it is generally easier. When a company uses the cash method, bank statements can inform how to book most transactions. Cash method companies don’t need to worry about booking month-end accrual entries, which can save a lot of time.
Another huge pro for cash method taxpayers is that income does not have to be recognized for tax purposes until cash is in hand. This advantage allows cash method taxpayers to always have the wherewithal to pay a tax liability due on their income. Put another way, accrual method taxpayers must report income for outstanding accounts receivable. This means that accrual method taxpayers often must pay income tax on funds that they have yet to receive. For companies with large amounts of accounts receivable, such as service firms, being a cash method taxpayer is a huge advantage.
The biggest con of keeping all accounting records on a cash basis is that it is hard to see exactly the state of the company by simply looking at the financial statements. For example, a company may enter into several transactions with customers and suppliers and incur a large number of accounts receivable and accounts payable. These transactions may display certain positive or negative trends for the business that will not be reflected on the financial statements until the cash actually changes hands. Without accrual entries, the financial statements do not show the entire picture of a company.
Another con is that taxpayers are not allowed to deduct any accrued expenses until cash actually changes hands. While accrual method taxpayers look at the economic performance test to determine the deductibility of expenses, cash method taxpayers simply deduct the expenses that have already been paid. In certain scenarios this can adversely affect cash flow to the business.
What Should Your Business Do?
One question that we get from business owners often is: which method of accounting should our business adopt? The most optimal answer varies for each company’s situation. When you have questions about which method of accounting your business should use, it is important to always consult with a professional. Please feel free to reach out to our team at Nimbl for additional information!