Cash basis accounting is a method of accounting that recognizes events only when cash is exchanged. For example revenues are recognized when the money is received and expenses are recognized when we write a check or pay cash.
Not every business can use this method of
accounting. Only small sole proprietor type businesses are usually
allowed to use it. These types of businesses include service businesses
like doctors, lawyers, small stores, etc. Larger corporate businesses
must use accrual accounting instead.
Cash accounting has benefits and pitfalls. The main benefit is that the business can sell or perform services near the year end and not have to recognize that revenue on their income taxes, until the following year when the cash is actually received.
If the business has done very well for the year, it can make purchases in the current year with cash that will benefit the next year. For example, a doctor may stock up on office supplies. In this way, some of the expenses for next year can be taken on this year's income tax statement.
In an accrual based accounting system the revenue and expenses must be recognized in the same period. The above revenue and expense situations would not be allowed.
Let's look at a couple of examples using journal entries. The first example is where we have performed a service for $1000 on Dec 23, and have allowed our customer to pay us in 30 days:
Cash basis accounting journal entry: (no journal entry is required in the accounting system until the cash is received, however, the amount due is kept track of in a separate ledger)
The accrual basis journal entry would record the revenue when the service was performed and also record an accounts receivable entry.
In the situation where we stocked up on supplies:
Cash basis journal entry (no journal entry required, until we pay the bill for the supplies)
The accrual basis journal entry would be to record the supplies as an asset and the amount due as a liability when the transaction took place. The supplies would be expenses as consumed.
You can see the two very different accounting methods. Cash accounting has tax advantages, but does not as accurately reflect the financial position of the company for a particular period in time.