Cash accounting is a bookkeeping system in which payments going out and coming in are only entered when they occur, rather than when the orders are placed.
Cash accounting contrasts with accrual accounting, in which income and expenditure are registered when the orders are placed.
Small enterprises tend to use cash accounting because it is straightforward and easier to understand. However, it can sometimes make profits look as if they are fluctuating wildly when in fact they are not.
With the cash accounting method, Sam’s Windows Ltd’s 3rd month was its best, even though no work was done in that month. The method can make profits appear to fluctuate steeply.
Larger companies have to comply with generally accepted accounting principles, which means using the accrual accounting method.
Example of cash accounting vs. accrual accounting
Imagine Lawn Mowers Ltd. receives an order for 10 lawn mowers from ZZZ Golf Club at $100 each (total $1,000) on January 5th, and receives payment on February 5th.
In a cash accounting system, the sale is recorded as having occurred on February 5th, but in an accrual accounting system the bookkeeper will make the entry for January 5th.
If Lawn Mowers Ltd. had Technicians Forever send an expert down for the day to service all its machinery on January 1st, and paid the invoice of $300 for this service on February 1st, the expense would be registered as having occurred on February 1st using the cash accounting method, and for January 1st using an accrual accounting method.
Disadvantage of cash accounting method
Sometimes a business may seem more cash rich than it really is.
If several payments are going to be made on April 3rd, the enterprise may seem overly cash rich when presenting its first quarter accounts, because invoices it received during that quarter for orders it had placed in that quarter have not yet been paid.
In an accrual accounting system, those deductions would already have been entered in the first quarter.
Conversely, the company that uses the cash accounting method may appear worse off if it has landed a giant order (for which it has not yet been paid).
If it pays its bills on time but the client is late, the business’ expenses to meet the large order may appear on the books, but not the large receipt.
Video – Cash Accounting
This video shows how a fairly stable catering business may appear to have wildly fluctuating monthly profits and losses because it uses a cash accounting system.