In this video you'll learn what the Cash Basis of Accounting is,
why loads of people use it, and what the Pros and Cons are.
[Music]
Hey, I'm James and welcome back to Accounting Stuff.
The Channel dedicated to all things Accounting.
In today's video we're continuing our series on Accounting Basics.
Today's topic is the Cash Basis of Accounting which is a handy way of doing your books if
you're a small business owner. If you haven't heard of it already, you may
in fact already be using it. Don't forget to stick around til the end of
this video because I'm going to be sharing
all of the Pros and Cons of this Accounting System.
And I'm starting right now. The Cash Basis of Accounting is a method of
recording financial transactions. Under this method, transactions are only recorded
once cash changes hands. We record Revenue only when cash is received,
and we record Expenses only when cash is paid out.
Let me elaborate on this with a simple example. Imagine you've got a Baking business and a
customer places an order for a birthday cake. The ingredients for this cake cost you $10
to buy, and you are selling it at a 150 percent markup on cost.
So the customer pays you $25. You've got two transactions to record.
First you need to record the expense, which in this case is the cost of buying the
ingredients for the cake. You Debit your expenses by $10 to increase
them, and you Credit your cash by $10 to reduce
your cash balance. You then need to recognise your Revenue
which is the $25 that the customer pays you. you Debit your cash by $25 to increase it,
and you Credit your Revenue by $25 to increase it as well.
If you're new to Debits and Credits or you'd like a refresher.
I recommend that you check out this video. Now I want you to consider two scenarios.
The first is that you buy the ingredients for your cake,
you bake it and you sell it, all the same day
on the 25th of October. The customer pays you in cash.
Under the Cash Basis of Accounting. Transactions are recorded when money changes
hands. So in this case, you record your expense and
your revenue on the same day The 25th of October.
The second scenario is the same as the first
except this time the customer pays on account. Your business has seven-day payment terms.
So you receive the cash a week after you baked and handed over the cake to the customer.
Under the Cash Basis of Accounting you record your Expense the day that you bought
the ingredients for your cake, and you recognise your Revenue the following
week on the first of November
because that's when you received the cash from the customer.
So what are the Pros of using this method? For one, it's a great way to record transactions
for small businesses that deal and operate mainly in cash.
It's simple and easy to understand. So your business doesn't necessarily need
to hire an Accountant or someone that understands more complex accounting
methods. That makes it cheap to maintain
and you might be able to get away without paying for more pricey Accounting software.
And finally, many countries accept this method of accounting
for tax purposes so long as your earnings are below a certain
threshold. So this could be a viable option for you.
Now you might be thinking… WOW!
This sounds amazing why doesn't everyone do it?
Well in reality, most businesses are much too complex to use
this method of accounting. When you cash account
you don't have an accurate way of recording your profits
so there can be huge fluctuations in your results.
this is caused by recording Income and Expenses in separate accounting periods.
If we go back to that second scenario, we can see that we recorded the Expense in
October and the Revenue in November.
So the October accounting period would show a Loss of $10
and the November accounting period would show a Profit of $25.
It would make much more sense to show a Profit of $15 in October
because that's when the work was done. In addition to this
you have no way of knowing your Financial Position
because you aren't recording your Payables and Receivables.
Finally… and this can be a clincher, the Cash Basis of Accounting isn't allowed
under GAAP or IFRS. So if you follow either of these Principles
or Standards… then “No Dice”.
So the Cash Basis of Accounting can be a great way to record transactions
if you've got a small business that relies solely on cash.
However, if your business has Payables and Receivables
this method probably won't work well for you because timing differences
between Cash in and Cash out mean that you don't have a reliable way of
recording your Profit. If that's you…
then you'll need to use the Accrual Basis of Accounting instead
to match up those Revenues and Expenses. I’ll take you through this method
in the next episode of Accounting Stuff. Thank you for watching today's video.
If you found it useful you can help support the channel
by giving it a LIKE it really makes a difference.
SUBSCRIBE if you want to see more, and hit that little bell so you don't miss
out in the next one. As always, if there are any topics you'd like
me to cover let me know in the comments below.
I love hearing what you guys have to say and I always do my best to respond.
I had a great time learning with you today. Til next time!
[Music]