Definition: Cash basis accounting is an accounting system that recognizes and records income and expenses as they are paid in cash. GAAP dictates that businesses cannot use the cash basis of accounting. Instead, businesses must use the accrual basis of accounting that recognizes revenues and expenses when they are earned or occur.
What Does Cash Basis Accounting Mean?
The cash basis is a much more simplified accounting system then the accrual basis. Cash basis accounting only recognizes income and expenses when cash is actually collected or disbursed. Net income under a cash basis system would always equal the company’s cash receipts minus the cash disbursements.
Assume a company starts only one bank account and all the cash receipts from the year are deposited in the account. In other words, all the revenue that the company collects is deposited in one single account. Additionally, all the expenses are paid out of this one account. At the end of the year, the balance of the bank account less than the beginning balance would be the cash basis net income for the company for the year.
As you can see, this is a much more simplified accounting system than the accrual accounting system. The cash basis of accounting does not recognize any accrued revenues or expenses because they were not paid in cash during the period.
GAAP does not allow companies to use the cash basis of accounting because it violates the matching principle, time period principle, and doesn’t reflect the actual company performance or financial status. Companies are allowed to use the cash basis for internal purposes. Some smaller companies are also allowed to file tax returns on the cash basis.