key term - Cash Basis

Definition

The cash basis is an accounting method where revenue and expenses are recognized when cash is received or paid, rather than when the transaction occurs. This method focuses on the timing of actual cash flows, rather than accruals or deferrals.

5 Must Know Facts For Your Next Test

1. The cash basis method is simpler and easier to understand than the accrual basis, as it only requires tracking actual cash inflows and outflows.
2. Under the cash basis, revenue is recognized when cash is received, and expenses are recognized when cash is paid, regardless of when the underlying transaction occurred.
3. The cash basis method does not follow the revenue recognition principle, as it does not match revenue with the expenses incurred to generate that revenue.
4. The cash basis is commonly used by small businesses and individuals for tax purposes, as it is easier to track and report cash transactions.
5. The statement of cash flows is prepared using the cash basis, as it focuses on the actual cash receipts and payments of a company during a specific period.

Review Questions

• Explain how the cash basis method differs from the accrual basis in terms of revenue recognition and expense recognition.
  • Under the cash basis method, revenue is recognized when cash is received, and expenses are recognized when cash is paid, regardless of when the underlying transaction occurred. In contrast, the accrual basis method recognizes revenue when it is earned and expenses when they are incurred, following the revenue recognition principle. The cash basis method does not match revenue with the expenses incurred to generate that revenue, while the accrual basis does.
• Describe the purpose of the statement of cash flows and how the cash basis method is used in its preparation.
  • The purpose of the statement of cash flows is to report the cash receipts and cash payments of a company during a specific period. The cash basis method is used in the preparation of the statement of cash flows, as it focuses on the actual cash inflows and outflows, rather than accruals or deferrals. This allows the statement of cash flows to provide information about the company's liquidity, solvency, and financial flexibility, which is crucial for users of financial statements.
• Analyze the advantages and disadvantages of using the cash basis method for small businesses and individuals in the context of tax reporting.
  • The cash basis method is commonly used by small businesses and individuals for tax purposes because it is simpler and easier to understand than the accrual basis. The cash basis only requires tracking actual cash inflows and outflows, which can be more straightforward for businesses with limited resources. However, the cash basis method does not follow the revenue recognition principle and can lead to a mismatch between revenue and expenses, potentially distorting the company's financial performance. This can be a disadvantage for small businesses and individuals who need to accurately report their financial information for tax purposes.

Related terms

Accrual Basis:

The accrual basis is an accounting method where revenue and expenses are recognized when they are earned or incurred, regardless of when cash is received or paid.

Revenue Recognition Principle:

The revenue recognition principle states that revenue should be recorded when it is earned, not necessarily when cash is received.

Statement of Cash Flows:

The statement of cash flows is a financial statement that reports the cash receipts and cash payments of a company during a specific period.