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Cash accounting is a specific method of accounting used on the balance sheets of some businesses. Cash accounting is often considered the simplest method of accounting. It is an alternative to accrual based accounting.
Typically, in business, work is done and/or goods are sold before payment is received. For example, an individual might do contract work, performing a service. He is not usually paid before performing the service, but is paid on a set schedule as determined by the terms of employment.
Under a cash accounting system, the individual or business does not record income until he actually receives the payment. This means if a person sells 100 widgets, or does 10 hours of work, the money he is owed for the widgets and the work is not listed as income on the balance sheet, nor is it considered taxable income for tax purposes at that stage. Instead, the money is listed as an account payable.
When the payment is actually received, the money is accounted for. Thus, monthly, annually and quarterly income is based only on actual payments that have been received. When a person or company files income taxes, applies for a loan or does any other activity that requires him to prove his income, he then reports only income that he has actually earned.
There are several benefits to cash accounting. First, it can be simpler because pending payments do not need to be calculated along with interest. With accrual accounting, the major alternative, money is counted as earned income as soon as it is earned. This makes it more difficult to keep track of how much actual tangible cash the person has received.
Furthermore, with accrual accounting, the money is essentially counted before it is paid. This can lead to problems if full payment is not made. If, for example, an individual uses an accrual accounting system for work he performs and bases his income tax payments on money he expects to receive, his tax calculations could be thrown off if a client does not pay him the money owed in full.
In addition to income only being counted when received, expenses are also only deducted when paid. So, although a person or business may know that rent is due or that a purchase will have to be made, the expense is not listed on the balance sheet until the money actually goes out. This allows for a real-time account of all of the tangible liquid assets. Because of the simplicity of cash accounting, it is often the preferred method for small businesses.