What it is:
Under cash accounting, a business records revenue and expenses in the period in which they are actually received or paid, rather than in the period in which they are incurred.
How it works (Example):
Let's assume Company XYZ sold 1,000 widgets in December for $1,000 each and that its customers usually take 60 days to pay for their widgets. If Company XYZ used cash accounting, it would record the revenue only when it receives the cash from the customers. Thus, it would record $0 in revenues in December, $0 in January, and $1,000 x 1,000 = $1,000,000 in February.
The same would apply to Company XYZ's expenses. If Company XYZ purchased $500,000 of raw materials in December but did not actually transfer cash to the seller for those materials until February, it would record $0 of expenses in December, $0 in January, and $500,000 in February.
Cash accounting is an alternative to accrual accounting, which records revenues and expenses in the periods in which they are incurred. In our example, Company XYZ would have recorded $1,000,000 in revenue and $500,000 in expenses in December if it made the widgets and delivered them to its customer in December.
Why it Matters:
The key difference between cash accounting and accrual accounting is not how much is recorded, but when it is recorded. Although small businesses can generally choose which method to use, accrual accounting is more common than cash accounting, and if a company keeps inventory or has more than a few million dollars in revenue, accrual accounting is virtually required.
Both methods have advantages and disadvantages. Accrual accounting tends to reflect the sequence of a business's activities better, but it gives less information about the business's cash situation than cash accounting does. For example, accrual accounting might show that Company XYZ has $1,000,000 in sales, but the company may not actually have a penny to show for it yet. Likewise, cash accounting can overstate and understate the condition of the business if collections or payments happen to be particularly high or low in one period versus another.
Cash accounting also has tax ramifications. In general, businesses can only deduct expenses that are recorded during the tax year. Thus, the choice of accounting method can determine which year a business can deduct an expense. For example, if Company XYZ incurs $500,000 of expenses in 2010 but doesn't actually pay those expenses until 2011, the expenses are not deductible until 2011. This affects the business's net income. It is possible to use one method for tax purposes and another for accounting purposes, but business owners should consult a tax advisor before making the decision.