The cash method of accounting, also known as cash-basis accounting, cash receipts and disbursements method of accounting or cash accounting (the
EU VAT directive vocabulary
A vocabulary (also known as a lexicon) is a set of words, typically the set in a language or the set known to an individual. The word ''vocabulary'' originated from the Latin , meaning "a word, name". It forms an essential component of languag ...
Article 226) records revenue when cash is received, and expenses when they are paid in cash.
As a
basis of accounting, this is in contrast to the alternative
accrual method which records income items when they are ''earned'' and records deductions when expenses are ''incurred'' regardless of the flow of cash.
Cash method of accounting in the United States (GAAP)
Use in contract accounting
The cash method of accounting has historically been one of the four methods of recognizing revenues and profits on contracts, the other ones being the
accrual method, the
completed-contract method and the
percentage-of-completion methods.
Since the
Tax Reform Act of 1986, the cash method can no longer be used for
C corporations, partnerships in which one or more partners are C Corporations,
tax shelters, and certain types of trusts.
Because of the 1986 reform, in general, construction businesses do not use the cash method of accounting. Some construction businesses use the cash method, and there are many other companies that use a modified form of the cash method, which is acceptable under federal income tax regulations. Under the modified cash method of accounting, most income and expenses are determined under cash receipts and disbursements, but purchases of equipment and items whose benefit will cover more than one year is to be capitalized, whereas such items as depreciation and amortization are charged to cost.
Use in other types of businesses
The cash method of accounting is also used by other types of businesses, such as farming businesses, qualified personal business corporations and entities with average gross receipts of $5,000,000 or less
for the last three fiscal years.
Advantages for tax planning and IRS stand
There are certain advantages in
tax planning when the cash method of accounting is used: for instance, payment of business expenses may be accelerated before year end, in order to maximize
tax deduction
A tax deduction or benefit is an amount deducted from taxable income, usually based on expenses such as those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. The diff ...
s, whereas billings for services may be postponed to after year end, so that payments won't be received until the new year, thus postponing tax payments on such income.
Because of these advantages and the manipulations that can occur with it in order to minimize taxable income, the
IRS
The Internal Revenue Service (IRS) is the revenue service for the Federal government of the United States, United States federal government, which is responsible for collecting Taxation in the United States, U.S. federal taxes and administerin ...
has discouraged (although not prohibited entirely) the cash basis of accounting for tax purposes. For instance, companies that use the cash basis of accounting may not report any inventory in their financial statements, in fact reporting of any inventory at year end can lead to manipulation of taxable income to an enormous extent.
See also
*
Percentage-of-completion method
References
{{reflist
Accounting systems
Cash