Cash Basis Accounting: Does It Include Loans?

Cash basis accounting is a method of recording revenues and expenses at the time cash is received or paid out. It is a popular method among small businesses as it is simpler, less expensive, and requires little accounting expertise. However, it does not account for accounts receivable or payable, which can make it difficult to analyse future earnings and identify trends. Cash basis loans are non-performing loans, where interest is recorded as earned when payment is collected. These are considered 'bad debt' by banks as they are defaulted loans that have not been paid for 90 days or more.

Cash basis accounting

The cash basis method is advantageous because it is simpler, less expensive, and gives an accurate picture of how much cash is on hand. For these reasons, it is a suitable accounting practice for some small business owners and independent contractors who carry no inventory. Many small businesses avoid employing accountants and complex accounting systems when using this method because of its ease of use.

However, the cash-basis method is not without disadvantages. It can paint an inaccurate picture of a business's health and growth. For example, a business can experience a decline in sales in one month, but if a large number of clients pay their invoices in the same period, cash-basis accounting can be misleading by showing an influx of cash. For business owners, comparative analysis (to project future earnings and identify trends) can be difficult with cash-basis accounting because of scenarios like this. In contrast, with the accrual method, businesses can get a better sense of their actual sales, profits, and overall financial health. Additionally, cash-basis accounting can make obtaining financing more difficult due to its high probability of inaccuracies.

The Internal Revenue Service (IRS) allows most small businesses to choose between the cash and accrual accounting methods. However, businesses with over $26 million in average annual gross receipts from sales for the preceding three tax years must use the accrual method. Some businesses may find that a modified cash-based accounting system works best, using accrual accounting for long-term assets and a cash basis for short-term assets. The Tax Reform Act of 1986 prohibits the cash basis accounting method from being used for C corporations, tax shelters, certain types of trusts, and partnerships that have C Corporation partners.

Cash basis loans as bad debt

A cash basis loan is a non-performing loan, meaning that the borrower hasn't made any scheduled principal or interest repayments for at least 90 days. Ordinarily, interest income is accrued on loans as regular payments of both principal and interest are assumed. However, in the case of non-performing loans, continuing payments are doubtful. Cash basis loans are considered to have gone bad when they are in default for 90 days, and the borrower hasn't made any scheduled repayments for at least that period.

Banks usually consider cash basis loans bad debt because it is unlikely they will be able to collect on them. When a bank has many cash basis loans on its records, its stock price can suffer. Non-performing loans can cause a bank to lose money and reduce the amount of money available to lend to other customers.

Cash basis loans are recorded as earned when payment is collected. This is different from accrual accounting, which recognizes income when it is earned and records expenses when liabilities are incurred, regardless of when cash is received or paid. Cash basis accounting is simpler and less expensive for a business to use, but it can also be misleading and make obtaining financing more difficult. For example, a business can experience a decline in sales one month, but if a large number of clients pay their invoices in the same period, cash-basis accounting will show an influx of cash.

Business bad debt is a loss from the worthlessness of a debt that was either created or acquired in a trade or business when it became partly or totally worthless. A business bad debt deduction is permitted if the income arising from the creation of the receivable was previously included in the income. For cash-basis taxpayers, a bad debt deduction is generally not allowed for uncollectible accounts receivable since these items are normally not included in income until received.

Cash basis balance sheets

A cash basis balance sheet is a major accounting method that recognises revenues and expenses at the time cash is received or paid out. This method is usually used by smaller organisations as it requires little accounting expertise and is simpler and less expensive than accrual accounting.

The cash basis balance sheet includes three parts: assets, liabilities, and equity. The balance sheet does not track or record accounts payable, accounts receivable, or inventory with this method. So, your balance sheet does not include any unpaid invoices or expenses.

The cash-basis method is not without its disadvantages. It can paint an inaccurate picture of a business's health and growth. For example, a business can experience a decline in sales one month, but if a large number of clients pay their invoices in the same period, cash-basis accounting can be misleading by showing an influx of cash.

Some businesses may find that a modified cash-based accounting system works best. In this system, accrual accounting is used for long-term assets, and a cash basis is used for short-term assets.

Modified cash basis accounting

The accrual method records income when a sale is fulfilled and expenses incurred, irrespective of cash movement. This enables a company to match revenue and expenses, giving a clearer picture of business performance. The cash basis identifies a transaction whenever cash is involved, recording revenue when there is a cash receipt and expenses when there is a cash payment. This method is simpler and less expensive for the business to use.

The modified cash basis provides more relevant financial information than the cash basis method and is cheaper than the accrual basis method. It is primarily used for internal accounting purposes at small private companies as it does not comply with International Financial Reporting Standards (IFRS) or the generally accepted accounting principles (GAAP).

Cash basis accounting for small businesses

Cash basis accounting is a popular choice for small businesses due to its simplicity and ease of use. It is a straightforward method that records income and expenses based on actual cash flow – revenue is recognised when cash is received, and expenses are recorded when they are paid. This makes it easier for small business owners to understand and manage their finances, especially when it comes to tax reporting and cash flow management.

One of the main advantages of cash basis accounting is its simplified approach. Unlike accrual basis accounting, it does not require complex calculations or the tracking of accounts receivable and payable. This makes it a more familiar process, similar to how individuals track their personal finances. It also provides a clear short-term vision of a company's financial situation, making it easier to track income and expenses for tax purposes.

However, cash basis accounting also has its drawbacks. One of the major disadvantages is that it may not accurately reflect a business's true financial performance. Since it does not account for unpaid invoices or outstanding bills, it may not provide a complete picture of a business's financial health. This can limit the ability to make informed management decisions based on accurate financial data and can make obtaining financing more difficult.

Additionally, cash basis accounting may not be suitable for businesses with complex financial transactions, such as those that deal with inventory or have significant accounts receivable and payable. Financial statements prepared using this method may also be less detailed or informative, which can make it more challenging for small businesses to attract investors or secure financing.

Overall, while cash basis accounting offers a simplified approach that is beneficial for small businesses, it is important to consider its limitations and potential inaccuracies when deciding if it is the best choice for a particular business.

Frequently asked questions