In the cash method of accounting, income is not counted unless the company receives cash/check payment for the goods sold. Similarly, there is also a rule for counting the expenses made by the firm. Expenses are not counted unless the amount of expense is actually paid by the company. So, in simple words, we can say that this is a realistic approach towards accounting. Accounting done with the help of cash accounting method gives exact details about the cash balance of the company. The problem of display of exaggerated earnings and profits will not occur in the books of companies which are maintained using the cash accounting method.
On the other hand, a company following cash accounting will not show expenses on taxes unless they are paid. So, in some quarters, when the expenses are not paid, the profits of the company may be higher than the expectations of most analysts. But, in the quarter when the company actually pays the tax, net profits will be squeezed. Financially weak firms may even report quarterly losses as against profits in the preceding quarters. So, shareholders tracking the performance of these companies should consider these facts before they calculate or estimate profits of the company and decide on making investment in their stocks.
The cash method of accounting for tax purposes is the most simplest to understand. It is just according to the normal human tendency of reporting money earned only after receiving it. Such kind of accounting is ideal for small businesses, enterprises and start up firms. One of the major advantages of cash method of accounting is its simplicity for use and getting realistic financial details of the company. Another advantage is that at times, the enterprise owner might not have to shell out more in taxes as he does not declare income until he receives the payment from the other party. So, if he gets the payment in the next financial year, he saves money in taxes in the current year.
Cash Accounting Example
Assume that a firm sells stock worth $10,000 to a client in the current financial year. Due to some reason, the client is unable to pay the firm immediately and can pay only in the next financial year. Now, if this firm uses cash accounting method, then it will not report profits unless they are actually credited in its bank. So, the profit earned on income of $10,000 sale of stock won’t be included in the total net income of the firm for the current financial year. The benefit of this is that the firm will get some relief in tax payment at least till it files taxes for next year, in which it will have to shell out taxes for this particular sale.
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