1. It provides a less accurate picture of the financial position of the business as compared to the accrual basis of accounting. 2. Business data can be manipulated by deferring payments or late deposit of cheques.
By only recognizing transactions when cash changes hands, cash basis accounting can result in a mismatch between the actual delivery of goods or services and the timing of revenue recognition, potentially distorting the reported profitability and financial health of the business.
While cash-based accounting generally indicates the health of a business's cash flow, it may offer a misleading picture of longer-term profitability. This is because the cash method doesn't show income that has been invoiced but not received. It also doesn't consider future expenses, which can be misleading.
A main drawback of cash accounting is that it may not provide an accurate picture of the liabilities that have been incurred (i.e. accrued) but not yet paid for, so that the business might appear to be better off than it really is.
Pros and Cons of Cash
Paying cash also avoids the interest charges on credit cards. If you can't pay your statement balance in full each cycle, you'll accrue interest charges. Some downsides to cash include the risk of loss, theft, and hygiene. If cash is lost or stolen, it is gone and very hard to recover.
Thus it fails to explain the dynamic behaviour of prices. 8. Neglects Interest Rate: The cash balances approach is also weak in that it ignores other influences, such as the rate of interest which exerts a decisive and significant influence upon the price level.
Disadvantage of Cash Basis Accounting
Customers may pay for services or products, which will count as income, while the related expenses may not yet be paid. This sort of situation may overstate or understate the income for a particular period.
The timing of each accounting method can affect profit, loss, and income taxes. The cash method is generally easier to use, but the accrual method can provide a more accurate picture of a business's financial performance.
As a cash flow statement is based on the cash basis of accounting, it ignores the basic accounting concept of accrual. Cash flow statements are not suitable for judging the profitability of a firm, as non-cash charges are ignored while calculating cash flows from operating activities.
Cash payments pose risks such as theft and loss, as physical currency can be easily stolen or misplaced.
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.
However, it comes with notable disadvantages. These include security risks, the lack of traceability, inconvenience for large transactions, and limitations for international transactions. As cash management technology continues to advance, the drawbacks associated with physical cash become less pronounced.
Limitations of the Cash Ratio
The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It's not realistic for a company to maintain excessive levels of cash and near-cash assets to cover current liabilities.
Only certain types of businesses are allowed to use cash-basis accounting, per the IRS. You cannot use this method if you offer customers credit; if your gross receipts are above the IRS requirement of $30,000,000 on average over the three prior tax years; or if you need to keep inventory on hand to account for income.
In general, most businesses use accrual accounting, while individuals and small businesses use the cash method. The IRS states that qualifying small business taxpayers can choose either method, but they must stick with the chosen method. 1 The chosen method must also accurately reflect business operations.
Disadvantages of the cash method
Not suitable for all businesses: Cash accounting is not applicable for your business if you offer credit to customers or maintain product inventory. Also, if your gross receipts cross the $25 million threshold, you have to use accrual accounting.
Following are the three golden rules of accounting: Debit What Comes In, Credit What Goes Out. Debit the Receiver, Credit the Giver. Debit All Expenses and Losses, Credit all Incomes and Gains.
The cash balances approach is regarded as superior to the transactions approach in following respects: (i) Prominence to human values and motives: The emphasis upon K in the cash balance approach brings into prominence the subjective valuation and a diversity of human motives which influence the price level.