Establishing the actual economic results of an organization that follows the cash basis of accounting may result cumbersome and subject to making mistakes in the process of converting the cash receipts to revenues earned and the cash payments to operating expenses.

Although in general most corporations use the accrual basis of accounting, small businesses and taxpayers use a strict cash basis of accounting. The downside of this method is that it does not take into consideration the impact of accounts receivables and accounts payables in the future cash flow of an organization.

According to the Internal Revenue Service, IRS, under the cash method, all income is included in the year it is actually or constructively receive IRC § 446(a) provides that a taxpayer shall compute its taxable income in the same manner in which it keeps its books and records. Section 446(b) provides that if the taxpayer has not chosen a method of accounting, or has chosen one which does not clearly reflect its income, the IRS may impose upon that taxpayer a method of reporting income which does clearly reflect income. For example, Section 446 provides that the following methods of accounting are permissible: the cash receipts and disbursements method, the accrual method, and other methods permitted by Subtitle A, Chapter 1 of the Code or any combination of the foregoing methods permitted under the regulations. A taxpayer engaged in more than one business may use a different method of accounting for each business.

Simply stated, the accrual basis of accounting recognizes revenue when it is earned and recognizes expenses in the period incurred, without regard to the time of receipt or payment of cash.

Under the strict cash basis of accounting, revenue is recorded only when the cash is received and expenses are recognized only when the cash is paid. As a result of not applying the revenue recognition and the matching principles, financial statements prepared using the cash basis of accounting are not in compliance with Generally Accepted Accounting Principles, GAAP. The consequences are that the cash basis of accounting understates revenues and assets and by the same token, it understates the owners’ equity by not recognizing amounts owed to a corporation which have not actually received. With respect to accounts that the company owes but does not record them because they have not been paid at the end of the year, the effect on the financial statements is that expenses and liabilities are understated.

Two relevant matters come into play when the cash basis of accounting is used. First, the cash receipts must be converted to revenue earned, and, second, the cash payments have to be converted to operating expenses. This model does not take into consideration non-cash amortization and depreciation expenses. However, these non-cash expenses have to be taken into consideration as they have an effect in the computation of net income.

To convert cash Receipts to Revenues Earned :
Cash received from customers
- Beginning accounts receivable
+ Ending accounts receivable
+ Beginning unearned revenues
- Ending unearned revenues
= Revenues earned

To convert cash payments to operating expenses:
Cash paid for operating expenses
+ Beginning prepaid expenses
- Ending prepaid expenses
- Beginning accrued payables
+ Ending accrued payables
= Operating expenses incurred

Although many advocate on behalf of the cash basis of accounting, its reliability is a big issue because it ignores the revenue recognition and matching principles required by GAAP. On the other hand, the accrual basis of accounting helps in predicting future cash flows with reasonable certainty, in addition to following GAAP. The choice is clear if organizations want to avoid the hassle of reconciling from cash to accrual basis.