Cash Accounting 

What does it mean

Cash Accounting is one of the two Accounting Methods most commonly seen in the US (the other is Accrual Accounting).  The main difference between the two methods is “when” revenue and expenses are recognized on an income statement and balance sheet.  Cash accounting is the more simple accounting method (but don’t confuse simple with better).  In cash amounting, revenue is recognized when it is received (cash deposited in a checking account) and expenses are recognized when they are paid (cash leaves the checking account).  As a result, cash accounting is very similar to a checkbook registry (for those of you old enough to know what that is).  Revenue happens when the deposit is made, and expense happen when the check has been written.  

Why does it matter

The reason why knowing a customer is working on cash account is to be aware of what you “don’t” know.  In cash accounting, revenue is recognized when deposited and expenses when paid.  That means if the revenue hasn’t been deposited or the expense hasn’t been paid, it isn’t included in the financials.  This can have the impact of making a strong company look weak or a weak company look strong.  Let me explain.

Weak Company Look Strong - This is your biggest risk.  A company that is struggling will likely delay payment of their payables (because they don’t have the cash to pay them) and they are probably pushing to get their receivables paid faster.  When that happens during cash accounting, this results in an overstatement of revenue and an understatement of expenses which results in a drastic OVERSTATEMENT of income.  Many banks pride themselves on being cash flow lenders, but in this scenario, you could be unknowingly walking into a bad situation.  So how do you protect yourself?  Here are some tips:

1. Require accrual accounting (I get it, easier said then done, but it is an option)
2. Get a solid beginning and ending balance sheet from the customer to make Accrual Adjustments to their income statement.  Also make sure this balance sheet includes Accounts Receivable and Accounts Payable.
3. Look for other warning signs of stress:
1. Low or recently decreased credit score
2. Presence of subprime lender debt
3. Turnover ratio on AP relative to peers

Cash accounting is very prevalent the smaller a borrower gets because it is the simpler method.  Knowing the key things that could get you in trouble will make sure you are stepping into a good situation.

Other Relevant Terms

• Capital
• Capacity
• Accrual Accounting
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