Cash-basis is an accounting method which records revenues at the time they are paid, as opposed to when they occur during the course of business. Companies that use cash-basis accounting to determine net income can reduce their tax liability, but they may also face a unique accounting dilemma, depending on when payment is actually received.
A company's net income is equal to its net profit, or the amount of money left after all expenses are deducted from the total value of any income earned. Net income is calculated as revenues plus gains, minus expenses and losses. Revenue is income received from sales or services, while gains include transactions such as the proceeds from the sale of a company car. Expenses are those required for operation, such as rent and loan interest payments. Losses may be included for any assets sold below purchase price.
When using cash-basis income accounting, expenses required for a project or service are recorded as work is performed. Revenue, however, is not recorded until work is completed. For example, a carpenter who contracts a job for $2,000 and estimates his expenses to be $1,200, would also estimate his profit to be $800, or $2,000 minus $1,200. If he completes the project on December 23, 2011, but does not receive payment until January 3, 2012, his net loss for the year is $1,200, or $2,000 minus $800.
Having a net loss can be beneficial for a company that wants to reduce its tax liability in a given year. In the carpenter's scenario, however, his business would be reporting a higher than actual net income for tax year 2012, when payment is received. Therefore, a cash-basis accounting method may reduce your liability one year, but increase it the next. A corporation that reports a net loss for the year may face a a lower stock price, as well as criticism from shareholders and potential investors.
Due to the complications inherent in cash-basis income accounting, most businesses use accrual income accounting. This type of accounting allows companies to record both their expenses and income as they occur. While this may result in a company paying taxes on income it has yet to receive, it eliminates the possibility of being overtaxed in a subsequent year. Likewise, accrual income accounting gives financiers and shareholders a more comprehensive picture of the company's net income and overall profitability.
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