What Is Cash-Basis Accounting?
As a business owner, there are two accounting systems that you can adopt for your business: the cash basis of accounting and the accrual method.
Cash-basis accounting records earnings and expenses only when cash is received or disbursed. Businesses that adopt cash-basis accounting don't consider revenue as income until payments are received or recognize expenses until they're paid out.
On the other hand, the accrual basis of accounting recognizes income when revenue is earned and records expenses when they're incurred, regardless of when they're paid. The accrual method is based on Generally Accepted Accounting Principles (GAAP). It tends to provide a clearer picture of how much a business generates and incurs during an accounting period. However, since the accrual method doesn't present the exact cash flow situation of a company, its use needs to be accompanied by careful cash flow monitoring.
Read on for more discussion of cash-basis accounting, how it's used to record business transactions, and when it's acceptable to use in a business setting.
What Does Cash-Basis Accounting Mean?
A business that uses the cash method records revenue when payments are received in the form of cash, checks, or credit card receipts. Similarly, this method only records expenses when money leaves the account to pay suppliers, vendors, and other third parties. Cash-basis accounting doesn't recognize accounts receivable or accounts payable, as it emphasizes cash flow — the amount of cash a business has on hand.
To illustrate how cash-basis accounting works, let's suppose you have a plumbing business. You were contracted by a construction company for a job on an apartment complex. Let's say you completed the project in January but you didn't receive payment until Feb. 20.
With cash-basis accounting, you'd record the payment as if the job was completed and earned in February. But note that any expenses, such as supplies and employee wages associated with the project, may have been paid out and recorded in January.
The cash-basis accounting method is best suited for businesses that deal mainly with cash transactions and don't buy or sell inventory on credit. However, it's worth noting that this method is not acceptable under GAAP or International Financial Reporting Standards (IFRS). This is why businesses, public companies, and other organizations that must file audited financial statements are not permitted by law to use a cash-basis accounting method.
What Is the Difference Between Cash-Basis Accounting and Accrual Accounting?
Small business owners favor cash-basis accounting because of its simplicity. It's straightforward and easy to use. It's a less expensive option for small business owners who know enough to do their bookkeeping and accounting without needing a full-time accountant.
Cash-basis accounting only records business transactions when cash is received or spent. In comparison, the accrual method records revenues and expenses when they're earned or billed, regardless of when they're paid. Hence, the difference between cash and accrual accounting is found in the timing of when revenue and expenses are recorded in the business accounts.
The timing of recording revenues and expenses affects cash flow, how you calculate your net income, and when you pay taxes on your profits.
For illustration, let's use the same example from our discussion above. Suppose you have a plumbing business with a contract to work on an apartment complex. Let's assume the following:
- You started the project in October 2020 and completed it in January 2021. You billed the construction company for $20,000 at the time of completion and received full payment in February.
- Your total earnings for 2020 were $50,000, with total expenses of $20,500.
Using the cash-basis method, your profit for the tax year 2020 would be $29,500 ($50,000 in total income minus $20,500 in total expenses).
Let's assume that $15,000 out of the $20,000 is revenue earned from October to December and the remaining $5,000 is income for January. Under the accrual method, your profit for 2020 would be $44,500 ($65,000 in total income minus $20,500 in total expenses). Your income for 2020 is $65,000 since we'll add income earned from the construction company.
This example shows how your net income, cash flow, and taxes can be affected by the accounting method you used.
Who Uses Cash-Basis Accounting?
Cash-basis accounting is a convenient and reliable way to keep track of income and expenses without the need for a great deal of bookkeeping. This is why organizations that do business mostly through cash transactions prefer this method.
The cash accounting method is best for a business that:
- Uses single-entry accounting
- Doesn't publish financial statements for audit, like sole proprietorships and partnerships
- Deals primarily with cash, checks, or credit card payments at the time of sale
- Doesn't carry inventory
- Doesn't sell goods or services on credit
- Doesn't buy goods or services on credit
The Internal Revenue Service (IRS) allows most small businesses to choose the cash method of accounting as long as:
- Their business is not a corporation (other than an S corporation) that averages more than $25 million in gross receipts over the last three years.
- Their business is not a C corporation, tax shelter, specific type of trust, or partnership that has a C corporation partner.
Keep in mind that the IRS requires you to use the same method for tax purposes as you do your own accounting records. You'll also need to file Form 3115 to get approval from the IRS when you want to change accounting methods.
Cash-basis accounting may be straightforward and simple; however, it still has disadvantages, which we'll dive into below.
Benefits of Cash-Basis Accounting
- Simple and less expensive: Businesses use the cash method because it's a more straightforward process than accrual-basis accounting. Small business owners can track their income and spending without needing a full-time accountant for bookkeeping.
- Reports accurate cash flow: Business owners who choose cash-basis accounting don't have to track their cash flow since the amount shown in their bank account is the amount of cash on hand.
- Taxes are based on cash received: Business owners who adopt this method only pay income taxes on profits they've received since cash-basis accounting only records financial transactions when money is received or disbursed. For example, if you bill a client for $1,000 in December and don't get paid until February, you'll pay taxes only when you receive the payment.
- Inaccurate representation of a business's financial standing: Cash-basis accounting doesn't accurately measure a business's growth. For example, if a business serves two clients in one month but receives payments from five other clients from the previous month, it would seem like the company is growing and its earnings are not declining.
- Difficult to track accounts receivable or accounts payable: Cash-basis accounting doesn't record accounts receivable or accounts payable. And it can be challenging to monitor your unpaid earnings and expenses when your business doesn't receive immediate payment or has outstanding bills.
Challenges of Cash-Basis Accounting
Example of How to Record an Entry Using Cash-Basis Accounting
For this example, we'll take some figures from our illustration above: a plumbing business contracted for a project with a construction company.
- The project was completed in January 2021. The invoice for $20,000 was sent at the time of completion and payment was received on Feb. 12.
- The business received an invoice for materials worth $500 and wages of $1,500 on Jan. 25 and paid them on Feb. 5.
With the cash accounting method, income and expenses will only be recorded when cash is exchanged with the following entries:
|Starting Cash Balance||01/31||$5,000|
Keep Accurate Accounting Records Using Skynova
With Skynova's all-in-one invoicing and accounting software for small business owners, you can choose between cash-basis accounting or the accrual method of accounting. And you won't have to spend hours learning single-entry or double-entry accounting — the software does it all for you.
Skynova's accounting software helps you keep accurate records of your income and expenses. It also enables you to keep track of how your business is doing. Create financial statements like balance sheets and income statements at any time.
Notice to the Reader
This article's content is meant to be used as general guidelines on cash-basis accounting and may not apply to your specific situation. Always consult with a professional accountant to ensure your methods are meeting accounting standards.