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What is Cash Accounting & How Does it Work
Accounting and bookkeeping

What is cash accounting & how does it work?

When it comes to keeping track of your business finances, there are two main accounting methods to choose from: cash accounting and accrual accounting.

Although both methods have their benefits and drawbacks, cash accounting tends to be the simplest way of recording revenue and expenses because you can update your accounts using your bank transactions rather than having to stay on top of all your invoices and bills as well.

In this guide, we’re walking through the basics of cash accounting: what it is, benefits and drawbacks, how it compares to accrual accounting, and the main categories in cash accounting.

What is cash accounting?

Cash accounting is a method of accounting revenue and expenses when they’re paid or received, rather than the order in which they occur.

In other words, revenue is only recognised when it’s paid to your bank account, and expenses are only recognised when they are withdrawn.

For example, let’s say a business invoices a customer for $500 on January 31, and the invoice is paid on March 5. With the cash accounting method, the $500 would be recorded on the business’ books as revenue on March 5 rather than January 31.

Cash accounting is most commonly used by smaller businesses, although it can be used by medium and large businesses as well. Using cash accounting provides a business with a clearer picture of what money the business has on hand at all times, but doesn’t necessarily provide an overview of profitability. This is because a business can have money in the bank but a backlog of bills to pay.

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Cash accounting vs. accrual accounting

As we’ve covered above, cash accounting only recognises revenue and expenses when the transaction has been settled. This means you can only update your books once an invoice has been paid by a customer, or once you’ve paid a bill. 

With cash accounting, you also only have to pay tax on money you’ve actually received rather than on invoices you’ve issued. This can be beneficial for cash flow, but keep in mind that some tax agencies have rules around which businesses are allowed to use cash basis accounting for tax purposes – so if you’re not sure, it’s best to check with a professional.

Accrual accounting, on the other hand, involves recording revenue as soon as it is invoiced, and recognising an expense as soon as a bill comes in. It can give you a more accurate picture of your true financial position and profitability, but it can also take more effort because you have to keep an eye on your invoices and bills as well as your bank account.

Benefits of cash accounting

  • It’s the simplest accounting method
  • It shows how much cash you have on hand
  • You only need to pay tax on money you’ve actually received, which can be beneficial for cash flow

Drawbacks of cash accounting

  • It doesn’t give you an accurate picture of your profitability – you could have cash in the bank but a backlog of bills to pay
  • It doesn’t give you a long-term view of your finances, which can leave decision-making to guesswork

Cash accounting example

Because cash accounting records revenue when money is received and expenses when money is paid out, it doesn’t record payables and receivables like accrual accounting does. Instead, transactions are simply recorded as revenue or expenses on a business’ books.

Example:

Let's say you run a business that sells gym equipment. If you sell $2,000 worth of gym equipment, under the cash accounting method, that amount will only be recorded as a revenue on your books when the customer’s payment hits your bank account.

The same concept applies to expenses. If the company receives a utilities bill for $500, under the cash method, the expense will only be recorded when the company pays the bill. 

Conversely, under the accrual accounting method, the $2,000 would be recorded as revenue on the day the sale is made, even though you might not receive the money for days, weeks, or even months. The $500 bill would also be recorded as an expense on the day the company receives the bill, even if payment isn’t due for a while.

Managing your finances with cash accounting

The cash method is the simplest and easiest accounting method, because you only need to think about transactions going in and out of your bank account rather than tracking all your invoices and bills. It can also be useful for cash flow as you don’t have to pay taxes on income until you actually receive it.

However, accrual accounting can give you a more accurate long-term view of your finances and help you decide when it’s a good time to invest back in your business. 

Whether the cash method or accrual method is the best approach for your business, QuickBooks’ accounting software makes it a breeze to keep your accounts organised and update income and expenses from anywhere, on any device. You can also easily switch between cash accounting and accrual accounting whenever you need to.