A business owner uses cash basis accounting.

What is cash basis accounting: Definition, examples, and pros and cons

What is cash basis accounting?

Cash basis accounting is an accounting method that records revenues and expenses when people receive or pay cash instead of when they incur them.

Cash basis accounting can help you simplify your accounting processes. Running a business is hard enough already. Cash basis accounting can streamline your accounting system and save you time—you just have to know how to navigate it. 

Here, we’ll help you understand what cash basis accounting is, how it differs from accrual accounting, and its advantages and disadvantages.

How does cash basis accounting work?

An illustration of the types of businesses using cash basis accounting.

Cash basis accounting is an accounting method that records and tracks financial information by the actual flow of cash in and out of a business. In other words, it only records income when you receive or pay cash. 

The cash basis of accounting is easier to understand than other accounting methods because it focuses on cash transactions only. It also requires fewer journal entries in your accounting ledger.

Should you choose cash basis vs. accrual accounting?

An illustration of the cash basis vs. accrual accounting differences.

When it comes to choosing between cash basis and accrual accounting, there are many factors to consider. Cash basis accounting is simpler to understand and requires fewer journal entries. If you have a rather simple business with only minor fluctuations in cash flow, then cash basis accounting may work well. 

Accrual accounting records income or expenses as soon as they are incurred, regardless of when payment is made or received, and this can provide a more accurate picture of the company’s financial health. An accrual-based system may better meet your needs if you have inventory, accounts payable, or need more detailed financial information.

Note that corporations with average annual revenues of over $26 million for the previous three tax years must use accrual accounting.

Cash basis of accounting examples

An example of cash basis accounting would be a small retail store that purchases products from a supplier. The store would recognize the expense only once the product payment has been made rather than when they receive the goods.

Another example of cash basis accounting would be a service-based business that provides services to its customers on credit terms. In this case, the income would only be recognized once payment has been received from the customer. 

Or consider the following transactions for your business: 

  1. You receive a $5,000 payment from a client for services on June 1
  2. You also pay office rent of $1,200 on June 1
  3. Then you purchase office supplies worth $500 using cash on June 10
  4. A few days later, you pay $3,000 in salaries to employees on June 15
  5. You then collect $2,500 for a customer sale on July 1

Here’s how the accounting journal entries would look in the accounting books:

Also note that companies using cash basis of accounting will have simpler financial statements. For example, here’s a cash basis income statement:

Revenue and expenses will only appear on a cash basis income statement after money exchanges hands. The balance sheet includes assets, liabilities, and equity but not inventory, payables, or receivables. Here’s an example:

And finally, the cash flow statement uses cash basis accounting—even if you use accrual accounting. Here’s what the cash flow statement looks like for our example company:

Note that the net income from the income statement carries over to the cash flow statement, and the cash at the end of the year on the cash flow statement matches the cash figure on the balance sheet. 

Advantages of cash basis accounting

An illustration of the pros of cash basis accounting.

Easy to understand 

Cash basis accounting is relatively easy to use and maintain, which makes it an attractive option for small business owners and individuals without extensive accounting knowledge. They can track their financial transactions based on cash inflows and outflows without the need to track accounts receivable or payable.

Focuses on cash flow

Focusing on the actual cash you receive and pay provides a clear picture of a company's cash flow. This clear picture is particularly important for small businesses and startups that must closely monitor their cash position to ensure they have enough funds to cover expenses and support growth. 

Your accounting software can help you with cash flow reporting, such as generating cash flow statements

Has tax benefits 

Cash basis accounting may provide tax advantages for small businesses. Businesses using cash basis accounting only report income when they receive it and expenses when they pay them. 

This approach can result in deferring tax liabilities, as income recognition may occur in a later tax period, potentially giving the business more time to use those funds for growth or other purposes.

Disadvantages of cash basis accounting 

An illustration of the cons of cash basis accounting.

Cash basis accounting has its advantages, but it also carries some drawbacks. Although tracking expenses on a cash basis makes it easier to understand the immediate financial situation of a business, this system does not provide an accurate picture of long-term profitability or financial health. 

So, when should you use the cash basis of accounting? Cash basis accounting is usually unsuitable for businesses looking to secure financing or manage investments, as lenders and investors prefer to see accrual-based records.

Accrual is more comprehensive

Cash basis accounting recognizes revenues when cash is received and expenses when cash is paid. This can lead to an inaccurate representation of a company's financial health, as it does not account for revenue earned but not yet received or expenses incurred but not yet paid. 

As a result, a company's financial statements may not accurately reflect its true financial position, making it difficult to assess its performance.

Not compliant with GAAP 

Cash basis accounting does not adhere to the Generally Accepted Accounting Principles (GAAP), widely recognized accounting standards that govern financial reporting in the US. 

Most businesses are required to follow GAAP, especially if they are publicly traded or seeking investment. Using cash basis accounting can limit a company's ability to attract investors or secure financing, as it may not provide a comprehensive and accurate picture of the business's financial health.

Not suitable for larger companies 

Cash basis accounting is suitable for small businesses with simple transactions and few accounts receivable and payable. However, it may not be the best choice for larger businesses or those with more complex financial transactions. 

Larger companies typically have more intricate financial operations, such as inventory management and long-term contracts, which require accrual accounting to accurately reflect their financial performance. 

Additionally, cash basis accounting makes it challenging to analyze financial trends and make informed decisions about a company's future growth and profitability.

Streamline your accounting and save time

Cash basis accounting can be a great way to streamline your accounting and save time. It allows you to easily track cash flow and better manage your budget. By eliminating the need for tracking accounts receivable and payable, businesses can also save time preparing their taxes. 

Overall, cash basis accounting is a great way to simplify your accounting software needs.

Cash basis accounting FAQ

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