Although accounting standards such as GAAP (Generally Accepted Accounting Principles) require the use of accrual accounting in financial reporting, many new small businesses and established organizations use cash accounting to keep their books.
The widespread adoption of cash accounting (also referred to as the “cash method”) among small businesses can be attributed to its simplicity and its primary focus on when cash enters and leaves a company’s bank account.
While the cash method is widely viewed as more straightforward and easier to use in relation to the accrual method of accounting, cash accounting has drawbacks when it comes to presenting the most accurate snapshot of a company’s budget and profitability.
Before choosing an accounting method for your business, weigh the pros and cons of cash accounting to determine if it supports your company’s long-term financial goals.
How Cash Accounting Works
Cash accounting is one of two principal accounting methods (the other being accrual accounting) used to determine how and when income and expenses are recorded. Unlike the accrual method, which records income when it’s earned and expenses when they’re incurred, cash accounting focuses on when money is deposited and cash is received. Cash earnings can also encompass checks, credit-card receipts or other forms of payment from customers.
Subsequently, cash accounting records your expenses when cash is paid out to suppliers, vendors and other third parties irrespective of when those expenses were incurred. So if your contracting business purchased tools on credit in October, but actually paid cash or check for those tools in November, you would record the payment as a November expense.
Advantages of Cash Accounting
As its name indicates, cash accounting is primarily concerned with one thing: cash flow. Cash accounting can also be cost-effective, especially if your business structure is a sole proprietorship or partnership.
Below are the main advantages of using cash accounting for financial reporting and tax purposes.
Cash accounting requires less staff and financial resources
Typically, most self-employed individuals and small businesses use the cash method because it’s easier to understand and use compared to the accrual method. There’s less need to outsource or hire additional accounting staff, a factor that is particularly important for freelancers, sole proprietors and unincorporated companies with limited budgets.
Thus, the cash method can be a cost-effective way to keep costs down if you do your business accounting on your own or if there are no immediate plans for business expansion. Cash accounting is also well-suited for companies that conduct mostly cash transactions.
Cash accounting clearly represents cash flows
The cash method wins when it comes to clearly representing cash inflows and outflows in your business. Since cash accounting requires you to record expenses and revenues when they appear in your company’s bank account, the cash method presents a more accurate picture of your cash reserves than the accrual method.
Cash accounting (sometimes) provides tax benefits
Under the cash method, any customer payments you receive in 2015 for projects completed in the previous year would be counted as income for the 2015 tax year. This reduces your net income and, as a result, can lower your tax payments for the 2014 tax year.
Disadvantages of Cash Accounting
While cash accounting is the superior method for showing the actual amount of cash you have in the bank, there are also a few areas where it falls short.
Cash accounting can misrepresent your company’s financial position
If you’re planning to hire employees or grow your business in the near future, then the accrual method may better serve your needs for matching income with the expenses incurred to produce that income.
Why? Because cash accounting sometimes offers a misleading picture of long-term profitability since it ignores when transactions occur and when products and services are delivered if cash isn’t exchanged between parties.
Consider the following scenario: Your business receives several customer payments during the month of July, but your overall sales have been down since May. Although the cash method shows positive cash flow, your business may still be unprofitable.
Using cash accounting can have negative tax implications as well. For example, if you incur $5,000 in expenses in 2014, but don’t pay those expenses until 2015, you’ll be unable to deduct those expenses for the 2014 tax year (i.e. the year you actually incurred them).
Thus, the cash method can create challenges for your financial planning if you’re aiming to develop an accurate picture of your operating expenses and profit each month. The cash method is only concerned with money that is paid and received, rather than matching incurred expenses and earned revenues on a month-to-month basis.
Cash accounting doesn’t conform to GAAP
GAAP are the standard framework of guidelines and rules that accountants use to prepare U.S. companies’ financial statements. Under GAAP, incorporated companies must use the accrual method to keep their books and report their financial performance.
Because it conforms to GAAP standards, with the exception of very small companies, the accrual method is considered to be the standard (and oftentimes more accurate) accounting method for most organizations. Thus, if you’re using the cash method, but decide to change your business structure to a C corporation, you’ll likely need to move to an accrual accounting system.
Is the Cash Method Right for Your Business?
Ultimately, the design of your company’s accounting system and financial reporting is a management decision. It will also depend on the objectives you set in your business plan, your people resources, and the financial requirements of your organization.
Unless you’re a C corporation, gross more than $5 million in annual sales or stock an inventory of products that you sell to the public and the gross sales of those items are over $1 million each year, you’re free to adopt the accounting method that works best for your organization.
Keep in mind, however, that the IRS requires companies to use the same accounting method to report taxable income and keep books for the tax year. Refer to IRS Publication 334: Accounting Periods and Methods for additional details on IRS rules regarding the use of cash accounting for your small business.