Cash Basis Accounting Guide

Cash Basis Accounting Guide | Accounting Smarts
Charles Hall

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Charles Hall

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June 10, 2022

Cash basis accounting refers to the accounting method of recognizing revenue when you receive money and expenses when you pay out the monies.

Cash basis accounting refers to the accounting method of recognizing revenue when you receive money and expenses when you pay out the monies.

Any company can use the cash basis accounting method; however, the timing of disbursements and receipts might be different from the actual period of operational activities.

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Simplifying Cash Basis Accounting

In simpler terms, you record both expenses and revenues as and when you pay or receive them, respectively. Cash basis accounting is also known as cash accounting. It is not only convenient but straightforward as well.

Cash basis accounting involves recording payment receipts during a specific period when a business receives them and recording expenses during a specific period when you actually make the payments.

Whether it is a perfect accounting system for your business depends primarily on the size of your company.  It is not recommended for mid to large sized companies as it does not always match revenue and expenses which is critical in the decision making process.

Cash Basis Accounting Vs. Accrual Accounting

Cash basis accounting is an easier form of the two accounting methods. The other method is known as accrual accounting that requires recording expenses and revenues as your business incurs them rather than when they are paid or received. Small-sized companies usually rely on a cash basis accounting for its simplicity and ease-of-use factor.

A key aspect to remember is Generally Accepted Accounting Principles (GAAP) obligates corporations to use the accrual basis of accounting to stay compliant.

When you record a transaction using cash basis accounting, it affects your business’s books. However, there is a delay in terms of the date of recording the transaction than when it actually happened. Therefore, in the short term, cash accounting can sometimes be less accurate than accrual accounting.

If you are a business thinking about which accounting method to adopt, you are free to choose either cash basis accounting or accrual method. However, if you are a business that handles annual gross receipts of more than $25 million, IRS obligates your business to use the accrual accounting method.

There are other prohibitions on using cash basis accounting. For example, the Tax Reform Act, 1986 prohibits businesses from using cash-based accounting if they belong to any of the categories mentioned below.

  • Tax shelters
  • Certain type of trust
  • C corporations
  • A business that has C corporation partners

However, you must ensure to use the same accounting system for tax reporting that you use for the business’s internal bookkeeping.

Since most non-profit businesses must stay compliant with IRS’s requirement to file for a 990 information return, accrual accounting may be a more suitable option. However, such organizations mostly struggle with their cash monitoring and may need to look at their cash projections and cash basis report more frequently.

For this purpose, an internal cash basis accounting system sounds like a more feasible option. In case you own a medium or large business with sales exceeding the $5 million mark on average in the last three years, IRS will require you to apply nothing but accrual basis accounting.

Cash Basis Accounting Scenarios

In order to understand cash basis accounting better, let us suppose your company receives $500,000 from making a sale of 10 cars. You sold these cars to the company on January 1st and recorded a sale in your books on the same date.

Now, in this case, the buying company probably placed the order to buy the cars a couple of months back, say, around November. However, the ordering date becomes irrelevant because the buying company did not make any payments until you delivered the cars to them on January 1st.

If you were using an accrual method, you would need to record that $500,000 sale on the date the buying company placed an order, even when you did not receive the payment.

On the other hand, in cash basis accounting, you will only record revenue unless you receive the actual payment and not when you incur them.

Similarly for expenses, let us suppose your company hires a contractor for pest control on January 1st, but the payment is due in February. In this case, cash basis accounting would not recognize the payment (expenses) until the day they are due.

Are there any Limitations

The most prominent limitation of cash basis accounting is that it might not provide you with an accurate view of the business’ liabilities that you have incurred. If there are any pending payments to go out or come in, cash basis accounting will not be able to offer you any information on those figures.

This means you will not know the exact financial standing of your business unless after receiving all your payments and settling all your expenses.

In terms of success, cash accounting is not suitable for companies taking large orders. The system will deem your company less successful because it will think you expanded your labor and materials for a job without collecting any payments. While you might make big bucks on this job, but cash accounting will recognize that success when the money actually comes in.

Therefore, cash basis accounting can both understate and/or overstate your business’s financial conditions. This is especially true when your business payments and collections are particularly low or high during a specific period.

Advantages and Disadvantages of Cash Basis Accounting

Cash basis accounting comes with both pros and cons. However, it depends on various circumstances and facts about your business to determine the efficiency level of this method.

Advantages

  • There is a bare minimum learning curve as cash accounting is easy to understand. So, if you are a small startup business looking for a simple cash management method, cash accounting is the perfect candidate. The best part is you will not require help from a professional accountant to set it up.
  • Cash accounting statements are simple and resemble cash flow statements. This method offers you an accurate picture of how much you have in hand on any given date.
  • It is a single entry system. If your business has simple financial transactions with money coming in or going out, cash accounting can help.

Disadvantages

  • Cash accounting shows the actual cash flow of your business, but this can often be misleading. This is because the method ignores any pending expenses or revenues that your business might be expecting. For instance, the system would not show any revenue you have invoiced unless it receives the payment. So if you are looking for a method to show you the entire picture of long-term business profitability, cash accounting is not it.
  • It is a single entry system, which is not suitable for accrual methods used by the regulatory authorities. The accrual method offers far greater control and a more precise picture of financial transactions and reduces the probability of errors.
  • There is a restriction by IRS for businesses. Your business must not use cash basis accounting if it is a corporation, maintains inventory, or your gross receipts exceed the $5 million mark per year.
  • Because cash basis accounting is simple, it may also restrict you from making any predictive decisions as you will have no insight into upcoming expenses and revenue generations.

When to Use Cash Basis Accounting

If you are a small business with simplistic financial transactions, cash basis accounting is a more convenient option for internal bookkeeping. The method is also suitable for sole proprietors and any other businesses solely dealing in cash.

However, if you are a business looking for a more powerful and growth-focused accounting tool, you may look at other options such as accrual accounting.

That said, cash accounting is also a cost-effective solution for small businesses as it does not require help from an expert accountant. Anyone can set up a simple cash accounting system using spreadsheets or other basic accounting tools.

All you need to do is, enter the money into the books when you receive a payment and log the expenses when you make payment. It cannot get any simpler than that.

If you are a business or startup that is still unsure if cash basis accounting is for you, ask yourself the following questions first.

  • Will your books require audits?
  • Are there any chances you will be selling your business anytime soon?
  • Are you interested in obtaining bank financing?
  • Will your company go public?

If the answer to all those questions is a No, then cash basis accounting is the best method for your company. However, if external parties and investors use a more complex reporting method, you might have to adapt to their accounting methods for swift matching of records.

Cash basis accounting is pretty basic; therefore, it might limit your ability to make any predictive financial decisions. Consequently, it would be best if you weighed its pros and cons against your business or industry requirement. That said, various online accounting software solutions are available to set up your cash basis accounting method.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall