What is cash accounting?
– Cash accounting (also called the cash-basis method) records revenue when cash is received and records expenses when cash is paid. It focuses on actual cash inflows and outflows, not on when goods or services were delivered or consumed.
How it differs from accrual accounting
– Accrual accounting recognizes income when it is earned and expenses when obligations are created, regardless of cash movement. For example, a sale made on credit is recorded immediately under accrual accounting, but only when payment arrives under cash accounting.
Why some small businesses use it
– Simplicity: fewer timing entries and easier bookkeeping.
– Cash visibility: the method gives a clear snapshot of cash on hand.
However, larger companies and public corporations generally must use accrual accounting to comply with Generally Accepted Accounting Principles (GAAP).
Key points (short)
– Records revenues when cash is received; records expenses when cash is disbursed.
– Simpler but can misstate performance during timing differences.
– IRS rules: businesses with more than $25 million in annual gross receipts must use accrual accounting; certain entities (C corporations, tax shelters, some trusts, and partnerships with C‑corp partners) generally cannot use cash accounting.
– The accounting method used for tax filings must match the company’s bookkeeping method.
Worked example (numeric, step-by-step)
Scenario: Company A sells 10 computers for $10,000. Order placed October 5; customer pays and receives the goods November 2.
– Under cash accounting:
– October: No entry (no cash received).
– November: Record $10,000 revenue when payment is received and delivered.
– Under accrual accounting:
– October: Record $10,000 revenue on October 5 (sale is earned at order/shipment).
– November: No revenue entry; cash receipt is recorded as a cash inflow and an offset to accounts receivable.
Another short numeric example (tax timing):
– Company incurs a repair expense of $5,000 on December 20, 2019, but pays the bill on January 10, 2020.
– Cash basis: Expense is deductible in 2020 (when paid).
– Accrual basis: Expense is deductible in 2019 (when incurred).
This timing can change taxable income for different years.
Practical checklist: should you use cash accounting?
– Are your annual gross receipts under the IRS threshold (currently $25 million)? If no, you may be required to use accrual accounting.
– Are you a C corporation, certain trusts, or a tax shelter? If yes, cash accounting may be disallowed.
– Do you want simple bookkeeping and close tracking of cash flow? Cash accounting can be appropriate.
– Do you need an accurate picture of liabilities and receivables for management, lending, or investors? If yes, accrual accounting is generally better.
– Will tax timing of deductions and revenue recognition materially affect your business results? Model both methods for a sample year to compare.
Limitations and caveats
– Timing distortions: cash accounting can make a firm look healthier or weaker than it really is when receipts or payments bunch up in certain periods.
– Incomplete liability visibility: unpaid obligations (accounts payable) don’t appear until paid, so balance sheets may understate true liabilities.
– Tax timing effects: deductions are only allowed in the year payments occur under cash accounting, which can increase tax in one year and reduce it in another.
– Consistency requirement: you must use the same method for tax reporting as for internal records unless you obtain IRS permission to change methods.
Quick implementation tips
– Keep a separate record of unpaid invoices and outstanding bills even if you use cash accounting; this helps management see future cash needs.
– Reconcile bank accounts regularly to ensure cash basis records match actual cash.
– If switching methods, consult IRS guidance because changing accounting methods may require filings or adjustments.
Sources for further reading
– Investopedia — Cash Accounting: https://www.investopedia.com/terms/c/cashaccounting.asp
– Internal Revenue Service — Publication 538, Accounting Periods and Methods: https://www.irs.gov/publications/p538
– IRS news release — IRS Issues Guidance on Small Business Accounting Method Changes Under Tax Cuts and Jobs Act: https://www.irs.gov/newsroom/irs-issues-guidance-on-small-business-accounting-method-changes-under-tax-cuts-and-jobs-act
– Congress.gov — H.R.3838 Tax Reform Act of 1986: https://www.congress.gov/bill/99th-congress/house-bill/3838
Educational disclaimer
This explainer is for educational purposes only and does not constitute tax, accounting, or investment advice for any specific situation. Consult a qualified accountant or tax professional before choosing or changing your business accounting method.