Cash Accounting

Key takeaways

• Cash accounting records revenues when cash is received and expenses when cash is paid.
• It is simple and provides a clear view of cash on hand, making it common for small businesses.
• It can distort financial position compared with accrual accounting, which records transactions when earned or incurred.
• Certain entities and larger businesses are required by tax rules or GAAP to use accrual accounting.

What is cash accounting?

Cash accounting (cash-basis accounting) is an accounting method that recognizes income only when payment is received and records expenses only when they are paid. It contrasts with accrual accounting, which recognizes revenue when earned and expenses when incurred, regardless of cash flows.

How it works

• Record a sale when customers pay you, not when you invoice them.
• Record an expense when you actually pay the bill, not when you receive the service or incur the obligation.
• Because entries follow cash movements, reported profit and loss closely match cash available at a given time.

Example

If a business sells equipment on October 5 but receives payment on November 2, cash accounting records the revenue on November 2 (the payment date). Under accrual accounting, the revenue would be recorded on October 5 (the sale date). Similarly, an expense incurred on January 15 but paid on February 15 is recorded in February under cash accounting.

Limitations and tax implications

• Timing distortions: Cash accounting can understate liabilities (expenses incurred but unpaid) or understate income (work completed but not yet paid), depending on when cash flows occur.
• Tax timing: Deductions and taxable income are tied to cash receipts and payments. Expenses paid in the next tax year cannot be deducted in the prior year under cash accounting, and revenue received in a later year is taxable in that later year.
• Regulatory limits:
• Corporations that follow GAAP typically must use accrual accounting.
• Tax rules generally require businesses with more than $25 million in annual gross receipts (thresholds may vary over time) to use the accrual method.
• Specific rules (e.g., provisions from tax legislation) prohibit cash-basis accounting for certain entities, such as C corporations, tax shelters, some trusts, and partnerships with C corporation partners.

When to use cash accounting

Cash accounting is well suited for very small businesses, sole proprietors, and cash-focused operations that want simplicity and a direct view of cash position. It is less appropriate for businesses with large inventories, long-term contracts, or complex receivables/payables where accrual accounting provides a more accurate picture of ongoing financial performance.

Conclusion

Cash accounting is straightforward and useful for tracking actual cash flow, but it can misrepresent economic activity because it ignores accrued receivables and payables. Businesses should choose the method that best reflects their operations and meets regulatory and tax requirements.