Whenever a business is born, owners need to decide whether they’re going to start with the cash basis accounting method or jump to the accrual basis route, which is a major decision that shapes the future of their company.
Cash basis accounting is usually a good fit for small businesses because it applies to those who make less than $1 million in revenue — but even so, you still may struggle to gain the benefits this method offers if you don’t understand how it works.
You also might not know when to switch to accrual accounting, which is an inevitable step if your business grows past a certain point. Here, we’ll cover everything you need to know about the basics of cash basis accounting.
Cash basis accounting is an accounting system in which you record revenue or expenses when cash is received or paid. This means that you would record income when a customer hands you cash, a check, or credit card payment. In commerce, “cash” refers to any money that is received in real-time.
Cash and accrual accounting are two different accounting styles that offer different sets of information and methods, so it’s good to know how each operates as your business grows.
The difference between cash and accrual basis accounting essentially all comes down to the timing and when transactions are recorded:
But these transaction recordings affect the way your financial statements are created and how much taxable income you owe every year, which are major considerations when
No matter the type or size, every company must have the same three foundational financial statements:
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Get startedLet’s take an example to get a clear picture of how cash basis accounting works:
Say you have a project to complete between April 1st and May 30th valued at $10,000. You and the client signed the contract on April 1st, and your entire staff started working on completing deliverables on that date, but you have yet to receive payment.
Many small businesses, community associations, non-profit organizations, and other entities use the cash method because of its simplicity: Cash basis accounting is a straightforward method of accounting that makes reporting financial statements and tax reporting an easy task for business owners.
You might opt for cash basis accounting if:
It’s especially convenient for companies that do not hold inventory: Because you aren’t looking at inventory transactions, it’s easier to focus on cash flow — and avoiding cash flow problems is essential for maintaining financial health.
But there are some limitations on who can and cannot use cash basis accounting, which are set by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). The cash accounting method violates the matching principle and time period principle of GAAP.
According to these internationally recognized accounting standards, you can use cash basis accounting if you meet these qualifications:
In some cases, the IRS may accept cash-basis accounting for a small business that does keep inventory if the business earns more than $1 million but less than $10 million. You’ll need annual gross receipts for the past three years to determine and support this claim and this is known as the inventory test.
For family-owned farms: You have average annual gross receipts of less than $25 million per year
If your business does not fit into any of these categories (if you’re a publicly-traded company, for example), you may have to switch to the accrual accounting method.
What accounting method you use can impact your tax liability. Let’s say that your business has had the following transactions in a single month:
If you use the cash method, your net income for this month would be $925. Here’s why:
$1,000 (cash received) – $75 (freelancer bill) = $925 (net income)
Remember that cash accounting relies on money received and paid out immediately, meaning that you’d only consider transactions 3 and 4 when considering your taxable income. In other words, you’d only pay taxes on the net income of $925 and not on the invoices sent or bills received.
As a business owner, you want to avoid “accounting hindsight,” which is when you unintentionally overestimate an accounting-related outcome that you could have predicted before it occurred.
In other words, you don’t want to choose a method that isn’t right for your business. A wrong choice made on fundamentals like the right accounting method could negatively affect your operations down the line when further research could have helped. Be sure to take some time to familiarize yourself with the pros and cons of cash basis accounting:
As a business owner, all you have to do is track money as it moves in and out of your business bank account. You don’t have to factor in expenses you haven’t paid for yet or payments you haven’t yet received.
Because the cash basis method is such an easy process, a business owner who does not have accounting knowledge can manage their finances without hiring external help like accountants — which is why it’s such a popular option for startups and small companies.
Because you only record the money going in and out of your business account, you have more control over your tax liability. If you send an invoice of $2,000 to a client in November and they pay you in January of next year, you won’t pay tax for that transaction until the following year.
This method might help you delay paying income tax on some earnings during a specific tax year — which can be especially helpful since small businesses have plenty of expenses and costs such as overhead, rent, and more. With this method, you can also lower your tax burden, for example, by paying some of your business expenses in November or December for services you’ll use the following year.
Cash basis accounting can only show you how much cash you have, but not any planned transactions. As such, it’s challenging to get a long-term picture of financial health, meaning this method can be misleading — especially to investors and lenders, which can lead to mistrust or cashing out early.
Let’s say that you checked your business bank account and are pleased to see several deposits from clients for past services you’ve performed.
At first glance, you might think your business is growing because of the cash balance in your account. But that revenue results from transactions that happened in the past, so it’s not a true reflection of your current revenue.
Accrual accounting has accounts receivable (A/R) and accounts payable (A/P) in financial statements, which inform you of what payments you will receive and your outstanding bills.
Without these items in your statements, you might have difficulty keeping track of what you are owed and what you owe.
Not having this vital information could damage your finances: For instance, you could forget large payments that a client owes you or fail to pay a bill.
Confidently automate AP/AR and control your business with BILL. Get startedCash and accrual accounting are two different ways businesses can track their financial performance:
Whichever accounting method you choose for your business, tracking your spending is the first step to understanding business finances and cash flow patterns.
