Cash accounting is an accounting method that records income when it’s received and expenses when they’re paid instead of when they were incurred. Small businesses typically use the cash accounting method.
Learn how cash accounting works, what types of businesses can use it, and its pros and cons.
Definition and Examples of Cash Accounting
Under cash accounting, a business’s bookkeeper records income and expenses only when the cash is received or spent. In other words, your accounting records will match the dates when cash hits or leaves your bank account. Cash accounting is often compared to accrual accounting, which records income and expenses as soon as they were incurred.
- Alternate name: Cash-basis accounting, cash method
Consider this example. Say a freelancer sent an invoice for $1,000 on August 31 for services rendered that month. The customer paid the invoice on September 7. The cash accounting method records the income of $1,000 on September 7, when the cash was received—not August 31, when the amount was incurred.
Alternatively, let’s say the freelancer received an invoice from a subcontractor for $500. If the invoice was dated October 5 and the freelancer paid it on October 15, the expense would be recorded on October 15.
How Does Cash Accounting Work?
Many small businesses use cash accounting for its simplicity. Income and expenses are recorded in your books only when the cash hits your account or leaves it. That means your actual profits and margins will match what is recorded in your account.
Under cash accounting, businesses pay taxes only on income they’ve actually received. If you send an invoice during the current tax year but you are not paid until the next tax year, that income will not be taxable for the current tax year. Instead, it would be factored into your income for the next tax year.
For example, let’s say a marketing agency delivers a project in mid-December 2021 and sends an invoice for $10,000 on Dec. 27. If the invoice is not paid until Jan. 5, 2022, under cash accounting, the $10,000 would not be counted as income for 2021. Instead, it would be taxed as part of the agency’s income in 2022, when the cash was actually received.
Using the cash account method doesn’t mean you can delay cashing checks as a way to postpone payments on taxable income. When you receive a payment, the cash is considered available to you and must be reported.
Alternatives to Cash Accounting
Instead of recording income as it’s received or expenses as they’re spent, the accrual accounting method records them as soon as they’re incurred. Accrual accounting offers a more accurate long-term view of your business finances, which allows you to see what income and expenses you have yet to earn or pay. This also means that your accounting records will not always match what is in your bank account, since your records will reflect pending income and expenditures.
If your business generates more than $25 million per year, you must use the accrual accounting method. Businesses that earn under that amount can use whichever accounting method works best for their needs.
If you choose the accrual accounting method, your business is required to pay taxes on income that is owed to you but not yet received. Keep in mind that you will want to use the same accounting method for each tax return you file. If you need to switch from cash accounting to accrual accounting, you must file IRS Form 3115.
Cash Accounting vs. Accrual Accounting
|Cash Accounting||Accrual Accounting|
|Records income when received and expenses when spent||Records income and expenses when they are incurred|
|Profits and expenses match what is in your account||Profits and expenses do not always match what is in your account|
|Income that is pending but not received is not subject to taxes||Income that is pending but not received is still subject to taxes|
|Often used by small businesses and sole proprietors||Required for larger enterprises that earn over $25 million in revenue|
Pros and Cons of Cash Accounting
Income is not taxed before it’s received
Easy to use
No records of accounts payable and accounts receivable
Unpopular among lenders
- Straightforward: Cash accounting is a simple methodology—you record income and expenses whenever you receive or spend the cash.
- Income is not taxed before it’s received: If a payment is still pending at the end of your fiscal year, you won’t pay taxes on that income until the following tax year.
- Easy to use: The method’s simplicity doesn’t require an in-depth understanding of accounting.
- Inaccurate: Short-term cash flow analysis can be inaccurate since earnings and expenses may have been earned or incurred in a previous month(s).
- No records of accounts payable and accounts receivable: Since cash accounting does not reflect amounts pending, there are no accounts payable (money your business owes) or accounts receivable (money owed to your business).
- Unpopular among lenders: Lenders may not trust the accuracy of financial statements under cash accounting, which could affect your chances of getting approved for financing.
- Cash accounting is an accounting method that records when cash enters or leaves your account instead of when income is earned or expenses are incurred.
- The cash accounting method can be used only by businesses that earn less than $25 million in annual revenue.
- The advantages of a cash accounting system include its simplicity and that income is not taxed before it’s received.
- The disadvantages of a cash accounting system include inaccurate short-term cash flow records and the potential to adversely affect your chances of getting approved for a loan.