Cash accounting is an accounting method where businesses record revenue when they receive it and expenses when they pay them. This accounting method differs from the accrual method, which requires firms to record income when they earn it and expenditures when they incur them.
How Cash Accounting Works in Action
Companies that use cash accounting record revenue in their books when they receive a cash payment, regardless of when the service is performed. If a customer decides to prepay for a year of legal services at the end of the prior year, you would still record the income when you receive the money.
You would record the whole year's worth of prepayments in December if you receive the check before December 31. You would record the full amount in January if the payment is dated December 31, but you receive it on January 1.
Expenses work in the same way. You record the expenditure in your books when you make the payment, regardless of when you receive the benefit from the payment. If you pay for six months of insurance premiums at one time to lock in a lower rate, you would record the entire expense in the month you make the payment. The expenditure is not divided by six and is partially expensed each month.
Benefits of the Cash Accounting Method
The cash accounting method is more straightforward and easier for most people to understand, as you record income and expenses when you receive and pay them. You don't need to learn accrual accounting requirements to properly place income and expenses in the correct periods based on when you earn or incur them.
The cash accounting method mirrors a business's cash flows. Companies that manage their books with this accounting method often have a better grasp of their company's cash position.
Taxation for businesses using this accounting method is usually based on the cash brought in and paid out. This means a firm using cash basis accounting should have the cash necessary to pay federal income taxes.
Drawbacks of Using Cash Accounting
Cash accounting doesn't give companies the real picture of their financial viability over the long term. A business may receive payments for services in advance but incur expenses in the future. It may appear profitable when the prepayment arrives but could quickly turn unprofitable in future months.
Some lenders may ask to see accrual-basis financial statements when a company applies for a loan. Businesses that keep their books using the cash accounting method may need to spend considerable time converting their records to the accrual method to apply for the loan they need.
Cash Accounting Can Only Be Used by Certain Businesses
Publicly traded companies must use the accrual method of accounting. However, most small businesses can choose to use either cash or the accrual accounting method to maintain their books. The Internal Revenue Service (IRS) may force a business to use the accrual method for tax purposes if they are one of the following:
- A corporation, not including S corporations, or a partnership with a corporation as a partner, not including S corps., with average annual gross receipts that exceed $25,000,000 for the three previous tax years after indexing for inflation
- A tax shelter
Your business likely uses the cash accounting method unless it's required to use accrual accounting.