Cash Basis Accounting: Understanding Small Business Finance

Cash basis accounting is an accounting system that tracks revenue when businesses receive them. The cash basis method also recognizes expenses only at the time they’re paid out.

Small business owners and sole proprietors typically use the cash basis method of accounting because of its simplicity. There are situations when a business cannot use cash basis accounting. For example, if inventory is important to account for your income, then you may have to use accrual accounting.

Accrual accounting recognizes financial transactions when incurred, regardless of when the business receives or pays the money. It is more complicated than cash basis accounting, but it may show a more accurate picture of a company’s long-term financial health.

Cash basis and accrual basis are the most common accounting systems. Here’s how they compare:

• Company: Generally, small businesses and sole proprietors use cash basis accounting. Meanwhile, the accrual method of accounting is the standard method of financial reporting for public companies.
• Revenue: For cash basis accounting, cash receipts (also known as accounts receivable) end up on the income statement at the time of payment, and not when they are originally billed. In accrual accounting, revenue recognition occurs in the tax year earned, regardless of when the payment’s received.
• Expenses: With cash basis accounting, you record expenses only at the time of payment—the same fiscal period the debit hits the bank account—not when you incur the expense. With accrual basis accounting, a business deducts expenses in the tax year they’re incurred, which is not always the same accounting period or tax year that a company makes the payment.

Small businesses owners and companies whose gross receipts are under IRS maximums have the option to use cash basis accounting. Here’s why some businesses use this system:

1. 1. Ease of use: Small business owners can typically handle the bookkeeping or use common accounting software when using cash basis accounting. A CPA is not always needed.
2. 2. Cash on hand: Cash basis provides an accurate short-term assessment of a business cash flow.
3. 3. Tax reporting: Businesses only pay income tax on cash received versus invoices issued, which influences tax liability.
4. 4. Inventory considerations: The cash method can prove more convenient for smaller businesses that don’t carry inventory as it provides an accurate picture of the current balance sheet for these types of businesses.

While the cash method of accounting is more simplified than the accrual method, there are disadvantages:

1. 1. GAAP requirement: Cash basis accounting is not acceptable under the generally accepted accounting principles (GAAP). Therefore, large corporations and public companies use the accrual basis of accounting.
2. 2. IRS restrictions: Corporations (excluding S corporations) with average annual gross receipts exceeding $25 million cannot use cash basis. Tax shelters and C corporations also cannot use this system.
3. 3. Financial statements: Depending on when you pay your bills, your financial statements may be misleading, showing profitability when in reality, net income may be less than the total outflows.

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