Cash basis accounting: Everything you need to know

When it comes to managing the finances of your business, accounting methods are one of the most crucial decisions entrepreneurs and financial managers make.

For smaller businesses and freelancers, cash basis accounting is a popular choice – but why?

Find out everything you need to know about cash basis accounting, the pros and cons, and how it works in practice.

Here’s what we cover:

What is cash basis accounting?

Cash basis is an accounting method where transactions are recorded only when cash or payments are exchanged. That means revenue is recognized when money is received, and expenses are recorded when they are paid.

This is in contrast to the accrual basis of accounting, which recognizes revenue when it is earned (regardless of when payment is made) and records expenses when they are incurred, regardless of when they are paid.

Who uses cash basis accounting?

Cash basis accounting is often favored by small businesses and freelancers due to its simplicity and the direct connection it provides between cash flow and accounting records. This method’s focus on cash flow makes it easy for businesses to track their actual cash position.

Is cash basis accounting GAAP compliant? 

No, because it fails to accurately match income with expenses, cash basis accounting doesn’t comply with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), which require the use of accrual accounting for most businesses.

How cash basis accounting affects financial statements

Cash basis accounting affects the preparation and presentation of financial statements, such as the income statement and balance sheet.

Income statement

Under cash basis accounting, your revenue is only recorded when money is received, so your cash basis net income statement may not reflect all earnings during a period if payments are still outstanding. Similarly, expenses are not recognized until they are actually paid, which can create a delay in reflecting the true financial performance for a given period.

Balance sheet

A cash basis balance sheet may not fully represent a business’ financial position because it doesn’t include accounts receivable and accounts payable. These are key elements in accrual accounting that show the amounts owed to or by the business, which can affect decisions made by lenders, investors, or other stakeholders.

Impact on financial insights

While cash basis accounting offers an accurate snapshot of your actual, current cash flow, it doesn’t provide a comprehensive picture of a company’s financial health. It may be difficult to gauge profitability or assess future financial risks, especially if a company relies on credit or has significant delayed payments.

Choosing between cash basis and accrual accounting

When looking at cash vs accrual accounting and deciding which method will work best for your business, you should consider various factors, including your company size, complexity, and regulatory requirements.

• Small businesses: cash basis can be an ideal accounting method for small businesses with relatively simple operations. It’s easy to implement, minimizes the risk of errors, and provides a straightforward view of cash flow.
• Larger businesses: for mid-sized to larger companies or businesses with more complex operations, accrual accounting might be a better fit, as it gives a more accurate view of financial performance and obligations. Accrual accounting is also required for publicly traded companies and businesses that exceed certain revenue thresholds.
• Tax considerations: in the US, businesses with average annual gross receipts of $30 million or less (as of the 2024 tax year) can use cash basis accounting. However, businesses exceeding this threshold generally have to use accrual accounting, unless they are sole proprietorships or partnerships.
• Industry standards: some industries may have standardized practices that lean toward one method over the other. For example, businesses in manufacturing, construction, and large-scale retail may find accrual accounting more effective bacuase of the complexity of their transactions.

Cash basis accounting example

Let’s consider a small business example to illustrate how cash basis accounting works in practice.

A freelance web developer completes a project for a client on December 15th. The developer sends a final invoice for $5,000 on that date, but the client doesn’t pay until January 5th. Under cash basis accounting, the revenue from the project would be recognized on January 5th when the payment is received, not on December 15th when the work was completed and invoiced for.

The developer also incurs a business expense of $500 for web hosting services on December 20^th, but does not pay the bill until January 10th. This expense is recorded in January when the payment is made, not in December when the service was used.

This means that although in theory, the web developer is $4,500 better off at the end of December, this won’t be reflected in their cash basis financial statements until January. This highlights how cash basis accounting ties revenue and expenses directly to cash flow, rather than the timing of transactions.

Pros and cons of using a cash accounting method

What are the main benefits of cash accounting?

Simplicity and ease of use

One of the most significant advantages of cash basis accounting is its simplicity.

It’s easy to implement because it involves fewer steps and less complexity compared to accrual accounting. There’s no need to track receivables or payables, and you don’t need to worry about adjusting for revenues and expenses that haven’t yet been received or paid.

So, if you’re a small business owners, this method can significantly reduce the time you need to spend on bookkeeping and accounting tasks.

Suitable for small businesses

Cash basis accounting is particularly well-suited for small businesses and sole traders who deal primarily in cash or have a relatively simple financial structure.

It provides an easy-to-understand method of tracking cash inflows and outflows, so if you have few employees and limited inventory, using cash basis accounting can help streamline operations and minimize accounting costs.

When paired with robust spend management solutions, cash basis accounting helps small businesses monitor and control cash flow more efficiently. This integration ensures businesses remain aligned with their financial goals, make informed decisions, and maintain a healthy cash flow.

What are the disadvantages of cash basis accounting?

While cash basis accounting offers simplicity and ease of use, it comes with some disadvantages that businesses should be aware of.

Limited financial insight

Since cash basis accounting focuses on cash flow, it won’t necessarily offer a complete picture of your business’ financial health.

A business could be profitable on paper but still face liquidity issues if it’s not receiving payments in a timely manner, or if it has significant unpaid bills.

This method doesn’t capture the value of accounts receivable (money owed to the business) or accounts payable (money the business owes), which are critical for understanding long-term financial stability. As such, it can distort profitability, leading to challenges in long-term financial planning and decision-making.

Potential compliance issues

The fact that cash basis accoutning isn’t GAAP compliant can be a significant issue if you want to attract investors or apply for loans.

In addition, businesses that plan to expand may find it challenging to switch from cash basis accounting to accrual accounting later on, particularly if they have grown significantly in size or complexity.

Tax implications of the cash basis method of accounting

One of the primary benefits of cash basis accounting is the potential tax advantage. By deferring income recognition until payment is received, businesses can reduce their taxable income in the short term. Likewise, expenses are only recognized when paid, which can also provide tax deferral benefits.

For instance, if a business invoices for a job in December but doesn’t get paid for it that same month (like in our example above), this could delay their payment of taxes on the income until the following tax year, potentially lowering the tax burden for the current year.

However, this advantage should be carefully considered, especially for businesses that are growing and may not want to delay the recognition of income. It’s important to consult with a tax professional to understand how cash basis accounting will impact your specific tax situation, as tax laws may vary by jurisdiction.

How to simplify your cash basis accounting workflow

For small businesses using cash basis accounting, the goal is to streamline accounting tasks and minimize the risk of errors:

• Use accounting software: to simplify your financial management, consider using accounting software that supports cash basis accounting. Implementing a digital solution will help you track cash basis income and expenses effortlessly, generate accurate financial reports, and stay compliant with tax regulations—all while saving time and reducing manual errors. Take control of your finances and focus on growing your business with the right accounting tools.
• Track your cash flow: whether you’re using autmated software or not, it’s important to make sure you keep a detailed record of all cash transactions, including payments received and expenses paid. Regularly update your cash flow statements to ensure you have an accurate picture of your business’ financial position.
• Plan for taxes: even with cash basis accounting, you need to be proactive about managing your taxes. Set aside a portion of your income to cover tax obligations and make sure you are aware of any tax deadlines.
• Separate personal and business finances: mixing personal and business finances can complicate your accounting process. Keep separate bank accounts for your business to ensure that you accurately track business-related cash transactions.

Cash basis accounting: Is it right for your business?

Cash basis accounting is an accessible and straightforward method of accounting that focuses on cash flow rather than when transactions occur. It’s ideal for small businesses, freelancers, and sole proprietors who need a simple way to track their financial performance.

However, it may not provide a complete picture of financial health and won’t necessarily comply with regulatory requirements for larger businesses and publicly traded companies.

By understanding the advantages, disadvantages, and tax implications, you can make informed decisions about whether cash basis accounting is right for you or not.