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.
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 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.
