Whenever a business is born, owners need to decide whether they’re going to start with the cash basis accounting method or jump to the accrual basis route, which is a major decision that shapes the future of their company.
Determining the right accounting method for your business
If you’re unsure whether your current accounting process is a good fit for your company, you’re not alone: A quarter of small business owners admit that they don’t have enough knowledge about their finances.
Cash basis accounting is usually a good fit for small businesses because it applies to those who make less than $1 million in revenue — but even so, you still may struggle to gain the benefits this method offers if you don’t understand how it works. You also might not know when to switch to accrual accounting, which is an inevitable step if your business grows past a certain point.
The best way for business owners to avoid these challenges is to understand the nuances of both cash and accrual. Here, we’ll cover everything you need to know about the basics of cash basis accounting.
Understanding cash basis accounting
In cash basis accounting, you record revenue or expenses when cash is received or paid, which means that you would record income when a customer hands you cash, a check, or credit card payment. In commerce, “cash” refers to any money that is received in real-time.
Let’s take an example to get a clear picture of how cash basis accounting works:
Say you have a project to complete between April 1st and May 30th valued at $10,000. You and the client signed the contract on April 1st, and your entire staff started working on completing deliverables on that date, but you have yet to receive payment.
- If you were to use the accrual method of accounting, you would record $10,000 of revenue only when it is earned, not when the contract is signed on April 1st. This method of revenue recognition is a critical differentiator that separates accrual accounting from other types.
- The record would be in the form of accounts receivable — that’s money that you will be receiving in the next few months or after you deliver the project on May 30th.
- With the cash method, you don’t record any transactions or accounts receivable. You only record the $10,000 as revenue when the client deposits $10,000 in your business account.
Why your business might use cash basis accounting
Many small businesses, community associations, non-profit organizations, and other entities use the cash method because of its simplicity: Cash basis accounting is a straightforward method of accounting that makes reporting financial statements and tax reporting an easy task for business owners.
You might opt for cash basis accounting if:
- You do not publish financial statements for auditing purposes.
- You have few transactions per day.
- You have a small number of employees.
It’s especially convenient for companies that do not hold inventory: Because you aren’t looking at inventory transactions, it’s easier to focus on cash flow — and avoiding cash flow problems is essential for maintaining financial health.
But there are some limitations on who can and cannot use cash basis accounting, which are set by the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP).
According to these internationally recognized accounting standards, you can use cash basis accounting if you meet these qualifications:
- For sole proprietors, partnerships, S corporations, C corporations, and limited liability companies:
- Your average annual gross receipts do not exceed $1 million in a single year, $5 million for the last three years.
- You do not (with some exceptions) hold inventory.
- You are a personal service business (law firms, accounting, consulting, engineering, and architecture firms) and not a specified service trade or business (SSTB).
In some cases, the IRS may accept cash-basis accounting for a small business that does keep inventory if the business earns more than $1 million but less than $10 million. You’ll need annual gross receipts for the past three years to determine and support this claim and this is known as the inventory test.
- For family-owned farms:
- You have average annual gross receipts of less than $25 million per year
If your business does not fit into any of these categories (if you’re a publicly-traded company, for example), you will have to switch to the accrual accounting method.
The difference between cash and accrual basis accounting
Cash and accrual accounting are two different accounting styles that offer different sets of information and methods, so it’s good to know how each operates as your business grows. It essentially all comes down to the timing and when transactions are recorded:
- Cash basis accounting recognizes revenues when your business receives cash or pays expenses.
- Accrual accounting recognizes revenues as earned and expenses as incurred when the transaction occurs, i.e. contract is substantially complete.
But these transaction recordings affect the way your financial statements are created and how much taxable income you owe every year, which are major considerations when choosing between cash and accrual.
Financial statements in cash vs. accrual accounting
With the accrual method, you would include accounts receivables and accounts payable on the balance sheet, whereas the cash method does not have these items.
Accounts receivable represent the money that your business will receive at some point from services provided while accounts payable shows the money you have to pay to vendors, suppliers, or lenders on a future date. These are not real-time payments and therefore don’t qualify for cash basis accounting.
Tax breakdown with the cash method
What accounting method you use can impact your tax liability. Let’s say that your business has had the following transactions in a single month:
- Sent an invoice of $5,000 for a project that you completed.
- Received a bill of $1,000 for hiring a freelancer (but haven’t yet paid for it).
- Paid $75 for a freelancer.
- Received $1,000 for a project you completed.
If you use the cash method, your net income for this month would be $925. Here’s why:
$1,000 (cash received) – $75 (freelancer bill) = $925 (net income)
Remember that cash accounting relies on money received and paid out immediately, meaning that you’d only consider transactions 3 and 4 when considering your taxable income. In other words, you’d only pay taxes on the net income of $925 and not on the invoices sent or bills received.
What you should consider when choosing the cash basis accounting method
As a business owner, you want to avoid “accounting hindsight,” which is when you unintentionally overestimate an accounting-related outcome that you could have predicted before it occurred.
In other words, you don’t want to choose a method that isn’t right for your business. A wrong choice made on fundamentals like the right accounting method could negatively affect your operations down the line when further research could have helped. Be sure to take some time to familiarize yourself with the pros and cons of cash basis accounting:
Advantage #1: Cash basis accounting is a simple, straightforward process
As a business owner, all you have to do is track money as it moves in and out of your business bank account. You don’t have to factor in expenses you haven’t paid for yet or payments you haven’t yet received.
Because the cash basis method is such an easy process, a business owner who does not have accounting knowledge can manage their finances without hiring external help like accountants — which is why it’s such a popular option for startups and small companies.
Advantage #2: Cash basis accounting offers manageable income tax
Because you only record the money going in and out of your business account, you have more control over your tax liability. If you send an invoice of $2,000 to a client in November and they pay you in January of next year, you won’t pay tax for that transaction until the following year.
This method might help you delay paying income tax on some earnings during a specific tax year — which can be especially helpful since small businesses have plenty of expenses and costs such as overhead, rent, and more. With this method, you can also lower your tax burden, for example, by paying some of your business expenses in November or December for services you’ll use the following year.
Drawback #1: The cash basis method could be misleading
Cash basis accounting can only show you how much cash you have, but not any planned transactions. As such, it’s challenging to get a long-term picture of financial health, meaning this method can be misleading — especially to investors and lenders, which can lead to mistrust or cashing out early.
Let’s say that you checked your business bank account and are pleased to see several deposits from clients for past services you’ve performed.
At first glance, you might think your business is growing because of the cash balance in your account. But that revenue results from transactions that happened in the past, so it’s not a true reflection of your current revenue.
Drawback #2: No use of accounts receivable or accounts payable
Accrual accounting has accounts receivable (A/R) and accounts payable (A/P) in financial statements, which inform you of what payments you will receive and your outstanding bills.
Without these items in your statements, you might have difficulty keeping track of what you are owed and what you owe.
Not having this vital information could damage your finances: For instance, you could forget large payments that a client owes you or fail to pay a bill.
Automatically track your budget and expenses with the right tools
Cash and accrual accounting are two different ways businesses can track their financial performance:
- The cash basis system is usually used in small business accounting because of its simplicity and ease. It only tracks the cash receipts coming in and expenses going out of the business.
- The accrual basis system tracks transactions rather than cash, providing a more accurate picture of your business performance, and is accepted by the industry.
Whichever accounting method you choose for your business, tracking your spending is the first step to understanding business finances and cash flow patterns.
That’s where Divvy comes in: Our expense management and tracking software can help you streamline financial management and take complete control of your finances — so request a demo to experience our unique features firsthand today!
The information provided on this page does not, and is not intended to constitute legal or financial advice and is for general informational purposes only. The content is provided “as-is”; no representations are made that the content is error free.
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