What Is Cash Accounting?

What Is Cash Accounting?

Let me explain cash accounting to you directly: it's a method where you record payment receipts in the period you receive them, and expenses in the period you actually pay them. In simple terms, you note revenues when cash comes in and expenses when cash goes out.

You might hear it called cash-basis accounting, and it stands in contrast to accrual accounting, which logs income when it's earned and expenses when liabilities arise, no matter when the cash actually moves.

Key Takeaways

Cash accounting keeps things simple and straightforward—you only record transactions when money enters or leaves your account. However, it doesn't suit larger companies or those with big inventories because it can hide the real financial picture. The main alternative is accrual accounting, where you record revenues as they're earned and expenses as they're incurred, ignoring the cash exchange timing.

Understanding Cash Accounting

Cash accounting is one of the two main accounting forms; the other is accrual, where you record revenue and expenses right when they happen. As someone explaining this, I can tell you small businesses often pick cash accounting because it's simpler and shows exactly how much cash you have on hand. But corporations have to use accrual accounting to follow Generally Accepted Accounting Principles (GAAP).

When you use cash basis, transactions hit your books later than when they're actually done, so it can be less accurate short-term compared to accrual. Most small businesses can choose between cash or accrual, but the IRS says if your annual gross receipts top $25 million, you must use accrual. Also, the Tax Reform Act of 1986 bans cash accounting for C corporations, tax shelters, certain trusts, and partnerships with C corp partners. Remember, you have to use the same method for taxes as for your internal books.

Example of Cash Accounting

Here's a straightforward example: suppose Company A sells 10 computers to Company B for $10,000 on November 2 and gets paid then—you record the sale on November 2 under cash accounting. It doesn't matter that Company B ordered them on October 5; the payment date is what counts.

In accrual accounting, you'd record that $10,000 sale on October 5, even without cash yet. For expenses, if Company C hires Company D for pest control on January 15 but pays on February 15, you record the expense on February 15 in cash accounting. But in accrual, it's on January 15 when the service happens.

Limitations of Cash Accounting

One big downside is that cash accounting might not show an accurate view of liabilities you've incurred but haven't paid yet, making your business look healthier than it is. Conversely, if you've finished a big job and are waiting on payment, it can make you seem less successful because you've spent on materials and labor without the cash in yet. So, cash accounting can overstate or understate your business's condition if payments or collections spike in one period.

There are tax drawbacks too: you can only deduct expenses in the tax year you pay them. If you incur costs in December 2019 but pay in January 2020, you can't deduct them for 2019, which hits your bottom line. Similarly, if a client pays in 2020 for 2019 services, you include that revenue in 2020's statements.