A guide to cash basis accounting: Definition & example

This means that if a business receives payment for an invoice in June but the work was done in May, the payment would be recorded as revenue for June. And if you maintain your books on a cash basis, there will be little difference between your financial statements and your tax returns. Accrual-basis net income is a key metric used in accounting to measure the financial performance of a company over a specific period. Cash basis accounting is an accounting system in which you record revenue or expenses when cash is received or paid. This means that you would record income when a customer hands you cash, a check, or credit card payment.

The accrual method records accounts receivables and payables and, as a result, can provide a more accurate picture of the profitability of a company, particularly in the long term. Cash basis accounting is a good option for small businesses or individuals, especially those who almost exclusively deal with cash. Although it’s the more simple accounting method, it doesn’t always leave you with an accurate view of the health of your business, which, in a lot of cases, can be very good to know. Although cash basis accounting has its perks, it does come with its disadvantages.

Should your small business use cash or accrual accounting?

If a business chose to track purchases and sales using cash basis accounting, it would lead to huge gaps between inventory accounting and the reported revenues and expense. Cash basis net income can be an essential metric for businesses to track, as it provides insight into the company’s financial performance over a specific period. This information is crucial in making informed decisions about future operations and investments.

This approach can result in deferring tax liabilities, as income recognition may occur in a later tax period, potentially giving the business more time to use those funds for growth or other purposes. Cash basis accounting can streamline your accounting system and save you time—you just have to know how to navigate it. For example, under the cash basis method, retailers would look extremely profitable in Q4 as consumers buy for the holiday season.

Cash basis vs. accrual basis accounting

Businesses using cash basis accounting must become familiar with the concept of constructive receipt. For tax purposes, you have constructive receipt of income when that income becomes available to you. This means that if a customer pays you in December, but the check is not picked up until January, you must still report that income as received in December.

• The benefits of accrual-basis accounting are numerous and can provide valuable insights for investors.
• Although the company has received no cash, the revenue is
  recorded at the time the company performs the service.
• Since cash-basis is just a snapshot of your business’ finances, you may not have a clear picture of what’s ahead for the long-term.
• That means it does a better job than cash basis accounting of matching expenses and revenue to the correct time period in which they were incurred.
• Cash accounting is much simpler, but accrual is required for certain businesses and preferable for others to leverage certain tax strategies.
• Understanding your business’s cash basis net income is crucial to make informed decisions and keep your finances in check.

For example, if a business sees that one expense category has increased significantly without a corresponding increase in revenue, they may investigate ways to reduce those costs. It’s easy to understand and requires minimal bookkeeping skills, which makes it ideal for small business owners who don’t have extensive financial experience. Throughout the text we will use the accrual basis
of cash basis accounting measures income based on accounting, which matches expenses incurred and revenues earned,
because most companies use the accrual basis. All of the accounting software products listed below support accrual basis accounting, and some let you choose whether you want to view reports on a cash vs. accrual basis. An example of cash basis accounting would be a small retail store that purchases products from a supplier.