The Cash Accounting Method
In this article, we aim to inform you about one of the two primary accounting methods – cash accounting.
It’s an accounting method where you record payments/expenses whenever you disburse cash, and receipts/income whenever you receive cash.
In short, you record income/expense transactions only when cash is involved.
This is a stark contrast to the accrual accounting method in which you record income when earned and expenses when incurred, regardless if there’s cash involved or not.
Cash Accounting – how it’s done
When you compare cash accounting to accrual accounting, bookkeeping is a bit simpler.
With cash accounting, you only record revenue whenever you receive a cash payment.
It doesn’t matter when the service is performed with cash accounting.
Just always remember that if you receive a cash payment, you record revenue.
For example, customer A decided to employ your services.
They also decided to pay you in advance.
Now with cash accounting, you would record customer A’s advance payment as revenue, regardless of whether you performed your services or not.
Simple isn’t it?
The same process can be applied to expenses – you only record them when you disburse cash.
This applies regardless of when you incurred these expenses, or when you received their benefit in the case of prepayments.
To illustrate this, imagine that your company decided to prepay 12 months of rent for the year.
With cash accounting, you record the whole payment as rent expense for the month that you made the payment.
No need to worry about spreading the expense over the year – just remember that with cash accounting, you record income and expenses whenever cash is involved.
There’s just a little caveat with cash accounting and receiving cash payments.
Say a client paid you at the end of the year, December 31, but you actually received the payment the next day, which is January 1 of a new year.
In this case, you record the cash payment as revenue for the new year.
Be extra careful with end-of-year cash payments!
Benefits of Cash Accounting
As already mentioned in this article, cash accounting is the simpler one of the two primary accounting methods.
Its system of recording income/expense only when cash is involved is straightforward and easier to understand, especially for those who aren’t well-versed in accounting.
And since the cash accounting method foregoes any accruals/deferments, that means fewer accounts to manage.
Since the cash accounting method is greatly involved with cash, it accurately reflects a business’s cash flow.
This can be attributed to the fact that most transactions are only recorded if cash is involved.
Businesses that use the cash accounting method should have a better understanding of their cash flow.
As for taxation, since the cash accounting method only records transactions whenever cash is involved, you’d have a better understanding of how much tax you’re supposed to pay.
Take note though that there may be additional rules for cash accounting (e.g. constructive receipt, prepayment of expenses over 12 months) and we strongly recommend that you consult the tax regulatory body of your country (e.g. IRS, BIR, HRMC).
The Limits of Cash Accounting
While the cash accounting method gives you a great picture of your business’s cash flow and position, it doesn’t necessarily reflect its financial standing.
Remember our example earlier with customer A where they paid you in advance?
Let’s do a reverse of that situation.
Let’s say that customer A decided to employ your services.
You successfully rendered your services in November, but customer A paid in February of the next year, three months after services were completed.
With the accrual accounting method, you could have recorded revenue when you successfully rendered your services.
But with cash accounting, you can only record revenue when a cash payment is received.
The same can be said with expenses. Since you only record expenses whenever you disburse cash, the cash accounting method does not accurately reflect your business’s liabilities.
You may have incurred expenses that you haven’t yet paid for such as utility bills, rent, interest, etc. In those cases, your business may appear more profitable than it really is, which isn’t a good sign.
Simply put, the cash accounting method does not always reflect a business’s true profitability.
Some lenders such as banks, credit unions, or other financial institutions may require you to present accrual-basis financial statements for loan applications.
If you’re only using the cash accounting method for bookkeeping, you will have to incur additional expenses to convert your financial statements so that they reflect the accrual accounting method if required by your lender.
We’ve mentioned taxation already, but we’ll mention it again since the cash accounting method could potentially have negative tax consequences.
Your tax regulatory body may have certain restrictions to the deductions that you can apply.
The IRS only allows expenses you paid in advance to be deductible in the taxable year to which they’re applicable, that is unless the expenses are qualified for the 12-month rule.
Who’s Allowed to Use Cash Accounting?
Small businesses are often allowed to use the cash accounting method for bookkeeping.
However, the IRS requires a business to use the accrual accounting method for taxation purposes if they’re:
- A corporation (other than an S corporation) with average annual gross receipts for the 3 preceding tax years exceeding $25 million (indexed for inflation).
- A partnership with a corporation (other than an S corporation) as a partner, with average annual gross receipts for the 3 preceding tax years exceeding $25 million (indexed for inflation).
- A tax shelter
Unless your business is one of the mentioned above, you’re probably using the cash accounting method.
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IRS.gov "Publication 538 (01/2019), Accounting Periods and Methods" Page 1 . August 17, 2021
IRS.gov "Publication 334 (2020), Tax Guide for Small Business" Page 1 . August 17, 2021
SBA.gov "Manage your finances" Page 1 . August 17, 2021