Cash basis accounting is preferred by many business owners—and accountants!—because it’s easy to implement, maintain, and understand. Since most businesses in the U.S. are cash basis taxpayers, it just makes sense for most small businesses to use cash basis accounting, right?
Sometimes. But cash basis accounting usually only shows you part of your financial picture. Although it is easy to implement, maintain, and understand, cash basis accounting can obscure financial information critical to making sound business decisions. There are exceptions to this, of course.
Both cash basis accounting and accrual basis accounting have benefits and drawbacks. In this article, we’ll take a look at cash basis accounting, including what it is, when you should use it, and what you need to know about the information this accounting method gives—and doesn’t give—you about your business.
What Is Cash Basis Accounting?
Cash basis accounting is sometimes referred to as “bank balance” accounting, because—with a few exceptions for non-cash expenses like depreciation—only transactions that have cleared your business’s bank accounts appear on cash basis financial statements. Cash basis accounting recognizes revenue when it is received and expenses when they are paid, regardless of when the revenue is actually earned and the expenses are actually incurred.
In other words, cash basis accounting doesn’t take into account outstanding invoices owed by your customers or outstanding bills you owe to your vendors. It also doesn’t take into account prepaid expenses and how those impact your business’s financial standing.
This might not seem like a big deal, but cash basis accounting disregards two of the 10 basic accounting principles: the matching principle and the revenue recognition principles of accounting. And although not all businesses in the U.S. are required to comply with generally accepted accounting principles (GAAP), there are many benefits to following them. As demonstrated in this article about accrual accounting, following the cash basis of accounting can give you a skewed view of your business’s health and performance.
Still, there are times when it is appropriate and even preferable to use cash basis accounting for managing your business.
When Cash Basis Accounting Is Appropriate for Your Business
Many businesses operate on a “payment due at time of service” model. Ecommerce businesses, retail stores, and even many professional service businesses have moved away from billing for merchandise or services delivered and waiting 30 days—or longer—for payment from their customers. Instead, these businesses require payment at the time of purchase or in some cases set their customers up on a subscription model so payments are made automatically. This eliminates the need for accounts receivable tracking.
Similarly, many business owners favor the automatic payment options offered by their vendors and service providers. It’s easy to set up automatic payments for everything from utilities and rent to credit card balances due. This not only frees the business owner from having to take time to pay bills, but it also eliminates the need for accounts payable tracking.
If your business never invoices customers and pays for all expenses either automatically or at the time of purchase, there is little need for accrual basis accounting. You can use cash basis accounting and still get financial reports that accurately report on your business’s income and expenses in the correct time period.
What to Keep in Mind About Cash Basis Accounting
Often, business owners will pay for memberships or subscriptions on an annual basis instead of monthly. It has become standard for membership organizations and software companies to offer discounts—often equaling 20% or more—for annual payments. These discounts can have a direct positive impact on your business’s bottom line and should be leveraged if your business’s cash flow can handle paying the expense in full.
However, paying for a membership or subscription in full on an annual basis can skew your financial reports for the month in which they are paid.
Let’s say you purchase an annual accounting software subscription for $2,000. If you had paid for the subscription monthly, you would have paid $200/month, and so paying annually will save you $400—a significant savings.
When you look at your financial statements for the month when you make the purchase, your profit and loss statement will reflect the $2,000 subscription payment, and your net income for the month will be reduced by this amount. This makes sense from a cash flow perspective—after all, this is when you paid for the subscription. But it will skew your expenses for the month in which you make the purchase and might even result in a loss for the month.
When you analyze your expenses as part of your planning process for the upcoming year, it might not be immediately obvious why your expenses were $2,000 higher in the month when you purchased the software subscription. Even if you do remember the subscription purchase, if you are trying to arrive at your average operating expenses per month for budgeting purposes, you will now have to do a separate calculation to arrive at your “monthly nut” amount.
Many business owners don’t mind this temporary skewing of their financial statements. And for many businesses, the benefits of cash basis accounting outweigh the minor inconvenience of a short-term misstatement of profitability for one month. Just be aware of this possibility if you choose cash basis accounting for your business.
Cash Basis Accounting and Cash Flow
Most business owners are primarily concerned with their business’s cash flow, and for good reason. Cash flow is critical to small businesses, and—unfortunately—cash flow issues often result in the failure of businesses that are “profitable on paper.”
From this perspective, cash basis accounting seems much more relevant than accrual basis accounting to many business owners, because cash basis accounting lets them see all their cash flow activity on their profit and loss statement.
The idea of only having to look at one financial statement—the P&L—in order to see how your business is performing and to get a handle on your cash flow is attractive. But if your accounting is done correctly, there will almost always be some cash flow activity that does not appear on your P&L.
If you take draws or distributions from your business, or if you are paying long-term debt like loans, these cash disbursements will not appear on your P&L. This is why your net income number on your P&L rarely matches your bank account balance.
There are several reasons to use cash basis accounting in your business, but tracking cash flow accurately shouldn’t be one of them.
When You Shouldn’t Use Cash Basis Accounting
The most compelling reason to not use cash basis accounting is if you extend credit to your customers or maintain open accounts with your vendors and suppliers. Using cash basis accounting if you have accounts receivable (A/R) or accounts payable (A/P) can lead to not collecting all money owed to you or to missing payments to your vendors.
What you shouldn’t do is base your decision to use cash basis accounting on your tax basis. Many accountants will tell you to keep your books on either cash basis or accrual basis based on your tax basis, but you use your financial statements to run your business 365 days a year and for taxes one day each year.
Use the accounting method that makes the most sense for your business and helps you drive your business toward greater growth and profitability, regardless of your tax basis. Most accounting software packages will let you produce either cash or accrual basis financial statements with the click of a button, so you can still give your accountant the reports they need at tax time.
Cash Basis Accounting: The Bottom Line
Cash basis accounting is the easiest accounting method to implement, maintain, and understand. If you use cash basis accounting, you can essentially do all your business’s accounting using the bank feed feature in your accounting package.
Cash basis accounting also mirrors your business’s cash flow more accurately than accrual basis accounting, but it still doesn’t give a complete picture of your cash flow. To get this information, you will need to produce either a statement of cash flows (an accrual basis statement, but you can still use it to see cash flow for draws and distributions, loans, and investments) or a comparative balance sheet (you can produce this statement on either cash or accrual basis) to see movements of cash that do not appear on your P&L.
Regardless of the accounting basis needed for your tax returns, you should choose the accounting basis for your books that makes the most sense for your business’s needs. Most software packages make it easy to produce cash basis financial statements from accrual basis books—and vice versa—with just a click of a button.
Now that you know more about cash basis accounting, speak with your bookkeeper or accountant about whether cash or accrual basis accounting is best for your business. They will be happy to help you understand which basis you should use, and why.