What Is Accounting on a Cash Basis? (Benefits and Examples)

By Indeed Editorial Team

Published June 17, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Businesses use various accounting records to track their income and expenses. A cash basis is an accounting method that records and recognizes a company's income and expenditure as it pays and receives cash. Understanding how this record works and individuals who use it in business can help you implement strategic methods to increase a company's income and reduce expenses. In this article, we define accounting on a cash basis, discuss the individuals and businesses who use it, list its benefits, compare cash basis and accrual accounting methods, and provide examples.

What is accounting on a cash basis?

Accounting on a cash basis is an accounting method used to record revenue when they receive cash and pay expenses. It reflects business transactions on a company's financial statement of when cash flows in or out of the company. This means it doesn't record income from credit accounts until it's in the business account. The cash basis accounting system doesn't consider amounts receivable or amounts payable.

It's similar to a cash book because businesses can use it to determine how much cash they have at a particular time at the end of a month. For example, a firm can perform work in one year and not receive payment until the following year. Under cash basis accounting, it may not report revenue in the year it performed work, but in the following year when it received cash. Cash basis accounting doesn't comply with the Generally Accepted Accounting Principles (GAAP). GAAP refers to the common accounting standards and procedures that the International Financial Reporting Standards (IFRS) issue.

Who uses cash basis accounting?

Sole proprietors, small businesses, government agencies, non-profit organizations, cash-based businesses, community associations, and small service companies often use the cash basis accounting method. This method is typically ideal for these businesses because it makes their accounting easier, enabling the management to focus on strategic planning. Companies with no inventory often use cash basis accounting because they have no product to track or value. Businesses that don't buy or sell or credit usually use this method to evaluate their financial performance.

Related: 7 Steps on How to Work Internationally Successfully

Why do businesses use cash basis accounting?

Aside from small businesses, some large companies often use cash basis accounting to assess their financial performance within a particular period. Here are common reasons a company may use cash basis accounting:

  • Few employees

  • Uses simple-entry accounting rather than double-entry accounting

  • Records a few financial transactions daily

  • Operates as a partnership and doesn't publish balance sheets, income statements, and other financial statements

  • Few clients or customers

  • Customers typically pay with cash or e-transfer at the point of sale

  • High positive cash flow

What are the benefits of cash basis accounting?

Businesses using this method may not prepare adjusting entries unless they discover an error in preparing an entry during the accounting period. The following are the benefits of using cash basis accounting:

Ease of use

A company may not need an accountant or a bookkeeper to perform a cash accounting basis because of its simplicity. It's easy to learn, implement, and maintain. Small businesses and individuals can typically handle bookkeeping or use standard accounting software when using this method. Cash basis accounting is especially cost efficient for startups to use. With it, businesses may not go into several accounting specifics because there's less information to track.

Potential tax reporting

Businesses that use cash basis accounting often have a tax advantage because they only record income and expenses when cash exchange actually occurs. This means a company can only pay income tax when it deposits the cash received rather than the invoice it issues at the bank. By doing this, they can control the timing of transactions. With cash basis accounting, companies can legally increase their expenses and decrease income to lower their tax liability.

Related: How to Calculate WACC (With Variables and Formula)

Exists in the present time

Another benefit of cash basis accounting is that it enables companies to determine how much cash they have available. This is because a cash basis only records substantial funds that currently exist in a company's account. Companies that use this method can quickly determine their financial position rather than calculating future income and expenses.

Factors to consider when choosing between cash basis and accrual accounting

Here are common factors you may consider before choosing between cash basis accounting and accrual accounting:

Purpose

For accelerating payments, a cash basis is often essential for small businesses and those that offer services because it can prevent them from accumulating debts. For reporting purposes, accrual accounting usually provides better financial intelligence on the state of a business. The accrual basis of accounting is a concept where companies record revenues during the period they earn them and expenses during the period they incur them.

Company's growth

Cash basis accounting is suitable for a sole proprietorship or partnership business that's unlikely to extend its business activities. If a small business becomes a medium or large business, it may require accrual accounting. This is because it may begin to record more daily financial transactions, requiring a more accurate representation of their finances. Large businesses can easily track their credit transactions using an accounts receivable system with accrual accounting. It also enables them to provide detailed reporting about their business' profitability.

Related: What Is an Income Statement? (With Definition and Template)

IFRS stipulation

The IFRS generally allows companies to choose which method of accounting they want to use, with some exceptions. It requires that businesses with the maximum annual gross receipt from sales over a three-year tax period often use the accrual method. For example, if a company has over $25 million in its annual gross receipt from sales for three years, the IFRS requires using the accrual accounting method. Some small businesses may also qualify to use the accrual accounting method when they begin to earn more than $10 million.

Financial position

Companies that prepare their financial statement under the accrual accounting method can easily understand their financial position at the end of the year. The statement usually shows the account payable and other obligations, such as committed pledges or receivables. The account payable system shows the transaction history between a company and a supplier or vendor. Meanwhile, the cash basis statement usually provides limited information. For example, a non-profit organization that receives donations, such as writing materials for its program, may not record their impact or value using cash basis statements.

Savings

A cash basis statement can provide administrative savings for companies. Administrative savings refer to an organization's costs that don't directly have a specific function, such as production or sales. A company can spend less money on accounting and save more with no accruals. If the company has a financial statement to audit, using the cash basis method may mean that there are fewer statements for an auditor to test. This can typically reduce the cost of an audit.

Cash payment

Cash basis accounting is usually suitable for businesses that rely on cash payments for revenue and expenses. In contrast, businesses that extend credits to clients or use credit with their suppliers may use accrual accounting. These businesses may also hold a large inventory, making accrual accounting a suitable method for tracking short-term cash flow. Short-term cash flow refers to the cash a company expects to receive and pay out of its business over a certain period.

Related: How to Calculate Net Profit Margin (With Examples)

Examples of cash basis accounting

The following examples can help you understand how businesses use cash basis accounting:

Example 1

Here's an example of an electronics company using a cash basis:

Pathway electronic corporation bills a client $5,000 for the services it rendered on April 2 and receives payment on May 16. It records the sale on the cash receipt date, which is May 16. Similarly, the corporation receives a $1,000 invoice from a vendor on August 20 and pays the bill on August 30. It records the expense on the day of payment, which is August 30.

If the corporation uses the accrual accounting method, it may record the transaction as revenue immediately after it makes the sale. It may also record the expense on the day it receives the invoice. This means that it can record its revenue on April 2 and incur expenses on August 20.

Example 2

Here's an example of a web design business using a cash basis:

Knits and Yarns business sent out an invoice of $6,000 for an app design project it completed on December 30, 2020. On February 28, 2021, it received the bill for the work performed. Then, the business paid $50 on March 8 for an electricity bill it received on February 10.

The company doesn't pay tax on its income because it records the invoice for $6,000 as part of its 2021 income. The accrual method may record the transaction as part of its 2020 income and pay tax on it, even if it actually received the payment in February 2020.

Please note that none of the companies, institutions, or organizations mentioned in this article are affiliated with Indeed.

Explore more articles