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Cash accounting is a bookkeeping method whereby a transaction is recorded only once a payment is actually made. It may be the right option for your business. At Padgett, we provide reliable accounting services for small businesses. Here, you’ll find an overview of the most important things you need to know about cash accounting.
Cash accounting—also often referred to as “cash-basis accounting”—is a method in which transactions are recorded only when cash changes hands. In other words, revenue is recognized when payment is received. Along the same lines, business expenses are recorded when they’re paid. Cash accounting offers a straightforward, transaction-based snapshot of a company’s financial health at any given time. It’s primarily used by small businesses and sole proprietors due to its simplicity.
The IRS permits certain businesses with average annual gross receipts for the three prior tax years equal to or less than an inflation-adjusted threshold to use cash accounting. That threshold was significantly increased under the Tax Cuts and Jobs Act of 2017, from generally $5 million to an inflation-adjusted $25 million, opening the door for many more businesses to use cash accounting. This accounting method can provide tax-planning opportunities for businesses to potentially defer income and accelerate expenses—or vice versa, depending on the circumstances—to defer or even lower overall tax obligations. In short, it offers some flexibility to control the timing of income and deductions for income tax purposes.
To understand how cash accounting works, it’s useful to look at a real-world example. Consider a small pool contractor. In June, the business installed a pool for a customer and sent the customer an invoice for $40,000, payable within 30 days. The company also paid $25,000 in materials and labor expenses in June when it installed the pool. Using cash accounting, the contractor would record the expenses for the job when they were paid in June, but it would report the revenue for the job when the customer paid the invoice in July.
The pool contractor also received delivery of materials for the project in June, but it has 30 days to pay the supplier’s invoice. Under cash accounting, these costs would be expensed when the cash is remitted in July.
As you can see from this example, cash accounting emphasizes cash received and paid, but it doesn’t necessarily match revenue earned with the expenses incurred in the accounting period. The use of cash accounting doesn’t allow management to see money owed to the business, bills not yet paid, and other probable economic benefits and obligations. In the example, the pool contractor would have an unclear picture of each project’s profitability until it had received payment from the customer and paid all expenses associated with the project. With cash accounting, revenue and expenses aren’t necessarily matched, potentially causing profits to fluctuate from one accounting period to the next.
Is cash accounting the right option for your small business? It could be. There are some significant advantages associated with this method—especially for smaller businesses, companies with limited inventory, and sole proprietorships. Here are two benefits of cash accounting:
Despite having some advantages, cash accounting isn’t the right choice for every type of business. Quite the contrary, in the eyes of the IRS, it’s not even a permissible form of accounting for large, more complex companies. Here are three drawbacks of cash accounting:
Accrual accounting is the primary alternative to cash accounting. It adheres to the matching principle, which mandates that revenue earned and expenses incurred be recorded in the same accounting period. It’s a method that provides a more comprehensive view of a company’s financial health, making it suitable for businesses of all sizes, especially corporations with complex operations. With accrual accounting, transactions are recorded as soon as they occur, regardless of when the money is exchanged.
For example, when a company delivers a service, revenue from that service is recognized, even if the payment will be received later. Similarly, when a company receives a service, the expense is recorded, even if the bill will be paid in the future. Accrual accounting offers more financial insight but also requires more bookkeeping expertise. Of course, you don’t have to handle accounting on your own. An experienced professional can help.
At Padgett, we help small businesses build a better foundation for their financial health. If you have any specific questions or concerns about cash accounting, we’re here as a resource. Whether cash accounting or accrual accounting is the right option for your company, a skilled professional can help you put the right system in place. Contact us today to learn more about what we can do for you and your business. We provide accounting services to small businesses nationwide.
