Learn more about what cash accounting is in business.
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Cash accounting is a bookkeeping method where the business records transactions only when it pays or receives money. Small business owners prefer this accounting method because of its simplicity. Let’s take a closer look at the cash accounting definition, how the method works, and the pros and cons of this type of accounting.
Cash accounting is a form of accounting where a business records transactions when money comes in and when money goes out. This method also goes by the names cash-basis accounting, cash method, and cash receipts and disbursements accounting.
The alternative accounting method is accrual accounting. Under this form, the company recognizes transactions when they incur the revenue or expense, not when they pay or receive payment. The main difference between the two accounting methods is the timing of when the company records the transaction.
It’s important to note that some businesses have to use the accrual method. For example, the Internal Revenue Service (IRS) requires C corporations, certain types of partnerships, and businesses that make over $25 million in annual gross receipts to use the accrual method.
To better understand cash accounting and compare it to accrual accounting, let’s look at an example. On January 1, Business A orders $5,000 worth of parts from Business B. On January 10, Business A pays the $5,000 bill. Business B, which uses the cash accounting method, records the transaction on January 10. If Business B used the accrual method, it would record the transaction on January 1.
It’s common for small businesses to use the cash method of accounting because it’s straightforward and doesn’t require you to have expert accounting knowledge. This method is much less time-consuming and reflects the company’s current cash on hand.
Another benefit of cash accounting is that you can time payments advantageously. For example, a company can make business expenses before the end of the year so they can claim more tax deductions. Alternatively, the company can wait until the following year to send a bill, so they don’t get paid in the current year. By doing this, the company pushes off its income (and income tax liability) into the next year. With the accrual method, there isn’t this kind of flexibility.
One major disadvantage of cash accounting is that it doesn’t always give a full and accurate picture. It can both overestimate and underestimate the true value of the company. For example, if you have an outstanding bill, your company may seem like it has more money than it actually does. On the flip side, if you’re waiting to be paid, your company may seem like it has less money than it actually does.
Under the cash accounting method, your business only records transactions when it receives or makes payments. If you have a small business with few transactions, the cash accounting method may be perfectly fine for you. As business picks up, however, the accrual method might be more advantageous.
Accounting is a necessary part of running a successful business. When you use our corporation or limited liability company (LLC) formation services, we include a free accounting consultation. Our experts can offer tax and accounting recommendations so that you get your business off to a great start. Reach out to us and let us know how we can help!
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.