What it means
Under cash accounting the only event that matters is the movement of money. Send a $40,000 invoice in March and get paid in June, and the sale belongs to June, not March.
The same logic applies to costs: a supplier bill sitting unpaid on the desk has no effect at all on this month's reported profit. The appeal is easy to see, because the bank statement is effectively the accounting record and there is almost nothing to estimate or interpret.
That makes the method cheap to run and difficult to manipulate, which is why tax authorities in many countries let smaller businesses report on this basis. The weakness is that timing distorts the picture badly.
A company that collects a full year of subscription fees every January looks spectacularly profitable in January and loss making for the eleven months in which it actually delivers the service. Anyone reading those monthly figures would draw completely the wrong conclusion about the underlying trade.
Accrual accounting, the alternative, matches income to the period in which the work was done and costs to the period in which they were incurred. It is the basis required for statutory company accounts under both UK and international reporting standards, so any business with outside shareholders, a bank covenant or an audit will need it.
Many owner managed businesses compromise by keeping cash based bookkeeping through the year and converting to accruals only at the year end. That works for tax, but it leaves the monthly management accounts close to useless for decision making, which is a high price to pay for a simpler ledger.
In practice
Real-world examples.
Example
A self employed plumber files a tax return on the cash basis. He completes a $9,000 bathroom installation on 20 December but is not paid until 8 January, so the income falls into the following tax year and his current year bill is lower.
Example
A small charity shop runs its bookkeeping on cash accounting because nearly every transaction is settled on the spot. The treasurer only needs to reconcile the till and the bank account, and the monthly report is ready within a day of month end.
Example
A software start up on cash accounting reports a $180,000 profit in the quarter it collects three annual contracts up front, then three loss making quarters. Its investors insist on a switch to accrual reporting so revenue is spread across the twelve months of service actually delivered.
Think of it
“Cash accounting only counts money when it actually moves-not when you earn or owe it.
Formula
Calculation
Cash basis profit = cash received during the period - cash paid during the period
A design agency banked $240,000 from clients during the year and paid out $170,000 in wages, rent and software subscriptions. Cash basis profit = $240,000 - $170,000 = $70,000.
The same year on an accrual basis looks different. The agency invoiced $300,000 of work, of which $60,000 was still unpaid at the year end, and incurred $200,000 of costs, of which $30,000 was still unpaid. Accrual profit = $300,000 - $200,000 = $100,000, and the $30,000 gap between the two answers is exactly the $60,000 of uncollected sales less the $30,000 of unpaid bills.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Harbour Lane Joinery, an invented cabinet making firm, ran cash accounting for its first six years and judged performance by the bank balance at month end. The owner took a large drawing every time the account looked healthy, without checking what was already committed.
In one busy autumn the firm collected $310,000 of staged payments on three big kitchen contracts while the timber and labour for those jobs would not be paid for until the following quarter. The cash books showed a record profit, the owner withdrew $80,000, and by February the company could not meet its supplier terms.
The fictional firm's accountant rebuilt the same period on an accrual basis and showed a modest $22,000 profit rather than a record one. Harbour Lane kept cash reporting for tax but moved its monthly management accounts to accruals, and the owner set drawings against accrual profit instead of the bank balance.
Watch out
Common mistakes.
- Treating a strong cash balance as proof of profitability, when it may simply reflect customer prepayments and supplier bills that have not yet been settled.
- Comparing one month against another on a cash basis when the two months contain very different numbers of payment runs or collection cycles.
- Assuming that because the tax return is on the cash basis, the management accounts have to be as well, when the two can quite happily differ.
Questions
People also ask.
Can a business switch from cash accounting to accrual accounting?
Yes, and most do as they grow, though the transition year needs a careful adjustment so income and costs are neither counted twice nor missed.
Does cash accounting still track debtors and creditors?
Not in the profit figure, but a sensible operator keeps a separate list of who owes what, because otherwise collections and supplier terms go unmanaged.
Is cash accounting allowed for a limited company's published accounts?
Generally no, as company reporting standards require the accruals basis, so cash accounting is mostly confined to sole traders, partnerships and internal record keeping.
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