What it means
Under the cash basis there is no such thing as a receivable or a payable, because a transaction only exists once money has moved. Send a $30,000 invoice in June and collect it in September, and the cash basis records $30,000 of income in September.
The accrual basis would record it in June, when the work was actually done. The appeal is simplicity, because the books follow the bank account, so there is little judgement, few adjustments and almost no year-end estimating.
For a consultancy with no stock, no borrowings and prompt clients, the picture the cash basis paints is close enough to reality. Many tax authorities allow small businesses to use it below a turnover threshold.
The weakness is that timing distorts performance. A business that pays twelve months of insurance in one go shows a terrible January and eleven flattering months, even though the cost was earned evenly.
Comparing one period with another becomes unreliable, which matters as soon as a lender, investor or buyer starts reading the numbers. Cash basis accounts also hide obligations, because unpaid supplier bills and unbilled customer work simply do not appear anywhere.
A company can look comfortably profitable while sitting on a large stack of invoices it has not settled. That is why accounting standards require the accrual basis for audited financial statements and for most companies above a modest size.
In practice many businesses run a hybrid, keeping cash basis records for tax and internal simplicity, then making accrual adjustments at year end to produce statutory accounts. Others keep accrual books but maintain a separate cash forecast, since the accrual profit figure alone will not tell you whether payroll clears.
The two views answer different questions and both are worth having.
In practice
Real-world examples.
Example
A self-employed plumber files a tax return on the cash basis, declaring the $84,000 he banked during the year rather than the $91,000 he invoiced. The remaining $7,000 falls into next year's return when the customers pay. Because he holds no stock and buys materials as he needs them, the simpler method gives a fair enough picture.
Example
A marketing agency preparing for its first outside investment switches to accrual accounts. Under the cash basis its monthly profit had swung between a $40,000 loss and a $70,000 gain purely on the timing of two large retainers. The accrual view showed steady monthly performance, which the investor found far easier to underwrite.
Example
A veterinary practice pays a $60,000 annual insurance premium every January. On the cash basis the whole cost lands in one month, making January look loss-making and the rest of the year look artificially strong. The owner adds a simple accrual adjustment of $5,000 a month so managers can compare periods sensibly.
Formula
Calculation
Cash Basis Profit = Cash Received in the Period - Cash Paid in the Period
A design studio has a quarter in which it invoices customers $180,000 but collects only $150,000, because $30,000 of invoices are still outstanding at quarter end. It incurs $120,000 of payroll and supplier costs but pays only $95,000, leaving $25,000 unpaid.
Cash Basis Profit = $150,000 - $95,000 = $55,000.
Accrual Profit = $180,000 - $120,000 = $60,000.
The $5,000 gap is pure timing: $30,000 of uncollected receivables less $25,000 of unpaid payables gives $30,000 - $25,000 = $5,000. Neither figure is wrong, but the studio would be unwise to judge its pricing on the cash number, since a single late-paying client can swing it by more than the whole quarter's margin.Case study
Seen in the real world.
Bramble Lane Landscaping is a fictional garden design firm used here for illustrative purposes only. Its cash basis records for the year showed a profit of $96,000, and the two owners drew most of it out as they went along.
When the bank asked for accrual accounts to support a loan application, the picture changed. Of the money received, $70,000 was customer deposits for projects that had not yet started, and the firm also had $54,000 of unpaid supplier invoices sitting in a drawer. On an accrual basis the year was a loss of $28,000, because $96,000 - $70,000 - $54,000 = -$28,000.
In this illustrative scenario the loan was declined, and Bramble Lane moved to accrual bookkeeping with a separate weekly cash view. The owners kept the cash basis for their tax return, which was still permitted, but stopped using it to decide how much they could safely take out of the business.
Watch out
Common mistakes.
- Reading a strong cash basis month as strong trading, when it may just be several late invoices landing at once.
- Forgetting that customer deposits are not earned income, which the cash basis has no way of showing.
- Using cash basis figures in a business valuation or loan application, where the reader expects an accrual view.
Questions
People also ask.
Can a company legally use the cash basis?
In many countries small businesses and sole traders can use it for tax below a turnover threshold, but audited statutory accounts must be prepared on the accrual basis.
Which basis shows the real profit?
The accrual basis shows performance because it matches income to the period it was earned, while the cash basis shows liquidity because it follows the bank account.
Can you switch between the two?
Yes, though the change requires transition adjustments so that income and expenses are not counted twice or missed altogether in the year of the switch.
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