What it means
Under cash basis accounting, the date that matters is the date cash moves. If you send a customer an invoice in March but they pay in May, the income is recorded in May.
If you receive a supplier's bill in June but pay it in July, the expense is recorded in July. The appeal is simplicity.
Your records look like your bank statement, so you do not need to track receivables (money customers owe you) or payables (money you owe suppliers). A sole trader, a freelancer or a small shop can often keep the books with little more than a spreadsheet.
The weakness is that profit can be misleading. A business can finish a month with a large profit simply because several customers paid early, or a large loss because it paid an annual insurance bill all at once.
The figures show cash timing rather than the real performance of the business in the period. Because of that, cash basis accounting does not match revenue with the costs that earned it.
Accrual accounting (recording income and costs when they are earned or incurred, regardless of payment) does this better, and it is required for most larger companies. Many tax authorities and accounting standards limit cash basis to small businesses below a set size, and the limits are set by each jurisdiction.
Finance teams in growing companies often start on cash basis and switch to accrual as they take on investors, lenders or inventory. The switch needs care, because opening balances for receivables and payables must be set up correctly.
Lenders and investors usually want accrual-based statements to judge true profitability. Record keeping still matters under this method.
Even if you only record cash movements, you should keep invoices, receipts and bank statements to support each entry. Tax authorities may ask to see them, and they make it much easier to switch methods or answer questions from a lender.
In practice
Real-world examples
Example 1
A freelance photographer is paid $2,500 in cash for a wedding shoot in June, although she delivered the photos in May. On a cash basis, the income belongs to June. She does not record anything for May.
Example 2
A small bakery buys flour for $1,200 on 28 February and pays the supplier on 5 March. The cash basis records the expense in March. The owner knows the cost belongs to February's production, so she keeps a separate note when judging margins.
Example 3
A consulting firm with $800,000 of annual revenue is planning to seek a bank loan. The bank asks for accrual statements, which show receivables and payables. The firm's accountant converts the figures so that the lender sees the full picture.
Think of it
Cash basis accounting is like tracking your diet by only counting meals you've paid for. If you eat now and pay later, it doesn't count until the money leaves your wallet.
Formula
Calculation
Cash basis profit = Cash received from customers - Cash paid for expenses
Worked example: in March, a design studio invoices clients for $30,000 but collects only $18,000 during the month. It incurs $14,000 of expenses, all of which it pays in March.
Cash basis profit = $18,000 - $14,000 = $4,000.
Under accrual accounting, the studio would count the full $30,000 of work done, so profit would be $30,000 - $14,000 = $16,000. The remaining $12,000 collected in later months would appear in those months under cash basis, which shows how the two methods can give very different pictures for the same period.Case study
Seen in the real world
Maple and Reed Landscaping is an illustrative, fictional gardening business run by two partners. In April it was paid only $9,000 because several corporate clients were slow to pay, while it spent $11,000 on wages and materials. On a cash basis, the books showed a loss of $2,000, and the partners worried that the business was failing.
Their accountant pointed out that the firm had invoiced $26,000 of work that month. On an accrual basis, April showed a profit of $15,000, since revenue of $26,000 less costs of $11,000 gave that figure. The real problem was slow collection, not a lack of profit.
The illustrative lesson is that cash basis shows cash movements, not performance. The partners started tracking unpaid invoices separately, so that they could see both the cash position and the profit. They also learned that many lenders insist on accrual figures, so the accountant prepared both versions and showed the bank how the two reconcile.
Watch out
Common mistakes
- Reading a cash basis profit figure as a true measure of how well the business performed in the period.
- Forgetting to track unpaid invoices and bills, which hides how much is owed to and by the business.
- Staying on cash basis after growing past the size where tax rules or lenders expect accrual accounting.
Questions
People also ask
Is cash basis accounting legal?
Yes, for small businesses in many countries, but each tax authority sets who may use it, so check the local rules.
What is the main difference from accrual accounting?
Accrual accounting records income and costs when they are earned or incurred, while cash basis records them when money changes hands.
Can I switch from cash to accrual?
Usually yes, but you must set opening receivables and payables correctly, and some tax systems need approval or a formal adjustment.
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