What it means
Under the cash basis, the books follow the bank account. An invoice raised in March and paid in May is May revenue.
A bill for March electricity paid in April is an April expense. Stock bought in November and sold in January is a November cost.
There are no accounts receivable, no accounts payable, no accruals and often no depreciation: assets may simply be expensed when bought. The result is a set of records that a non-accountant can keep and understand, and that answers the question "how much cash did we make?" precisely.
The method fails when the timing of cash differs from the timing of activity, which is most of the time for most businesses. A company that collects deposits in advance looks wonderfully profitable until it delivers the work.
A company that offers customers 60 days' credit looks like it is losing money while its receivables build up. A large annual insurance payment or a piece of equipment makes one month a disaster.
Comparing one period with another, or one business with another, becomes unreliable, and the balance sheet, if one is produced at all, shows nothing of what is owed to or by the business. For that reason lenders, investors and buyers almost always insist on accrual accounts, and any business seeking finance, taking on partners or planning to sell will need to convert.
Tax rules typically restrict cash basis to small businesses and exclude those holding inventory or of certain legal forms; the thresholds and exclusions vary by country and change over time. Cash basis has a legitimate place.
For a freelancer with few customers, no stock and immediate expenses, the difference between cash and accrual is small and the simplicity is worth a great deal. For anyone else, it is best treated as a cash flow record kept alongside proper accounts, not as a substitute for them.
In practice
Real-world examples.
Example
A self-employed plumber records income when customers pay and expenses when he buys parts, files his tax return on the cash basis as the rules allow, and keeps no accruals.
Example
A small charity with grant income and few creditors reports on a receipts-and-payments basis to its members, as permitted below its regulator's threshold.
Example
A start-up that kept cash basis books for two years spends a month converting to accrual accounts before its first investor round, and discovers its true margin is lower than it thought.
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 minus Cash Paid for Expenses
Conversion to accrual profit = Cash basis profit + Increase in receivables minus Increase in payables + Increase in prepayments minus Increase in accrued expenses, with depreciation replacing asset purchases
Worked example. A small web agency's activity for a quarter:
- Invoices raised for work completed: $90,000, of which $65,000 was collected in the quarter
- Collected in the quarter from the previous quarter's invoices: $20,000
- Wages paid: $48,000 (all for work in the quarter)
- Annual software licences paid at the start of the quarter: $12,000 (covering twelve months)
- New computers bought: $9,000 (expected to last three years)
- Electricity used in the quarter, billed and paid the following quarter: $900
Cash basis:
- Cash in = $65,000 + $20,000 = $85,000
- Cash out = $48,000 + $12,000 + $9,000 = $69,000
- Cash basis profit = $16,000
Accrual basis:
- Revenue = $90,000 (earned in the quarter)
- Expenses = $48,000 wages + $3,000 software (one quarter of $12,000) + $750 depreciation ($9,000 over three years, one quarter) + $900 electricity = $52,650
- Accrual profit = $37,350
The cash basis understates the quarter's profit by more than half, because it counts a whole year's software and three years' worth of computers against one quarter's income and ignores $25,000 of work done but not yet paid for. Next quarter, when that $25,000 arrives, the cash basis will overstate profit by a similar margin.Case study
Seen in the real world.
A wedding photography business kept cash basis records. Couples paid a 30% deposit on booking, often a year in advance, and the balance a month before the wedding. The owner's records showed spring and summer as hugely profitable, when deposits for the following year flooded in on top of balance payments for the current season, and winter as loss-making.
Believing the business was more profitable than it was, she took large drawings each summer and struggled every winter. When she applied for a mortgage, the lender's underwriter restated three years of figures on an accrual basis, treating deposits as deferred revenue until each wedding took place and spreading equipment costs over their life.
Annual profit was 35% lower than her records showed, and the mortgage was scaled back accordingly. She moved to accrual accounting the following year, kept a separate cash forecast, and set her drawings against real profit rather than the bank balance.
Watch out
Common mistakes.
- Reading a cash basis profit as a measure of performance. It measures bank movements, which depend heavily on timing.
- Taking drawings or dividends on the strength of a cash surplus that is really customer deposits or delayed bills.
- Staying on the cash basis past the point where the business has stock, credit customers or significant assets.
Questions
People also ask.
Who can use cash basis accounting?
Rules differ by country, but typically small unincorporated businesses below a turnover limit, with exclusions for those holding inventory or trading through certain structures.
What is the difference between cash basis and accrual basis?
Cash basis records transactions when money moves. Accrual basis records revenue when earned and expenses when incurred, whatever the cash timing.
Can I switch from cash to accrual?
Yes, and most growing businesses do. The switch requires setting up receivables, payables, accruals, prepayments and a fixed asset register at the changeover date, and may have tax consequences.
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