Cash-based accounting, also known as cash basis accounting, is a method of recording financial transactions in which you recognise revenues and expenses only when cash is received or paid. This system contrasts with accrual accounting, which records revenues and expenses when they are earned or incurred, regardless of when the cash is exchanged.
Below, we’ll explain the pros and cons of cash-based accounting, how this method affects tax reporting, and how businesses can transition from cash-based to accrual accounting.
What’s in this article?
- How does cash-based accounting work?
- What are the pros and cons of cash-based accounting?
- When is cash-based accounting a good fit?
- How does cash-based accounting affect tax reporting?
- How can businesses transition from cash-based to accrual accounting?
How does cash-based accounting work?
With cash-based accounting, you track money as it moves in and out of your accounts. Here’s how it works:
Recording income: You log revenue only when you receive actual payment. For example, if you send an invoice in June but don’t get paid until July, the income is recorded in July.
Recording expenses: You document expenses only when you pay for them. For instance, if you get a bill for office supplies in April but pay it in May, you record it in May.
This system focuses on cash flow. It doesn’t account for money owed to you (accounts receivable) or money you owe (accounts payable). This can make it harder to get a full picture of your financial situation.
What are the pros and cons of cash-based accounting?
Cash-based accounting is simpler than other accounting methods but it has some drawbacks.
As for the pros, cash-based accounting:
Is easy to understand and manage, especially for small businesses or people with straightforward finances
Offers a clear view of cash availability at any given time, since it tracks money as it’s received or spent
Assists in managing tax liabilities, since you don’t pay taxes on income until you’ve received it
Requires less time and fewer resources to maintain than other forms of accounting
As for the cons, cash-based accounting:
Doesn’t factor in accounts receivable or accounts payable, which can make your financial health appear better or worse than it is
Can lead to distortions (e.g. recording a big expense in one month but the related income in another)
Doesn’t comply with Generally Accepted Accounting Principles (GAAP), which require accrual accounting
Makes it harder to track performance over time or make important decisions, since you can’t see future liabilities or revenues
When is cash-based accounting a good fit?
The United States requires businesses with $25 million or more in revenue over a three-year period to use accrual accounting in accordance with GAAP, but smaller businesses have the option to use the cash-based method. If you’re not required to use accrual accounting, cash-based accounting is a good option because it simplifies the process. It’s a great choice for businesses that focus on immediate cash flow and aren’t seeking long-term financial insight. These include:
Small businesses and sole proprietors who don’t handle complex financial transactions or substantial inventories
Businesses that are paid at the time of sale (e.g. retail shops, small service providers)
Startups and freelancers who are just starting out or operating solo
How does cash-based accounting affect tax reporting?
Cash-based accounting tracks when money is exchanged. Here’s how that impacts tax reporting:
Income recognition: You report income only when you get paid – when the funds are in your account, not when you send out an invoice. This means if a client delays payment until the next tax year, you don’t have to report that income this year.
Expense deduction: Deductions happen only when you pay for something, not when you receive the bill. For example, if you order supplies in December but don’t pay until January, the expense would fall into the next year’s taxes (in countries where the tax year is the same as the calendar year).
Tax timing: Cash-based accounting gives you a lot of control over timing. By managing when you get paid or when you pay expenses, you can shift income or deductions between tax years to fine-tune your tax bill. For instance, you might delay sending invoices at the end of the year to push taxable income into the following year.
Tax filing: Because cash-based accounting follows your bank transactions, it’s easier to track and report income and expenses – you’re not juggling accounts receivable or payable on your tax forms.
How can businesses transition from cash-based to accrual accounting?
With accrual accounting, you record income when it’s earned, not when it arrives. You record expenses when they’re incurred, even if you haven’t paid the bill yet. There are many reasons why you might want to switch from cash-based accounting to accrual accounting: maybe you’ve outgrown cash accounting or maybe investors, lenders, or tax requirements are pushing for more detailed reporting. Whatever the reason, switching to accrual accounting can give you a clearer, more accurate view of your business.
Here’s how to do so:
Create new records: First, ensure your cash-based records are up-to-date and accurate. From there, set up an opening balance sheet with the following:
- Accounts receivable: Money you’re owed
- Accounts payable: Money you owe
- Prepaid expenses: Things you’ve paid for but haven’t fully used
- Unearned revenue: Payments you’ve received for services or products you haven’t delivered yet
- Accounts receivable: Money you’re owed
Upgrade your tools: Your accounting software needs to be ready to handle accrual entries. Most platforms support them, but you might need to adjust your setup. If you’re still managing your books manually, now’s the time to switch to software. This transition will be easier if you have the right tools.
Bring in the professionals: An accountant can be an important ally during this transition. They’ll help you adjust your financials, work through tax implications, and set up a system that works for your business.
Plan for taxes: Switching to accrual accounting can change your taxable income so plan ahead. Work with your accountant or tax professional to ensure you’re covered and that there are no surprises when you do taxes.
Update your team: If you have a team that handles your finances, ensure they understand the new process and new workflows, such as tracking receivables and payables.
Communicate the change: If you share financials with investors, lenders, or other stakeholders, let them know you’re making the switch.
The content in this article is for general information and education purposes only and should not be construed as legal or tax advice. Stripe does not warrant or guarantee the accuracy, completeness, adequacy, or currency of the information in the article. You should seek the advice of a competent lawyer or accountant licensed to practise in your jurisdiction for advice on your particular situation.