Small business owner? Then you might be familiar with cash basis accounting—even if you don’t know it by name.
So, let us introduce you. 👋
Cash basis accounting is an accounting method that recognizes cash only when it’s received, not earned.
It means that any funds that haven’t been paid aren’t officially recorded in your books until they’re delivered. Even if the work has been done or your product has been sold, the money isn’t accounted for until it hits the bank, the till, or your pocket.
(Okay, maybe don’t put it in your pocket.)
Now that you’re better acquainted with the idea of cash basis accounting, let’s take this relationship to the next level. By the end of this post, you’ll know:
- How cash basis accounting works
- When to use cash basis accounting
- The advantages and disadvantages of cash basis accounting
- The difference between cash accounting vs. accrual basis accounting
Lastly, you’ll be able to determine if cash basis accounting is right for you and your business.
Let’s get to it.
What is cash basis accounting?
Cash basis accounting is when you only record transactions when the money enters or leaves your business, even if they were earned or billed earlier.
It’s a simpler way of recording cash inflow and outflow. Take expenses, for example. With cash basis accounting, your expenses are only recognized when the payments are made out. So, if you've received goods or services, like inventory for your shop or a month of rent—but haven’t paid for them yet—the expense wouldn't be recorded until you have.
How does cash accounting work?
Cash basis accounting is a simple way to track the cash that’s flowing in and out of your business.
Here are a few examples of what it can look like:
- You’ve enabled a flexible payment service for your online shop (like the “pay in just four installments!” type). With cash basis accounting, you can only record the funds for the products you sell as they come in, not prior.
- Similarly, if your customers or clients pay for your goods and services with their credit cards, the revenue isn’t recorded at the time of the sale, but at the time when the payment is received from the credit card company.
- You’re a graphic designer who spends a week in April creating a brochure for a local gallery. You submit an invoice of net 30, which means that the gallery is paying you in May. With cash basis accounting, you’d recognize that income in May when you receive the payment rather than in April, when you did the work.
- You have an online clothing shop. If you’re using cash basis accounting, you only account for sales when payment hits the account in the form of debit or cash, not credit.
When is cash basis accounting used?
Cash basis accounting isn’t right for every business. Normally, it’s only used by individuals, small companies, or by those who deal with cash, and cash only.
Some examples include:
- Freelancers or sole proprietors with small-scale operations
- Small retailers without a lot of credit transactions, like your favorite coffee cart or a vintage market vendor
- Service providers like photographers, cleaners, trainers, or tutors who receive payment in cash or e-transfer
Cash basis accounting is easy to manage if the business or individual has a positive cash flow, which means the cash they generate from operations (like sales) is more than what they spend to keep their business running.
The advantages of the cash accounting method
Looking for funds with benefits? You might be in the right place.
While not for all businesses, cash-based accounting does have its advantages. For one, it’s simple! After all, you’re only tracking cash transactions as they happen. So, if you’re a small business with little-to-inventory and few credit card transactions, it can be an easy way to stay organized.
Speaking of being organized, cash basis accounting has the benefit of giving you an accurate and reliable picture of the money you have on hand. Plus, there’s little need for the more complex record-keeping associated with other types of accounting.
Disadvantages of cash basis accounting
Although cash basis accounting has its perks, it does come with its disadvantages.
Let’s start with what it shows you, or, more accurately, doesn’t.
Yes, cash basis accounting can give you a solid indication of the cash you have on hand, but it doesn’t give you an accurate look at the health of your business, or shed light on opportunities for growth.
For example, if you’re a retailer of kids’ clothing, you might experience a slow summer, but a surge in sales come August and early September. Without forecasting and completing a comparative analysis, you might assume you’re in a profitable spot without accounting for the past decline in sales and a slow-to-steady fall.
Cash accounting vs. accrual basis accounting: What's the difference?
Now that you know more about cash accounting, you might be wondering: what’s the alternative? Good question. That’s called accrual basis accounting.
This method of accounting allows a business to record revenue before they receive payment, which means you can track it in your books before the money hits the bank.
Let’s break the differences down.
- SIMPLICITY: Cash basis accounting is simpler. Accrual basis accounting is more complex, but more widely adopted.
- ACCURACY: When it comes to credit accounts, with cash basis accounting, there’s zero record of accounts receivable (the amount your business is owed by your customers or clients) and accounts payable (the amount your business owes for the goods and services that have been received but not yet paid for). This could overstate the health of your business. But with accrual basis accounting, receivable and accounts payable are both tracked, and the health of a business is more accurate.
- USABILITY: Cash accounting is better suited for small, service-based businesses or individuals and nonprofits, whereas accrual basis accounting is utilized by all public companies and organizations that are required to file audited financials and businesses that keep inventory or sell goods.
Psst: want a bit more info on accrual basis accounting? Get out your readers and dive into this article for all you need to know. 🤓
The bottom line on cash basis accounting
Cash basis accounting is a good option for small businesses or individuals, especially those who almost exclusively deal with cash.
Although it’s the more simple accounting method, it doesn’t always leave you with an accurate view of the health of your business, which, in a lot of cases, can be very good to know.
So, if you need more support with accounting methods or bookkeeping, Wave’s in-house experts can help! (It’s kinda our thing.) You’ll get personal 1:1 advice that’ll give you the peace of mind you’re doing things right, and get set up to know what’s going on in your business—and make smart decisions.
The information and tips shared on this blog are meant to be used as learning and personal development tools as you launch, run and grow your business. While a good place to start, these articles should not take the place of personalized advice from professionals. As our lawyers would say: “All content on Wave’s blog is intended for informational purposes only. It should not be considered legal or financial advice.” Additionally, Wave is the legal copyright holder of all materials on the blog, and others cannot re-use or publish it without our written consent.