There are multiple useful methods for completing your company’s accounting—and if you do business in cash, you might want to opt for cash basis accounting.
Defining Cash Basis Accounting
Cash basis accounting is a system of financial recordkeeping that records transactions only when cash is exchanged. Sales and expenses are only logged when cash changes hands.
What makes cash basis accounting unique: the timing of how transactions are recorded. Other methods record income when a sale is made on credit or an invoice is sent out, but cash basis accounting only notes the transaction when you receive cash for the work in your hands. On the expense side, instead of logging an expense when a bill is received, in cash basis accounting, you record the expense only when you actually pay for the expense.
For smaller companies, this can be a useful method because it allows you to keep close tabs on your cash flows (i.e., how much money is coming in and out of your accounts). Therefore, you don’t have to be concerned with accounts receivable or accounts payable.
Which Businesses Use Cash Basis Accounting?
Typically, cash basis accounting is only used by businesses that deal exclusively with cash. Sole proprietorships or businesses with very few employees might opt to do their accounting this way. It can also be a useful way to think about your personal finances.
An important note: cash basis accounting is not permitted under the Generally Acceptable Accounting Principles (GAAP) as required by the Securities and Exchange Commission, so it isn’t used by publicly-traded companies.
What’s the Difference Between Cash Basis and Accrual Accounting?
As opposed to cash basis accounting, most companies follow accrual accounting. GAAP requires accrual accounting, and publicly-traded US companies must follow GAAP—therefore, they all use accrual accounting.
The vast majority of companies, especially larger ones, would probably utilize accrual accounting regardless of GAAP rules, as it provides a more accurate and smooth-edged examination of a business’s financial health.
Accrual accounting keeps records of all accounts payable, accounts receivable, outstanding invoices, credit card charges, and bills. For your business, recording a transaction when you complete a sale or finish a job for a client might present a more holistic image of your company’s financial wellbeing than waiting until you actually have cash in hand.
On the other hand, you may be far more concerned about emptying out your bank accounts, so cash basis accounting could be a better fit.
What Does the IRS Say About Cash Basis Accounting?
The Internal Revenue Service has rules about how your business does its accounting. You must use accrual accounting if your business is structured as a corporation—other than an S corporation—and your average annual gross receipts for the 3 previous tax years have exceeded $25 million, indexed for inflation.
If this doesn’t describe your business, you can use cash basis accounting. Make sure you keep copious records, like receipts, for every transaction—even if it’s all in cash.
To change your accounting style, you need to file Form 3115 to get permission from the IRS.