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Everything you need to know about cash accounting

Among other things, that includes an accounting system.

Cash accounting is a bookkeeping method whereby a transaction is recorded only once a payment is actually made. It may be the right option for your business. At Padgett, we provide reliable accounting services for small businesses. Here, you’ll find an overview of the most important things you need to know about cash accounting.

What is cash accounting?

Cash accounting—also often referred to as “cash-basis accounting”—is a method in which transactions are recorded only when cash changes hands. In other words, revenue is recognized when payment is received. Along the same lines, business expenses are recorded when they’re paid. Cash accounting offers a straightforward, transaction-based snapshot of a company’s financial health at any given time. It’s primarily used by small businesses and sole proprietors due to its simplicity.

The IRS permits certain businesses with average annual gross receipts for the three prior tax years equal to or less than an inflation-adjusted threshold to use cash accounting. That threshold was significantly increased under the Tax Cuts and Jobs Act of 2017, from generally $5 million to an inflation-adjusted $25 million, opening the door for many more businesses to use cash accounting. This accounting method can provide tax-planning opportunities for businesses to potentially defer income and accelerate expenses—or vice versa, depending on the circumstances—to defer or even lower overall tax obligations. In short, it offers some flexibility to control the timing of income and deductions for income tax purposes.

An example of cash accounting

To understand how cash accounting works, it’s useful to look at a real-world example. Consider a small pool contractor. In June, the business installed a pool for a customer and sent the customer an invoice for $40,000, payable within 30 days. The company also paid $25,000 in materials and labor expenses in June when it installed the pool. Using cash accounting, the contractor would record the expenses for the job when they were paid in June, but it would report the revenue for the job when the customer paid the invoice in July.

The pool contractor also received delivery of materials for the project in June, but it has 30 days to pay the supplier’s invoice. Under cash accounting, these costs would be expensed when the cash is remitted in July.

As you can see from this example, cash accounting emphasizes cash received and paid, but it doesn’t necessarily match revenue earned with the expenses incurred in the accounting period. The use of cash accounting doesn’t allow management to see money owed to the business, bills not yet paid, and other probable economic benefits and obligations. In the example, the pool contractor would have an unclear picture of each project’s profitability until it had received payment from the customer and paid all expenses associated with the project. With cash accounting, revenue and expenses aren’t necessarily matched, potentially causing profits to fluctuate from one accounting period to the next.

Benefits of cash accounting

Is cash accounting the right option for your small business? It could be. There are some significant advantages associated with this method—especially for smaller businesses, companies with limited inventory, and sole proprietorships. Here are two benefits of cash accounting:

  1. Simplicity: Cash accounting is straightforward; you record when money comes in and when it goes out. It can be useful for owners of small businesses and sole proprietors who may not have extensive accounting knowledge. It eliminates the complexities of accounts receivable and payable, deferred revenue, prepaid assets, accrued expenses, and other types of technical-sounding accounts.
  2. Consistency with income tax reporting: Many eligible small businesses file their income tax returns on a cash basis because it aligns with their ability to pay. This method also may provide year-end tax planning opportunities. Cash-basis businesses may have the ability to lower their taxable income in the current tax year by deferring invoicing customers for products or services until the next year or accelerating payment of expenses into the current year. Alternatively, cash-basis businesses sometimes use the opposite strategy—accelerating revenue and deferring expenses—if management expects to be subject to higher tax rates in the coming tax year.

Cash Accounting

Despite having some advantages, cash accounting isn’t the right choice for every type of business. Quite the contrary, in the eyes of the IRS, it’s not even a permissible form of accounting for large, more complex companies. Here are three drawbacks of cash accounting:

  • Mismatching of revenue and expenses: Revenue and expenses aren’t always aligned with the accounting period they relate to. For example, a business might receive a large payment one month for a service that will be delivered over the next year—thereby distorting the actual revenue for that month. Likewise, expenses are reported as soon as they’re paid under the cash method. So it isn’t a great option for businesses with highly variable month-to-month revenue or expenses. This can make it hard to compare the company’s financial performance over time.
  • Difficult to effectively benchmark results: Another disadvantage is that businesses that use cash accounting can’t effectively benchmark their results against competitors, especially industry leaders who may use accrual accounting. This lack of comparability could make it hard for small businesses to obtain loans or attract equity investors to pursue growth opportunities.
  • Compliance: The IRS prohibits businesses with average annual gross receipts for the prior three tax years above an inflation-adjusted $25 million threshold from using cash accounting. So it may not be an option for large, more complex businesses. In addition, cash-basis businesses may lose out on certain tax planning strategies that may be available only to businesses that use accrual accounting.

Understanding the primary alternative: accrual accounting

Accrual accounting is the primary alternative to cash accounting. It adheres to the matching principle, which mandates that revenue earned and expenses incurred be recorded in the same accounting period. It’s a method that provides a more comprehensive view of a company’s financial health, making it suitable for businesses of all sizes, especially corporations with complex operations. With accrual accounting, transactions are recorded as soon as they occur, regardless of when the money is exchanged.

For example, when a company delivers a service, revenue from that service is recognized, even if the payment will be received later. Similarly, when a company receives a service, the expense is recorded, even if the bill will be paid in the future. Accrual accounting offers more financial insight but also requires more bookkeeping expertise. Of course, you don’t have to handle accounting on your own. An experienced professional can help.

We encourage you to contact us with any questions.

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