Cash-basis accounting

In cash-basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when paid. It is the simplest form of accounting and is used by many small businesses and nonprofit organizations. However, it is not permitted for public companies under GAAP or IFRS, because it distorts economic performance. A company can be profitable on cash basis while economically insolvent, or vice versa. For this reason, public company financial statements must use accrual-accounting.

The mechanics: cash in, cash out

Cash-basis accounting tracks only cash transactions:

• When a customer pays $1,000, revenue of $1,000 is recorded. No accounts receivable is created.
• When a supplier is paid $500, an expense of $500 is recorded. No accounts payable is carried forward.
• When cash is spent on a truck, the entire cost is expensed immediately. No depreciation or asset balance is recorded.

The result is a series of cash inflows and outflows that can be summed to show profit or loss. But there is no balance sheet in the traditional sense, no matching of expenses to revenue, and no distinction between one-time and recurring transactions.

Why it fails for complex businesses

Cash-basis accounting breaks down quickly for any business with complexity:

• A retailer with inventory: If you buy $10,000 of inventory in November and sell it all in December but customers don’t pay until January, cash-basis accounting shows $10,000 expense in November and $10,000 revenue in January. Profit is split across two periods despite the work happening in December.
• A service company with large contracts: A consulting firm that signs a three-year contract in January for $300,000 (paid at year-end) shows zero revenue in years one and two under cash basis, then $300,000 in year three. Accrual-accounting spreads $100,000 across each year, which is accurate.
• A manufacturer with capital equipment: Buying a $1 million machine and expensing it immediately distorts profit that year. Depreciation over the useful life is more honest.

The role in small business and tax accounting

Despite its limitations, cash-basis accounting is common in small businesses because it is simple and can be done without an accountant. Many sole proprietors and partnerships use it.

It is also relevant for tax accounting. Some small businesses and nonprofits are permitted (or required) to use cash basis for tax reporting, even if they use accrual-accounting for financial statements. The IRS allows this for small businesses (under certain revenue thresholds) because it is simpler to enforce and audit.

The IRS and small business exception

The IRS historically permitted small businesses (gross receipts under $5 million) to use cash-basis accounting for tax purposes. This has simplified compliance. However, businesses that trade in inventory (like retailers and wholesalers) must typically use accrual-accounting for tax purposes, even if small.

A business might use cash basis for its internal books and tax return, but if it ever needs a bank loan or outside capital, the lender will demand accrual-accounting statements. Investors and lenders never accept cash-basis statements.

Why public companies must use accrual accounting

The income statement must reflect economic reality, not just cash timing. If a company can choose when to collect from customers or pay suppliers, cash-basis accounting would let it manipulate reported profit. By requiring accrual-accounting, GAAP ensures profit reflects actual business performance.

Moreover, accrual-accounting enables comparison: two companies in the same industry that use accrual-accounting are more comparable than two using different cash-collection policies.

Relationship to the cash flow statement

Public companies use accrual-accounting for the income statement but also file a cash flow statement. The cash flow statement is, in effect, a cash-basis view: it reconciles accrual profit to actual cash movement.

A business owner who is familiar with cash-basis accounting will find the cash flow statement more intuitive than the income statement.

See also