Cash basis accounting is one of the major accounting methods that records revenues at the time cash is actually in your hand (or more likely your bank account since you probably don’t keep all your company’s money in your hands) or reflects expenses when they are paid in cash.
This is opposite from the other major accounting method called accrual basis accounting, where income is reported when it’s earned and expenses are reported as they occur, whether or not cash has been received or paid yet.
The reason people might prefer accrual basis accounting is that it gives a long term picture of income and expenses over a period of time. The downside is that you can’t see your cash flow as you can with the aptly-named cash basis accounting.
So why are there two methods anyway? Isn’t accounting complicated enough as it is?
The answer is NO. But it’s also probably a good thing that there are two options for small businesses.
The cash basis used to work just fine. You’d sell something, someone would hand you money for it, and that was that. But when credit came into the picture, it became a lot harder to estimate revenue and expenses, hence why the accrual method was born.
When you file your first tax return as a new business, you’ll have to choose a side, accrual or cash. Keep in mind that certain kinds of businesses have to use the accrual method instead of cash basis. The IRS requires you to use accrual accounting if your business produces, buys or sells merchandise. As with everything related to the IRS, there are of course exceptions. Be sure to check what the rules are when it comes to your specific business before you file.
Say you’re a contractor working on a huge construction project that will last a few years. However, the nature of the contract states that you will get paid upon completion of the project. Using the cash basis method, you won’t have that money in your books and therefore your actual projected income won’t balance out with your expenses, making cash basis less accurate.
However, cash basis accounting does have the advantage is that it is the cheaper way to go. If you’re a small business or you don’t hold an inventory, cash basis usually works just fine for your purposes and can save you in accounting fees.
Cash basis accounting makes sense for our tiny dog grooming business right now, but my accountant says we might have to switch to accrual basis once we start selling dog costumes as part of the grooming package.