What Is the Cash Method of Accounting? (Plus Pros and Cons)
By Indeed Editorial Team
Updated December 1, 2022 | Published September 2, 2021
Updated December 1, 2022
Published September 2, 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Many industries use accounting methods as part of their daily function to keep records of their financial transactions. Implementing proper accounting principles and methods, like the cash method of accounting, can help a company track its business expenses accurately. Understanding how to use this method and knowing when to apply it can help organizations determine if it's the right choice for them.
In this article, we discuss the cash method of accounting and the pros and cons of this method, and we provide two examples you can use as a guide.
What is the cash method of accounting?
The cash method of accounting, or cash accounting, is a process that involves businesses recording the actual date of payments received and expenses when paid. Some companies also refer to this method as cash-basis accounting, which differs from accrual accounting, which records transactions based on the date the business earns the revenue and incurs liabilities. Although this method's use may seem simpler, some organizations may not to implement it because of its short-term basis inaccuracies.
For example, if an accountant is reviewing the financial records before a payment cashes from the bank, it may reflect a delay in payment or receipt of revenue, because of bank holds and processing. Documenting these changes can also create discrepancies if notated too early and there's a request for a refund.
Who uses cash basis accounting?
Small businesses typically use the cash method of accounting, however, any company can use this method to assist with their accounting needs. Small business owners may look for a simpler and easier way to understand their company's financials, and using cash-basis accounting can help. When reviewing the account books, organizations can see how much money they have available based on expenditure credits and debits. Although using accrual accounting for a small business may offer long-term clarity, it may rarely reflect real-time payments and credits needed for immediate calculations.
For larger companies with more substantial inventory, they may choose the accrual method because purchasing inventory can affect the accuracy of financial records. If they want to change their company's chosen method, organizational leaders may consider contacting the IRS for the steps to do so. When reviewing which method to use, companies can consider their business type and consult with others on their team to decide on the right option.
How does the cash method of accounting work for businesses?
A business typically records all financial transactions in a ledger. Accounting or bookkeeping can help ensure that relevant information is available when doing company taxes and when making financial business decisions. This method may also depend on the preferences of those managing the process and any federal guidance and regulations that might apply based on the type of business.
The type of business can also determine how it files with the IRS and the method it uses, as there are limitations for companies and their selected accounting methods. If a business uses one method for its internal accounting, it typically uses the same approach for reporting its taxes as well. Companies with more than $25 million in annual gross receipts, such as C corporations, must use the accrual method of accounting rather than the cash method. Also, certain types of trusts have accounting limitations and may have to use the accrual method as well.
Examples of the cash method of accounting
Here are some helpful examples of what the cash method of accounting looks like when applied:
Tom's Pizza Company takes a catering order of $500 worth of pizza on March 1, with a March 25 delivery date. The company records the sale on March 25 in the accounting ledger, although the client placed the order on March 1. Upon delivery of the pizza, the client provides the $500 payment on March 25.
Robertson Supply Company places an order for tools and supplies on September 1, with an expected delivery date of September 14. The vendor supplying the items requires payment at the time of order, rather than delivery. Robertson Supply Company records the transaction on September 1, when submitting payment for the order.
Pros and cons to the cash method of accounting
When considering the cash method of accounting, understanding the advantages and challenges of this process can help you determine if it's right for your business. Here are some common accounting pros and cons when using this method:
This method offers the following advantages:
Simplicity: Noting the transactions as they occur can simplify the accounting process and allow for easier reconciliation.
Accessibility: When applying the cash method of accounting, you can look at your financial records at any point and see how much cash you have in the bank and what you've spent on expenses.
Familiarity: The cash method of accounting may feel more familiar than other methods because it's similar to how you may manage your personal finances and track purchases and payments as they occur. This means you rarely need accounting experience to use this method.
Some challenges of this method include:
Delay of revenue or payment recognition: A delay between the payment being cashed or the revenue being credited can create financial discrepancies.
Potential for inaccurate financial representation: Although the cash method of accounting can provide information about expenses and revenue in real time, it can also cause inaccuracy. For example, if a company hires a contractor who bills quarterly, that expense may not show in the financial records until the company submits payment for the invoice.
Tax issues: The cash method of accounting can also make it difficult when filing taxes, particularly for expenses and revenue received at the end of one year or the beginning of the next year. Since the notation of expenses happens at the time of the credit or debit, future expenses may not count toward that year's tax filing.
Explore more articles
- Account-Based vs. Inbound Marketing: Definitions, Differences and Tips
- How to Build a Successful Email Funnel for Your Business
- 23 Tips for Working at Home With Kids
- What Is a Business Environment? (With Types, Benefits and Examples)
- 10 Graduate Schools for Electrical Engineers (With Tips)
- How To Create an Effective Lead Funnel (With Tips)
- How To Develop a Mentoring Plan (With Benefits and Tips)
- 10 Expert Cross-Selling Tips for Sales Professionals
- HR Tips for Professionals Starting Their Careers
- What Are Financial Modeling Skills? (Plus How To Improve Them)
- Etiquette for Requesting a Pharmacy Residency Letter of Recommendation
- How To Make an Inventory Spreadsheet (Plus Benefits)