Managing business finances starts with choosing the right accounting method, and for many small businesses, cash accounting is the simplest and most practical choice. Unlike accrual accounting, which records income and expenses when they are earned or incurred, cash accounting recognizes transactions only when money changes hands. This makes it easier to track actual cash flow and know exactly how much money is available at any given time.
Favored by freelancers, sole proprietors, and small enterprises, cash accounting is straightforward to implement and requires minimal bookkeeping expertise. However, it comes with its own set of limitations, and not every business is eligible to use it. Understanding how cash accounting works, its benefits, and its drawbacks will help you decide whether it’s the right fit for your business.
What Is Cash Accounting?
Cash accounting, also known as the cash basis of accounting, is a method of recording financial transactions based on the actual movement of cash.
- Revenue is recorded only when payment is received from customers.
- Expenses are recorded only when payment is made to suppliers or service providers.
This method focuses entirely on real cash flow rather than the timing of income earned or expenses incurred. It is especially popular among small businesses, freelancers, and sole proprietors because of its simplicity and reduced administrative work. However, IRS rules prevent certain larger businesses from using this method.
Understanding Cash Accounting
The main principle of cash accounting is simple—transactions are recognized only when cash is received or paid. This allows small businesses to track their liquidity with minimal effort.
Key Features
- Simplicity – Records are easy to maintain since transactions are logged only when cash moves.
- Clear Cash Position – Bank balances align closely with accounting records.
- Cost-Effective – Less complex and cheaper to manage than accrual accounting.
Who Can Use It
Many small businesses are eligible to use cash accounting if their average annual gross receipts over the past three years are $25 million or less (adjusted annually for inflation). Some entities, such as certain C corporations and partnerships, are required to use accrual accounting unless they qualify for exceptions.
Example of Cash Accounting
Example 1 – Revenue:
A marketing consultant completes a project worth $2,000 on March 10. The client pays on March 25. Under cash accounting, the $2,000 is recorded on March 25—the date payment is received—not when the work was completed.
Example 2 – Expenses:
A bakery orders flour for $600 on July 5 but pays the supplier on July 20. The $600 expense is recorded on July 20—the date the payment is made—not the order date.
Key Takeaway:
No matter when goods or services are delivered, the transaction is recorded only when the actual cash exchange takes place.
Limitations of Cash Accounting
While cash accounting offers simplicity, it has important limitations:
| Limitation | Explanation |
| Incomplete Financial Picture | Does not include accounts receivable or accounts payable, potentially hiding your true financial position. |
| Timing Distortions | Revenue and expenses may be recorded in periods that do not match actual business activity. |
| Eligibility Restrictions | Larger businesses and some corporations cannot use this method under IRS rules. |
| Limited Usefulness for Analysis | Does not follow the matching principle, making it harder to evaluate long-term performance. |
IRS Guidance on Cash Accounting for Small Businesses
The Tax Cuts and Jobs Act (TCJA) increased the eligibility threshold for cash accounting to $25 million in gross receipts, adjusted annually for inflation. Businesses under this threshold can adopt cash accounting and may also be exempt from certain inventory and long-term contract rules.
Switching from accrual to cash accounting typically requires filing Form 3115, Application for Change in Accounting Method, though the process is simplified for eligible small businesses.
Conclusion
Cash accounting is a great choice for small businesses, freelancers, and sole proprietors who want a clear and straightforward view of their cash position. It is easy to maintain, cost-effective, and provides a direct understanding of available funds.
However, it is not ideal for companies with significant receivables, payables, or long-term projects that require precise matching of income and expenses. Businesses should consider their growth plans and reporting needs before deciding whether cash accounting is the right fit.
