Cash Method of Accounting

I am working with a professional who recently transitioned from full-time employment to self-employment in a solo practice.  We were recently calculating his year-to-date income and projecting his total income for the year in order to determine what he should make for estimated tax payments (more about self-employment and estimated taxes).   Many of his questions reminded me that cash-basis accounting has some nuances worth reviewing for those start-up professionals tracking their own financials.

Recording Income

Recording income under the cash method is simple; you recognize the revenue when you receive the payment.  If the payment is a check, you should record the revenue when you receive the check, rather than when you deposit it.  Invoices you have billed to clients but for which you have not been paid are not included in cash-basis income.  Cash-basis balance sheets do not have an accounts receivable current asset account; the unpaid invoices are not recognized as an asset.

Recording Expenses

As with income, expenses are recognized when they are paid.  The date of a bill is not relevant in cash method accounting; what matters is when the bill is paid.  The bill is considered paid when you initiate the payment process.  If you mailed a check payment to a vendor, you record the expense before the check clears and the cash is deducted from your bank. 

When credit cards are used for paying expenses, you record the expense when the credit card purchase transaction occurs.  The credit card is a current liability that does appear on cash-basis balance sheets.  For cash method accounting, purchases made with credit cards, loans or lines of credit are expensed as they are made.  The actual repayment of any principal balances of credit cards, loans or lines of credit are not captured in expenses; these are the repayments of liabilities and only affect the balance sheet.

Benefits

Cash basis accounting is simple and familiar, since it is how most people operate their own personal finances.  A start-up practice can track its income and expenses on a cash method with a spreadsheet.  As a next step, a small practice can link its bank and credit card accounts to a cloud-based general ledger software (e.g. QuickBooks Online or Zero) to track income, expenses, and bank and credit card balances quickly.  Most small businesses would be wise to have a bookkeeper or accountant assist with setting-up the general ledger and to provide some training; working with a professional to set-up your books at the onset is always more economical than cleaning up any problems afterward.

For small businesses with gross revenues under $25 million annually, this is a permitted accounting method for income tax returns.  Cash method accounting is very tax-friendly; you are only taxed on income after you receive it.  There is some ability to accelerate expenses by paying bills early; this can reduce taxable income for a given period. 

Detriments

Cash method accounting does not tie income to periods when it is earned or expenses to when they are incurred.  If there are lag-times between when income is invoiced and when it is received, the financial reports can provide a skewed perspective of financial performance. Skewing of expenses can similarly occur if payments are made long after bills are received. 

Cash method accounting does not conform to Generally Accepted Accounting Principles (GAAP).  For most small businesses, this is not an issue.  For research-intensive start-ups with large capital needs, I recommend using GAAP method accounting at the outset; even if early investors do not require reviewed or audited GAAP financial statements, later investors or grantors are likely to require them.  For larger, more mature businesses looking at certain exit plans including Employee Stock Ownership Plans (ESOPs), GAAP financials will also be needed.

Conclusion

For most small service businesses, cash method accounting is the better choice for both internal financial management and income tax purposes.  Cash method accounting is simple to understand and implement, since income is recorded when received and expenses are recorded when paid.  General ledger software linked to bank and credit card accounts easily generates cash method financial statements.  Work with your professionals to determine if cash method accounting suits your business and to get your books properly set-up at the outset.