Cash accounting, also called the cash basis or cash method, is a way of keeping books in which income is recorded when money is actually received and expenses are recorded when money is actually paid. Invoices sent but not yet paid, and bills received but not yet settled, are left out until the cash moves. The result is a record that closely follows the business's bank account.
Cash accounting is used mainly by individuals, sole traders, small partnerships and very small companies, often because tax rules allow it and because it is simple. It is the opposite of accrual accounting, which records revenue when earned and costs when incurred. Financial statements under IFRS Accounting Standards or US GAAP cannot be prepared on a pure cash basis, so larger businesses use accruals even if they also track cash closely through cash flow reports.
Cash accounting in plain terms
Cash accounting works like a household checkbook register or a jar of money on a market stall. When cash goes into the jar, you write down income. When you take cash out to pay for stock or rent, you write down a cost. Anything that hasn't touched the jar yet doesn't count.
That makes the books easy to keep and easy to check against the bank: if the record says you have $2,000, the bank should say roughly the same. The catch is that the jar says nothing about the customer who still owes you $500 or the supplier you still have to pay next week.
How it works, with an example
Under cash accounting, profit for a period is simply:
A freelance photographer has this activity in December:
- She completes three weddings worth $6,000, but only $4,000 is paid in December; $2,000 arrives in January.
- She pays $1,500 for equipment rental in December, and receives a $500 printing bill for December work that she pays in January.
On a cash basis, December income is $4,000 and December expenses are $1,500, so cash profit is $2,500. Under accrual accounting, December revenue would be $6,000 and expenses $2,000, giving net income of $4,000. Over the two months combined, both methods give the same total; only the timing differs. Cash accounting has no accounts receivable, no accounts payable, no prepaid expenses and no deferred revenue on its books.
Many small firms use a modified cash basis: day-to-day items on a cash basis, but long-lived assets capitalised and depreciated, and loans recorded as liabilities. Tax rules often require these modifications anyway.
Cash accounting and tax rules
Tax law, rather than accounting standards, is where cash accounting is most often permitted or required:
- United States. Most individuals and many small businesses use the cash method for federal income tax. Under section 448 of the Internal Revenue Code, C corporations and partnerships with a C corporation partner may use it only if their average annual gross receipts over the prior three years stay under an inflation-indexed threshold ($31 million for tax years beginning in 2025); tax shelters may not use it at all. Prepayments are limited by rules such as the 12-month rule for deducting prepaid expenses. IRS Publication 538 sets out the methods.
- United Kingdom. From the 2024 to 2025 tax year, the cash basis became the default method for sole traders and most partnerships filing Self Assessment, and the old turnover limits for joining and leaving it (previously £150,000 to enter) were removed. Traders can opt out and use accruals. Limited companies and partnerships with a company or limited liability partnership as a member cannot use it.
- Value added tax. Many VAT systems offer cash accounting schemes for small businesses, so that VAT is paid to the tax authority only when customers pay, which helps cash flow.
Rules differ by country and change often, so small businesses usually check the current position each year when they handle tax filing.
Strengths and limitations
Cash accounting is popular with small businesses and people in the freelancer economy because:
- It is simple. Records can be kept from bank statements and receipts, with little accounting training.
- Tax follows cash. Tax is not due on income that has not yet been received.
- It matches the bank. Bank reconciliation is straightforward because the books and the bank record the same events.
Its weaknesses grow with the business. Profit can swing from month to month depending on when customers happen to pay or bills happen to fall due, so it is a poor guide to performance. It hides debts owed to and by the business, which matters to lenders and buyers. It can also be timed: paying expenses early or delaying invoices shifts taxable profit between years. For these reasons, firms that seek outside investment, borrow significantly or prepare audited financials switch to accrual accounting, while still managing their cash through cash forecasting and a budget.