What is cash basis accounting: Concept, Pros & Cons vs Accrual Method

Cash basis accounting is a straightforward method where you record income only when you receive the money, and record expenses only when you actually pay them. It gives a clear picture of your cash flow but doesn’t show what you’ve earned or owe if the money hasn’t changed hands yet.

Anushka, a freelance designer, finished a ₹30,000 project on 1st March but got paid on 10th April, so she recorded the income in April. She received a ₹5,000 software bill on 20th March but paid it on 5th May, so the expense went into May’s records. In April, she also earned and received ₹10,000 from another job. By the end of May, her books showed ₹40,000 in income and ₹5,000 in expenses, based only on the cash she received or spent. This method made it easy for her to track real cash in the bank, but it didn’t reflect when the work was done or when bills were due. In this blog, you’ll learn about cash basis accounting, its concept, advantages and disadvantages, and how it compares to the accrual method.

Top Advantages of Cash Basis Accounting

Cash basis accounting is a popular choice for freelancers, sole traders, and small business owners because it’s easy to understand and manage. It focuses only on actual cash received and paid, which helps simplify bookkeeping, control spending, and manage taxes more flexibly. Below are the key advantages explained in clear terms:

These benefits make cash basis accounting a smart option for those who want to keep finances simple, stay on top of their cash position, and maintain control over their tax planning, especially in the early stages of running a business.

Example:

Anushka, a freelance designer, finishes a project worth ₹50,000 in December but gets paid in January. She also receives a software bill for ₹15,000 in December but pays it in January.

Under cash basis accounting, both the income and the expense are recorded in January, because that’s when the money actually moves.
 

This method helps her keep things simple and only pay tax on money she’s actually received. But it also means her accounts won’t show what she earned or owed in December unless the cash changed hands.

Limitations & Risks: What Cash Basis Doesn’t Show

Cash basis accounting is simple, but it doesn’t show everything you need to understand your business fully. It only records money when it moves in or out, so it misses unpaid bills, money customers owe you, and what you owe others. This can make your profit and debts look different from reality.

Limitations of Cash Basis Accounting:
 

• Misses Important Details: It doesn’t track money owed to you or what you need to pay. This can give a wrong idea of how well your business is really doing.
   
• Not Accepted by Big Companies: Businesses that follow official accounting rules (like GAAP or IFRS) or are publicly listed can’t use the cash basis. They must use accrual accounting.
   
• Tax Problems: Sometimes you might pay tax on money you haven’t received yet, or miss deductions because you paid expenses late. This can cause money flow problems.
   
• Hard to Change Later: Switching from cash to accrual accounting takes work and may require official permission from tax authorities.

Example:

Raj runs a small consultancy:
 

• He finishes work worth ₹80,000 in December but gets paid in February.
   
• He gets a bill for ₹25,000 in December but pays it in February.
   

With cash basis accounting, Raj records no income or expenses in December or January. He only records ₹80,000 income and ₹25,000 expenses in February, so his profit shows up in February.
 

With accrual accounting:

Raj would record ₹80,000 income and ₹25,000 expenses in December, showing a clearer picture of his business performance that month.

Tips for Small Businesses:
 

• Use the cash basis if you want simple bookkeeping and mostly deal with cash payments.
   
• Be aware that your profit might look smaller or bigger depending on when the money moves.
   
• If your business grows or you start selling on credit, consider switching to accrual accounting.
   
• Always keep track of unpaid bills and money owed, even if you use a cash basis, to avoid surprises.

Cash vs. Accrual Method: Which Should Your Business Use?

Choosing between cash basis and accrual accounting depends on your business size, complexity, and financial needs.

When Cash Basis May Be Best
 

• You run a small business, freelance, or work alone with mostly cash payments.
   
• You don’t hold stock or sell on credit.
   
• You want simple records and an easy way to see how much cash you have.
   
• You want to control when you pay tax by timing your income and expenses.
   
• Your business income stays under tax authority limits, allowing a cash basis.

When the Accrual Method Is Better
 

• You sell goods on credit or keep stock.
   
• You need detailed accounts that show what customers owe you and what you owe suppliers.
   
• You want financial reports that follow official rules (like GAAP or IFRS).
   
• You plan to grow your business, seek investors, or apply for loans.

Example:

Two businesses finish a project worth ₹100,000 in December but get paid in January. They also receive a bill for ₹30,000 in December but pay it in January.
 

• With a cash basis, the income and expenses show in January, so December looks empty.
   
• With the accrual basis, December shows the true income and expense, giving a clearer picture of the business.

This shows a cash basis suits simple businesses wanting easy cash tracking. Accrual suits businesses needing accurate financial reports for growth or investment.

Conclusion

Cash basis accounting means you record income only when you receive money and expenses only when you pay money. It’s simple and shows exactly how much cash you have right now. This method works well for small businesses or freelancers who mostly deal with cash and want easy bookkeeping.

FAQs
 

1. Can I switch from the cash basis to another accounting method?

Yes, you can switch to accrual accounting, but you’ll need to update your records to include unpaid bills and invoices. You might also need to tell the tax authorities and follow their rules.

2. Does cash basis accounting affect how I pay tax?

Yes, it can. You only pay tax on money you’ve actually received, not on money owed to you. This can help you manage your tax payments better by timing income and expenses.

3. Can I use cash basis accounting if I have stock or inventory?

Usually not. Cash basis works best if you don’t have stock or sell on credit. If you manage inventory, accrual accounting gives a clearer picture of your business.

4. Is cash basis accounting accepted by banks and investors?

Small businesses often use the cash basis, but banks and investors usually prefer accrual accounting. They want detailed reports showing money owed and owed to suppliers to understand your business health better.
 

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LoansJagat Team

‘Simplify Finance for Everyone.’ This is the common goal of our team, as we try to explain any topic with relatable examples. From personal to business finance, managing EMIs to becoming debt-free, we do extensive research on each and every parameter, so you don’t have to. Scroll up and have a look at what 15+ years of experience in the BFSI sector looks like.