Cash basis accounting
Recording revenue when cash is received and expenses when cash is paid, regardless of when the work was done.
In short
- It is simple: the books follow the bank account.
- It can distort profit from month to month and hides what is owed and owing.
- In Canada, most businesses must use accrual accounting for income tax, with limited exceptions.
Cash basis accounting records a sale when the customer pays and an expense when the business pays its bill. There are no receivables, payables or accruals: if money has not moved, nothing is recorded.
Why some use it
It is easy to understand and easy to keep. The books effectively mirror the bank account, which suits very small businesses and sole proprietors with simple transactions and no inventory.
Its weaknesses
- Misleading profit: a month in which several customers happen to pay looks profitable; a month in which a large annual bill is paid looks like a loss.
- No view of obligations: the books don't show what customers owe or what the business owes suppliers.
- Harder to borrow: lenders and investors usually want accrual-based statements.
What the rules allow
Accounting standards such as IFRS and ASPE require accrual accounting for general-purpose financial statements. For Canadian income tax, the CRA generally requires business income to be reported on an accrual basis; farmers, fishers and certain self-employed commission agents can use the cash method. In the United States, smaller businesses below a revenue threshold can generally use the cash method for tax.
Many small businesses keep cash-based records during the year and have their accountant convert them to accrual at year end.
Worked example
A misleading December
A freelance designer invoices $12,000 in November for work done that month, and the clients pay in December. She also prepays $3,600 for a year of software in December. On a cash basis, November shows no income and December shows $8,400 of profit. On an accrual basis, November shows the $12,000 of income, and only $300 of the software cost belongs to December.