Definition
Cash accounting is an accounting method where revenue is recorded when cash is received and expenses are recorded when cash is paid out. The business does not recognise income until money arrives in its bank account, and does not record an expense until the payment has actually been made.
Who Uses Cash Accounting?
This is the simpler of the two main accounting methods, and it is commonly used by sole traders, small businesses, and businesses with straightforward finances. Cash accounting gives a direct view of what is physically in the bank at any point in time, which can make it easier for small business owners without accounting backgrounds to understand their financial position.
Cash Accounting Example
Consider a plumber who completes a job in October and invoices the customer, but the customer pays in November. Under cash accounting, that income is recorded in November when the money arrives. Under accrual accounting, it would be recorded in October when the work was completed.
Cash Accounting and GST in Australia
The Australian Taxation Office allows eligible small businesses with an annual turnover below $10 million to use cash accounting for GST reporting. This means GST is only reported on sales once the payment has been received, rather than when the invoice is issued. For businesses dealing with slow-paying customers, this can provide a tax timing advantage.
Limitations of Cash Accounting
The primary limitation of cash accounting is that it can misrepresent the financial health of a business in a given period. A business might show strong cash receipts one month simply because several large invoices happened to be paid, while the next month looks poor because payments are delayed. This makes it harder to assess true profitability over time.
For any business holding inventory, extending credit to customers, or seeking external finance, cash accounting tends to be inadequate on its own. Lenders and investors typically expect accounts prepared on the accrual basis because it provides a more accurate picture of revenue earned and obligations incurred, regardless of when cash changes hands.