What Is a Cash Accounting System?

Running a small business or startup can feel like sailing in uncharted waters, with challenges like limited resources and tight budgets making the journey uncertain.

One of the biggest difficulties is managing cash flow—knowing how much money you have on hand and how to use it to fuel growth.

For many small businesses and startups, a cash accounting system is an ideal solution.

A cash accounting system is one of the simplest and most commonly used accounting methods for companies dealing with limited resources. Best of all, it’s simple to understand, even if you don’t have a dedicated, full-time financial team in place.

Let’s go through the ins and outs of cash accounting so you can understand exactly what it is and how it works.

What is the Cash Accounting Method?

In a nutshell, cash accounting tracks financial transactions based on cash inflows and outflows. This means that income is recorded the moment it comes in and expenses are recorded the moment they are paid.

This method is one of the simplest ways to track your business finances. You’re only accounting for cash that you have, which gives you a real-time snapshot of your business’s current cash on hand.

The cash accounting method is ideal for businesses that operate on tight margins and don’t have an excess of cash to play with. You’ll always know where you stand financially without needing to have extensive accounting experience.

Moreover, it focuses on cash flow rather than profit, giving you a much more realistic overview of the available resources you have.

For example, let’s say you have sent out 10 invoices at $1,000 each. That doesn’t mean you currently have $10,000 worth of cash on hand to spend.

The cash accounting system will only account for this money once your clients have paid their invoices.

Month-End Close in Cash Accounting

When using the cash accounting method, we recommend that you conduct a month-end close. This means that at the end of each month, you’ll need to review all incoming and outgoing cash transactions to ensure that everything is accurately recorded. 

The month-end close process allows you to evaluate your current financial position and verify that all transactions have been recorded. Moreover, it gives you the opportunity to make any necessary adjustments.

This process lays a solid foundation for understanding how much cash is available for growth and future expenses.

How Is Cash Accounting Different from Accrual Accounting?

Cash and accrual accounting are two common methods businesses use to track financial transactions. The main difference lies in the timing they are recorded:

• When using cash basis accounting, transactions are recorded when the cash changes hands.
• When using accrual basis accounting, you’ll record income and expenses when they are incurred, regardless of when the cash is received or paid.

For example, you send a customer an invoice with 14-day payment terms. If you’re using cash method accounting, you would record the transaction when the customer makes the payment. 

However, if you’re using accrual accounting, you would record the transaction when you send the invoice, even if the payment is due later.

Accrual accounting provides a more accurate picture of your revenues, expenses, and liabilities. However, it is more complex and time-consuming than cash accounting. For these reasons, this method is most frequently used by large and inventory-based businesses.

What Statements Does a Cash Accounting System Use?

Cash accounting uses numbers from three main financial statements: 

• Income statement
• Balance sheet
• Cash flow statement

All focus on actual cash movements. By recording each invoice as and when it’s paid, you’ll have a clear, up-to-date picture of your business’s immediate financial position and liquidity.

However, it’s important to note that cash accounting doesn’t always reflect profitability, especially if you receive advance payments for future goods or services. 

Advantages of a Cash Accounting System for Startups

We have already touched on several advantages of using this system but it’s worth exploring them in more detail.

Simple

A cash accounting system is incredibly easy to implement and maintain. It’s suitable for business owners who lack financial expertise or accounting knowledge. 

Transactions are simple to record and typically use the single-entry accounting method as opposed to double-entry, which is more complicated.

You can use online accounting software like QuickBooks or Xero to facilitate and automate cash accounting, or even use a basic Excel spreadsheet.

Focuses on Cash Flow

Cash accounting provides a clear view of cash flow for startups with limited resources. This allows you to keep a close eye on your financial position. 

If funds are tight, as they often are for startups, this method prevents overspending and ensures you have enough money available for upcoming expenses.

Straightforward for Small Businesses

Cash accounting is ideal for businesses with straightforward transactions, such as sole proprietors, partnerships and startups.

As your business grows, however, accounting needs may become more complex, and you might consider switching to accrual accounting. Local and federal regulations may even require companies that make over a certain amount of money to use an accrual system.

Simplified Taxes

You’ll be pleased to hear that tax season is much easier to deal with when you use cash accounting.

Income is taxed only when received, so your tax liabilities are limited to cash received within the current tax year. This prevents unexpected tax bills on unrealized income and ensures you have sufficient funds to cover them.

Limitations of a Cash Accounting System for Startups

Like any system, cash accounting does have some drawbacks that you need to be aware of.

Limited Financial Insight

The main drawback to using cash accounting is that it only focuses on cash flows and doesn’t provide a complete picture of your business’s financial health. You may find that it prevents you from planning growth strategies or exploring investment opportunities.

No Insight into Performance

Since the focus is firmly on cash flow, cash accounting isn’t really suitable for determining the long-term profitability of a business. This can lead to confusion about whether your business is truly profitable, potentially giving you a false sense of financial success.

Works Best for Small Businesses

As we have mentioned, cash accounting isn’t really suitable for companies that are expanding or are already fairly large. If you’re planning significant growth, consider switching to an accrual system, especially since larger businesses may be legally required to adopt it.

If you’re not sure about which method is best to help support the future growth of your company, we recommend talking to a financial expert to clarify your financial obligations and help you determine which accounting method is best suited for your business. 

Who Should Use a Cash Accounting System?

Cash-basis accounting is ideal for small businesses, but what does that mean, exactly?

The Internal Revenue Service (IRS) permits cash accounting for businesses with average annual gross receipts of $26 million or less over the past three tax years (indexed for inflation). These can be:

• Small-scale operations: Companies with straightforward or minimal transactions. Coffee shops, independent tradesmen and personal trainers, for example.
• Cash-focused businesses: Companies that receive immediate payment for what they provide. Freelancers, consultants and small retailers are good examples here.
• Early-stage or startup companies: New businesses with limited resources and lack of financial expertise.

The following organizations may NOT use cash accounting, regardless of their scale:

• Corporations
• Limited companies
• Limited liability partnerships
• Businesses that maintain inventory

Cash Accounting Versus Accrual Accounting

Let’s go back to accrual accounting because it’s important to understand the differences between the two systems and which one will work better for your business.

Here’s a quick side-by-side overview of them:

As you may expect, accrual accounting requires more detailed and complex tracking. Although it gives a more comprehensive overview of financial health, it’s more challenging to carry out. In many cases, it requires a financial expert to manage.

Can a Business Transition Between Systems?

If you start off with cash accounting, you’re not stuck with it. Transitioning to the accrual system is possible.

The shift involves adjusting records to reflect the unpaid receivables (AR) and any outstanding payables (AP). While it may sound straightforward, it’s an in-depth process that requires the following:

1. Conducting a financial audit to identify differences between the two accounting methods.
2. Gathering all financial documents.
3. Migrating existing financial data from the cash system to the accrual system, ensuring everything is accurate.
4. Making journal entries for earned revenue that has not yet been recorded and accounting for expenses by identifying unpaid invoices.
5. Capitalizing fixed assets by identifying them, determining their useful life, and calculating depreciation expenses.
6. Ensuring that everyone understands the new system and their responsibilities through proper training.

Because of the complexity involved, we thoroughly recommend enlisting the help of an accountant to oversee the transition and any further financial needs as your business scales.

How Can Cash Accounting Help Your Startup Grow?

To answer this question, let’s look at another example to see how it can help a startup efficiently grow and succeed.

Let’s say a small digital marketing agency has decided to implement cash accounting in its first year of doing business.

• In the first quarter, the agency secured three clients, each paying $20,000 upon project completion. 
• By recording income only when payments were received, the agency accurately reflected $60,000 in revenue for Q1. 
• This allowed the agency to cover $35,000 in operating expenses, reinvest $10,000 in marketing, and retain $15,000 for future projects.

By focusing on its cash flow, the agency has made the best of its limited resources and avoided overspending. This has set it up well to continue into the second quarter of the year:

• In Q2, the agency secured five additional projects, each worth $25,000. 
• However, two clients delayed their payments, resulting in only $75,000 being recorded for Q2 instead of the full $125,000. 
• This accurate cash reflection allowed the agency to adjust its expenses, limiting software investments to $15,000 and deferring some marketing activities to Q3 when it had more cash on hand.

This approach keeps the agency’s cash flow positive and helps avoid budget shortfalls based on unreceived payments.

If the agency continues growing in this manner, it may become more appropriate to switch to the accrual accounting method. Then, it could plan its upcoming marketing strategies more efficiently and make decisions based on expected income. 

Closing Thoughts

There’s no doubt that cash accounting offers a practical and easy way to manage business finances without requiring extensive accounting knowledge. It’s also a great way to learn the basics of financial management—skills that every business owner should possess.

Every business is unique, though. To make the right decision over which accounting method you should use, you must take the time to evaluate your current business needs and how quickly you plan to scale it.

Most crucially, don’t neglect to look up what your legal accounting obligations are, as they may dictate the method you must use.

To ensure you’re on the right track, it’s wise to consult an expert. While this may seem daunting if cash flow is tight, outsourced financial services like those offered by Finvisor can provide affordable, expert help.

At Finvisor, we specialize in supporting small businesses and startups with services like bookkeeping, planning, forecasting, and more. Our scalable solutions allow you to pay only for the services you need, with add-ons to meet all your financial management needs—including transitioning from cash accounting to accrual.

To find out more about Finvisor and what we do, get in touch today!