How to Record Cash Basis Accounting

Recording transactions on a cash basis means acknowledging revenue only when you receive money and expenses only when you pay money out. This method is straightforward and popular with small businesses for its simplicity. This guide will walk you through exactly how to record your daily transactions using the cash basis accounting method, with clear examples for both income and expenses.

What is Cash Basis Accounting? A Quick Refresher

The core principle of cash basis accounting is timing. A transaction is only recorded when cash changes hands. It doesn't matter when an invoice is sent or when a bill is received. The only date that counts is the one on your bank statement showing money coming in or going out.

Let's compare this to the alternative, accrual basis accounting. Under accrual, you record revenue when you earn it (i.e., when you send the invoice) and expenses when you incur them (i.e., when you receive the bill). For example, if you complete a project and invoice your client for $2,000 on December 15th but they don't pay you until January 10th:

• Cash Basis: The $2,000 is January revenue.
• Accrual Basis: The $2,000 is December revenue.

Because of its simplicity, cash basis is a great fit for freelancers, sole proprietors, and small businesses without inventory. It gives you a clear, real-time picture of your cash flow. Its main limitation, however, is that it doesn't show you near-term liabilities (bills you need to pay) or future income (invoices you are waiting on), which can sometimes mask the larger financial health of the business.

Preparing Your Chart of Accounts for Cash Basis

Before you can record any transactions, you need a Chart of Accounts (COA). Think of this as the master list of all the categories you use to organize your financial data. For cash basis accounting, your COA will be relatively simple.

Here are the key accounts you'll need:

• Assets: At a minimum, you'll need an account for your primary business checking or savings account. This is the heart of cash basis accounting. Other assets might include equipment or vehicles if you make large purchases.
• Revenue/Income: This is where you categorize money coming in. You might have one general account like "Service Revenue" or get more specific with "Consulting Income," "Sales Revenue," or "Design Fees."
• Expenses: These accounts track where your money goes. Common examples include Advertising & Marketing, Bank Fees, Office Supplies, Rent Expense, Software Subscriptions, and Utilities.

Notably, two accounts you won't find in a pure cash basis system are Accounts Receivable (A/R) and Accounts Payable (A/P). Accounts Receivable is used to track money owed to you by customers, and Accounts Payable tracks money you owe to vendors. Since cash basis only cares about cash that has moved, these "IOU" accounts are not part of the daily process.

Most accounting software like QuickBooks, Xero, or Wave will ask you to choose your accounting method during setup. If you select "Cash," the software will automatically generate reports like your Profit and Loss statement based on cash moving in and out of your bank accounts, simplifying the process immensely.

How to Record Revenue When You Get Paid

Recording income under the cash basis method is direct. When a customer pays you, you record the event on the date the money is deposited into your account. Forget the invoice date; the deposit date is all that matters.

Let's walk through an example. Imagine you are a freelance web developer, and you finished a project for a client. You invoiced them for $1,500 on May 20th. The client paid you via direct deposit, and the money appeared in your business checking account on June 2nd.

Here’s how you would record this transaction using a double-entry journal entry, which is the foundation of all accounting.

Step 1: Identify the Transaction Details

• Date: June 2nd
• Amount: $1,500
• Nature: Cash received for services provided.

Step 2: Create the Journal Entry
In double-entry bookkeeping, every transaction affects at least two accounts. One account is debited, and one is credited.

• Your Checking Account (an asset) is increasing. An increase to an asset account is a debit.
• Your Service Revenue (an income account) is increasing. An increase to a revenue account is a credit.

The journal entry would look like this:

Date: June 2
Account                   Debit             Credit
Checking Account       $1,500
     Service Revenue                       $1,500
     (To record cash payment received for web development)

How This Works in Accounting Software:
You likely won't be making manual journal entries. Instead, you'll use the software's features. When you connect your bank account, the $1,500 deposit will appear in your bank feed. You would simply categorize this deposit directly into your "Service Revenue" account. The software handles the debit and credit actions behind the scenes, and the revenue is correctly reported in June's financial statements.

How to Record Expenses When You Pay Bills

Recording expenses follows the same logic: the transaction is recorded on the date money leaves your account. The date you receive a bill is irrelevant for bookkeeping purposes. The payment date is what matters.

Let’s continue with our web developer example. You receive a bill for your monthly internet service for $120. The bill is dated August 5th, but you pay it online from your business checking account on August 15th.

Step 1: Identify the Transaction Details

• Date: August 15th
• Amount: $120
• Nature: Cash paid for utilities/internet expense.

Step 2: Create the Journal Entry

• Your Utilities Expense (an expense account) is increasing. An increase to an expense account is a debit.
• Your Checking Account (an asset) is decreasing. A decrease to an asset account is a credit.

The journal entry would look like this:

Date: August 15
Account                   Debit             Credit
Utilities Expense         $120
     Checking Account                       $120
     (To record payment for monthly internet service)

How This Works in Accounting Software:
Just like with income, you would see the $120 withdrawal in your bank feed. You’d categorize it to your "Utilities Expense" or "Internet Expense" account. Once categorized, the software logs it as an August expense, correctly reflecting the cash outflow for that month.

Handling Prepayments and Fixed Assets

While cash basis is simple, there are a few situations that require special handling to align with tax rules and provide a more accurate financial picture.

Prepaid Expenses
What happens if you pay for a full year of business insurance in January? Let's say it costs $2,400. Under a strict cash basis method, you'd record a massive $2,400 expense in January and $0 for the next 11 months. This would make January look unprofitable and the following months look artificially profitable.

To solve this, many businesses use a "modified cash basis" approach for big prepayments. They might still record the full cash payment in January but, for their internal management reports, spread the expense over the 12-month period ($200 per month). For tax purposes, however, the rules around when you can deduct a prepaid expense can be specific, so it’s important to follow IRS guidelines.

Fixed Assets
You aren't supposed to record the full cost of a significant purchase that will last for more than a year as a single expense. Think about buying a company vehicle for $30,000 or a high-end computer for $3,500. These are not typical day-to-day expenses.

Even under cash basis, these items are treated as fixed assets. Here’s the general process:

1. When you pay for the item, the cash outflow is recorded, but instead of debiting an expense account, you debit an asset account (e.g., "Computer Equipment" or "Vehicles").
2. The cost of that asset is then gradually expensed over its useful life through a process called depreciation.

The IRS has very specific rules for how to depreciate different types of assets, such as the Section 179 deduction, which allows businesses to deduct the full purchase price of qualifying equipment in the year it was placed in service. This is an area where cash basis accounting adheres to overarching tax regulations.

Final Thoughts

Recording transactions on a cash basis is all about following the flow of money. When cash comes in, you record income. When cash goes out, you record an expense. This discipline offers a clear and straightforward way for small business owners to manage their finances and understand their immediate cash position.

While keeping the books is often simple, nuanced tax questions can arise, especially concerning things like depreciation, prepayments, or state-specific tax deductibility. Instead of spending hours hunting through IRS publications, we built Feather AI to help accountants and tax professionals get instant, authoritative answers. By asking a question in plain language, you can receive a clear summary backed by the relevant tax code, ensuring your financial records are both simple and fully compliant.