Cash basis

Definition

The cash basis records income when received and expenses when paid, following the bank account rather than when income is earned or costs incurred. It is available to the smallest unincorporated businesses but not to companies.

In plain terms

It is the simplest way to keep accounts — just track money in and out. But it can distort profit, because a big unpaid invoice at year end simply does not appear.

Why it matters for your company

Companies must use the accruals basis, not the cash basis, so directors need to understand why their reported profit differs from their cash. Knowing the distinction explains why a profitable company can still be short of cash.

In practice

Picture a small UK limited company that has just finished a busy quarter. Its accounts show healthy profit because several large invoices have gone out and been booked as earned income, yet the same invoices remain unpaid in the bank account. Under the accruals rules that companies must follow, that gap between paper profit and cleared cash is exactly what the cash basis was designed to avoid, since it would simply not recognise income until the customer actually pays.

Directors sometimes reason informally in cash-basis terms even though their statutory accounts are accruals-based, mentally tracking money as it lands rather than as it is invoiced. That instinct is useful for day-to-day cash management, but it can mislead if it is confused with the company's real financial position, which must reflect what is owed as well as what has been received.

Common pitfalls

The main pitfall is assuming a company can simply choose the cash basis because it is simpler; it cannot, since the option is reserved for the smallest unincorporated businesses and companies are required to use the accruals basis regardless of size. A second pitfall is treating a healthy bank balance as proof of profitability, when in fact strong cash and weak underlying profit — or the reverse — can both occur depending on the timing of invoicing and payment.

Lenders and other readers of a company's figures generally expect accruals-based statements, and any commentary that mixes cash-basis thinking into a discussion of a company's accruals basis results risks understating or overstating the true trading position. Being clear about which basis a figure comes from helps directors avoid drawing the wrong conclusion from their own numbers, a distinction explored further in why profitable firms run out of cash.