Cash basis accounting records revenue when cash is received and expenses when cash is paid, regardless of when the sale actually happened or the cost was incurred. It is the simpler of the two primary accounting methods and the one most people intuitively use for personal finances, but it has real limitations once a business grows past a certain size.
EXAMPLE
A business delivers $50,000 of services in March and is paid in April. Under cash basis, March shows $0 revenue and April shows $50,000. Under accrual, March shows $50,000 revenue and an offsetting receivable, and April simply converts that receivable to cash with no new revenue recognized.
The difference matters most in how well the financials reflect actual business performance in a given period. Cash basis can make a strong month look weak, or a weak month look strong, purely based on when invoices happened to get paid.
For US tax purposes, the IRS generally permits cash basis for businesses without inventory as a material income-producing factor and, for corporations and partnerships with a corporate partner, average annual gross receipts under an indexed threshold, historically around $30 million and adjusted periodically for inflation. Businesses with inventory, and larger businesses generally, are typically required to use accrual accounting.
Cash basis is not GAAP compliant. Businesses required to produce GAAP financial statements, including most seeking outside investment, audited financials, or lender covenants, must use accrual accounting regardless of size.
Modified cash basis is a hybrid: most transactions are recorded on a cash basis, but certain items, most commonly fixed assets and long-term debt, are handled on an accrual basis. It is common among smaller businesses that want simplicity for day-to-day bookkeeping but still need to track depreciation and loan balances accurately.
It is not a formally defined accounting framework, so what gets treated on an accrual basis under a modified approach varies by business and should be documented consistently rather than decided transaction by transaction.
Cash basis works well for very small operations with few, simple transactions, where the timing distortion described above does not meaningfully affect decision-making. It becomes a problem as a business adds inventory, extends credit to customers, or takes on debt, all of which create genuine timing gaps between economic activity and cash movement that cash basis simply does not capture.
The common trigger for switching is external: a lender requiring GAAP financials, an investor requiring accrual-based reporting, or the business crossing the IRS gross receipts threshold. Waiting until the trigger forces the change, rather than switching proactively, usually means converting a backlog of transactions retroactively, which is far more work than adopting accrual accounting a year or two earlier.
