Cash Basis vs. Accrual Accounting for Small Business

Choosing between cash vs accrual accounting is one of the first decisions a small business owner faces. The two methods follow the same basic records, but they record income and expenses at different times. That timing affects your reports, your taxes, and how closely your profit matches your actual activity.

This guide explains how each method works, shows a simple example, and covers the IRS rules that can limit your choice. It is general information, not tax advice, so talk with a tax professional before you decide.

What Is an Accounting Method?

An accounting method is a set of rules that determines when and how income and expenses are reported on your tax return. The IRS explains the rules in IRS Publication 538, Accounting Periods and Methods.

A few basics apply to every business:

• No single accounting method is required of all taxpayers.
• Your method must clearly reflect your income and expenses, and you must keep records that support your return.
• You use the same method from year to year.
• You choose your method when you file your first tax return. After that, changing it generally requires IRS approval.

Cash vs Accrual Accounting: What’s the Difference?

The Cash Method

Under the cash method, you generally report income in the year you receive it and deduct expenses in the year you pay them. Income counts as received when it is actually in your hands, or when it is credited to your account or made available to you without restriction.

The IRS notes that most individuals and many small businesses use the cash method.

The Accrual Method

Under the accrual method, you generally report income in the year you earn it, regardless of when payment arrives. You deduct expenses in the year you incur them, regardless of when you pay them.

The purpose of the accrual method is to match income and expenses in the correct year.

Side-by-Side Comparison

• Income: Cash records it when received. Accrual records it when earned.
• Expenses: Cash records them when paid. Accrual records them when incurred.
• Unpaid invoices and bills: Cash ignores them until money moves. Accrual records them right away.

Cash vs Accrual Accounting Example (Hypothetical)

Suppose a consultant finishes a project and sends a $5,000 invoice on December 20. The client pays on January 10. The consultant also receives a $1,200 supplier bill dated December 22 and pays it on January 5. These numbers are hypothetical.

Under the cash method

• December: no money moved, so December shows $0 in income and $0 in expenses.
• January: the consultant records $5,000 in income and $1,200 in expenses, for a profit of $3,800.

Under the accrual method

• December: the consultant records $5,000 in income and $1,200 in expenses, for a profit of $3,800.
• January: nothing new is recorded for these items.

The totals are the same. Only the timing changes, and for tax purposes that can mean a different tax year.

Advantages and Limits of Each Method

Cash Method

The cash method follows your bank activity, so it is straightforward to match with your deposits and payments. However, it can make a period look better or worse than the work you actually did. In the example above, December shows no profit even though the project was finished.

Accrual Method

The accrual method shows income and expenses in the period they belong to, which gives a fuller picture of your activity. However, it requires you to track unpaid invoices and unpaid bills. Our guides to accounts receivable for small business and accounts payable for small business explain how to do that.

It also means profit can appear before the cash arrives. For that reason, it helps to watch your [small business cash flow] alongside your reports.

Who Can Use the Cash Method?

The IRS rules depend on your business type and size:

• Many small businesses can use it. The IRS says most individuals and many small businesses use the cash method.
• Inventory matters. If you produce, purchase, or sell merchandise, you generally must keep an inventory and use an accrual method for purchases and sales. However, there is an exception for small business taxpayers, which are businesses below an inflation-adjusted gross receipts limit.
• Some entities face limits. Certain corporations, partnerships with corporate partners, and tax shelters generally cannot use the cash method unless an exception applies, such as meeting the gross receipts test.
• Growth can change the answer. A corporation or partnership that fails the gross receipts test must switch to an accrual method.

The gross receipts limit is based on your average annual gross receipts for the 3 prior tax years, and it is adjusted for inflation. Check the current figure with the IRS or a tax professional.

The Hybrid Method

A hybrid method combines elements of the cash and accrual methods. Generally, you can use any combination if it clearly reflects your income and you use it consistently. The IRS adds some restrictions:

• If you use the cash method for income, you must use it for expenses.
• If you use an accrual method for expenses, you must use it for income.
• If you must account for inventory, you generally use an accrual method for purchases and sales, and you can generally use the cash method for other items.

Cash vs Accrual Accounting: Which Should You Choose?

Start with these questions:

• Do the IRS rules limit your choice? Your business structure, inventory, and size can matter.
• Do you carry inventory? If so, review the inventory rules above.
• Do you invoice customers or buy from vendors on credit? If so, accrual shows those amounts as soon as they exist.
• Do you want profit to match the period it was earned in? Accrual is designed for that.
• What does your tax professional recommend? Because no single method fits every business, professional advice is worth getting. Our guide to small business bookkeeping explains how your method fits into your day-to-day records.

Changing Your Accounting Method

Once you have set your method and filed your first return, you generally need IRS approval before you change it. A change from the cash method to the accrual method, or the reverse, is one of the changes that requires approval. The IRS uses Form 3115, Application for Change in Accounting Method, for this purpose. Speak with a tax professional before making a change.

Common Mistakes

• Switching methods without approval. A change generally requires IRS approval.
• Using methods inconsistently. The IRS expects you to use the same method from year to year.
• Assuming you can choose freely. Inventory, entity type, and size can limit your options.
• Forgetting unpaid items under accrual. Track invoices and bills that have not been paid yet.

Frequently Asked Questions

What is the main difference between cash and accrual accounting?

Timing. Cash records income and expenses when money moves, and accrual records them when they are earned or incurred.

Which method do most small businesses use?

According to the IRS, most individuals and many small businesses use the cash method.

Can I use the cash method if I have inventory?

If you produce, purchase, or sell merchandise, you generally must keep an inventory and use an accrual method for purchases and sales. However, small business taxpayers below an inflation-adjusted gross receipts limit have an exception.

Can I switch from cash to accrual?

Yes, but a change generally requires IRS approval. The IRS uses Form 3115 for this request.

What is a hybrid accounting method?

It is a combination of cash and accrual elements. The IRS allows it if the combination clearly reflects your income and you use it consistently.

Conclusion

Cash vs accrual accounting comes down to timing: cash follows the money, and accrual follows the activity. The right choice depends on your business type, inventory, size, and the IRS rules that apply to you. Review the questions above, check the current IRS guidance, and talk with a tax professional before you settle on a method. This guide is general information and not tax or legal advice.