Cash vs Accrual Accounting: Which Method Should Your Business Use?
Cash or accrual is the first accounting decision a new business makes, often without realizing it. The choice changes what your profit looks like, when you pay tax and how useful your reports are. Here is how both methods work, side by side, and how to pick the right one.
Key takeaways
- Cash accounting records income when money arrives and expenses when money leaves. Accrual accounting records them when they are earned or incurred, regardless of payment.
- Cash is simpler and tracks the bank balance. Accrual is more accurate about profitability and is required for larger businesses and by most lenders and investors.
- Tax rules on which method you may use vary by country and by business size. In the US, most small businesses can choose; above a revenue threshold, accrual is required.
- Many small businesses run accrual books and use the cash method for tax, which gets the best of both. Ask an accountant before switching, because changing methods has tax consequences.
Suppose you finish a project in December and the client pays in January. Did you earn that money in December or January? Under cash accounting, January. Under accrual accounting, December. That one question, applied to every transaction, is the whole difference between the two methods, and it has consequences for how you understand your business, what you owe in tax and what a bank sees when it looks at your statements.
This comparison explains both methods, works through an example, lays out the rules on who can use which, and gives a practical way to decide.
How cash accounting works
Under the cash method, you record revenue when the money is received and expenses when they are paid. Your profit and loss statement is effectively a summary of your bank account, sorted into categories.
The appeal is simplicity. There are no receivables or payables to track, no accruals or prepayments, and the profit figure is close to the change in cash. For a sole proprietor with no inventory and customers who pay promptly, the cash method can be entirely adequate.
The weakness is timing. A business that invoices $30,000 in December and collects it in January shows a weak December and a strong January, even though all the work happened in December. Expenses behave the same way: an annual insurance premium paid in March makes March look terrible and the other eleven months look better than they are.
How accrual accounting works
Under the accrual method, you record revenue when it is earned, usually when you deliver the goods or complete the service and issue an invoice, and expenses when they are incurred, usually when you receive the goods or service, regardless of when money changes hands.
This requires a few extra accounts. Accounts receivable tracks what customers owe you. Accounts payable tracks what you owe suppliers. Prepaid expenses spread an up-front payment over the period it covers. Accrued expenses record costs you have incurred but not yet been billed for. Deferred revenue holds customer payments for work you have not yet done.
The result is a profit figure that matches revenue to the costs of earning it in the same period, which is the principle that generally accepted accounting standards, both US GAAP and IFRS, are built on. It is more work, but accounting software handles most of the mechanics once invoices and bills are entered promptly.
Common mistake
Running accrual books and then reading the profit figure as if it were cash. A $20,000 accrual profit can coexist with an empty bank account if customers have not paid. Accrual accounting answers "are we profitable?" It does not answer "can we make payroll?" For that you need a cash flow statement or a cash forecast alongside it.
A worked example: the same month, two answers
Imagine a small web design studio with the following activity in March.
- Completed and invoiced a $12,000 website on March 20. Client pays on April 15.
- Received $5,000 on March 3 for a project invoiced in February.
- Received a $4,000 deposit on March 28 for a project that starts in April.
- Paid $9,000 in salaries on March 31 for March work.
- Paid $3,600 on March 1 for a 12-month software license.
- Received a $1,500 contractor invoice dated March 29 for March work, paid April 10.
| Item | Cash method (March) | Accrual method (March) |
|---|---|---|
| $12,000 website, paid in April | $0 | $12,000 revenue |
| $5,000 received for February work | $5,000 revenue | $0 (recorded in February) |
| $4,000 deposit for April project | $4,000 revenue | $0 (deferred revenue, a liability) |
| Salaries | ($9,000) | ($9,000) |
| 12-month software license | ($3,600) | ($300), one month of twelve |
| Contractor invoice, paid in April | $0 | ($1,500) |
| March profit | ($3,600) loss | $1,200 profit |
Same business, same month, a $3,600 loss or a $1,200 profit depending on the method. Neither is wrong. The cash figure tells the owner that the bank balance fell by $3,600. The accrual figure tells the owner that March's work was modestly profitable once the timing of payments is stripped out. A studio that only looks at the cash figure might panic in March and overspend in April when the $12,000 arrives. A studio that only looks at accrual might not notice that it is about to run short of cash.
Who is allowed to use which method
This is where the rules depend on where you are and how big you are, and where you should check with a local accountant because thresholds change.
United States
For federal income tax, the IRS generally lets small businesses choose. Under rules introduced by the 2017 tax law, a business can use the cash method if its average annual gross receipts over the previous three years are below a threshold that was set at $25 million and is adjusted for inflation, so it is now somewhat higher. Businesses above that threshold must use accrual. Businesses that carry inventory were historically required to use accrual, but the same small business exception now allows many of them to use the cash method. C corporations and partnerships with C corporation partners face additional rules. IRS Publication 538 is the reference, and the threshold figure should be checked for the current year.
Other countries
Many countries offer a cash basis to the smallest businesses for tax while requiring accrual for larger ones or for companies. In the UK, for example, the cash basis has become the default for most self-employed people and partnerships, while limited companies must prepare accrual accounts. Australia allows businesses under a turnover threshold to account for GST on a cash basis. The specifics, and the thresholds, differ in every jurisdiction and are revised regularly.
Lenders, investors and buyers
Regardless of what tax law allows, anyone who seriously evaluates your business will want accrual-based statements, because they want to see profitability with timing removed. If you plan to raise money, borrow significantly or sell the business, you will need accrual books eventually.
Comparing the two methods
Cash accounting
- Simple to keep and easy to understand
- Profit tracks the bank balance closely
- Tax is paid on money actually received, which helps cash flow
- Some ability to manage taxable income by timing payments near year end
Accrual accounting
- Shows true profitability by period, which makes trends visible
- Tracks what you are owed and what you owe, which cash books ignore
- Required by accounting standards, larger-business tax rules and most lenders
- Needed for inventory businesses, subscriptions and long projects to make any sense
How to choose: a decision sequence
- Check what you are required to use. If your revenue, legal form or country rules mandate accrual, the decision is made. Confirm the current thresholds with an accountant.
- Look at the timing gap in your business. If customers pay at the point of sale and you have no inventory, cash accounting loses little. If you invoice on terms, hold stock, take deposits or run multi-month projects, the cash picture will mislead you every month.
- Ask who will read your statements. If you will seek a loan, an investor or a buyer within two years, start accrual books now so you have a history.
- Consider the hybrid. Many US small businesses keep accrual books for management purposes and file taxes on the cash method, which is permitted when the business qualifies. Accounting software can usually produce both views from the same data if invoices and bills are entered when they occur.
- Decide at the start of a tax year and stick with it. Changing methods later is allowed but, in the US, generally requires filing a change-of-method request with the IRS and making a catch-up adjustment. Other countries have their own procedures. It is not something to do casually.
Hypothetical example
Imagine a landscaping company that started with cash books because it was simple. In year three, it begins taking on commercial contracts invoiced monthly on 45-day terms and buys materials in bulk each spring. Cash-basis reports now show a huge loss in April, when materials are bought, and large profits in late summer when invoices are collected. The owner cannot tell which contracts are profitable. Switching to accrual books, with revenue recognized when each month's work is done and materials expensed as they are used, shows a steady margin of around 18% on commercial work and 30% on residential, information that was invisible before. The company keeps filing tax on the cash method, as it qualifies to do, so tax is still paid only on money received.
Pro tip
Whichever method you use for tax, enter invoices and bills into your accounting software on the date they are issued, not when they are paid. That single habit lets the software produce both a cash view and an accrual view, and it gives you receivables and payables reports that cash-only bookkeeping cannot.
What changes in practice when you move to accrual
- You enter invoices and bills promptly, because the date matters.
- You reconcile receivables and payables monthly, not just the bank.
- You record month-end adjustments: prepaid expenses spread over their period, accrued costs for work received but not yet billed, deferred revenue for deposits.
- You read the cash flow statement alongside the profit and loss statement, because profit no longer equals cash.
- Your bookkeeping takes a little longer, typically an extra hour or two a month for a small business using software.
Software and cost
Most mainstream accounting software, including QuickBooks Online, Xero, FreshBooks and Wave, supports both methods and can switch the report view with a setting, as long as transactions have been entered with their proper dates. You do not need different software for accrual. What you need is the discipline to enter invoices and bills when they occur. Pricing and features change frequently, so check the current plans, and if your country has local tax filing requirements, confirm that the software supports them.
Your accounting method checklist
- Confirm with an accountant which methods your country and business size allow for tax
- List the timing gaps in your business: invoice terms, inventory, deposits, long projects, annual bills
- Decide whether lenders, investors or a buyer will need accrual statements within two years
- Choose the method for tax and the method for management reporting; they can differ where permitted
- Set your accounting software's reporting basis and confirm it produces both views
- Enter every invoice and bill on its issue date from now on
- Add month-end adjustments to your bookkeeping routine if using accrual
- Review the choice before each tax year, and get advice before changing
Frequently asked questions
Can I use cash accounting if I have inventory?
In the US, the small business exception now allows many businesses with inventory to use the cash method, treating inventory as non-incidental materials and supplies or following their book method. The rules are detailed and have changed in recent years, so check with an accountant. In other countries, inventory businesses are often required to use accrual.
Does the cash method mean I pay less tax?
Not less, but possibly later. Under cash accounting, income is taxed when received, so unpaid December invoices are taxed in the following year. Over the life of the business the total is similar; the timing differs. In a growing business the cash method tends to defer tax, which helps cash flow.
Is modified cash accounting a real option?
Some small businesses use a hybrid that records most items on a cash basis but tracks a few, such as inventory or fixed assets, on an accrual basis. It is common in practice but is not a recognized standard, and tax authorities have rules about mixing methods. Ask an accountant before relying on it.
Which method do accountants recommend?
For anything beyond a very simple service business, most accountants recommend accrual books for management because they show real profitability, with tax filed on whatever basis is most advantageous and permitted. The exception is the smallest businesses, where the extra work of accrual outweighs the insight.
Related reading
The bottom line
Cash accounting tracks the bank. Accrual accounting tracks the business. If customers pay immediately and you hold no stock, cash may be all you need. If you invoice on terms, carry inventory, take deposits or plan to borrow or raise money, keep accrual books, and file tax on whichever method the rules allow and your accountant advises. Enter every invoice and bill on the day it happens, and the software will give you both views from the same data.
