Choosing between cash vs. accrual accounting can affect how you track income and expenses, understand your finances, and prepare for taxes. While cash accounting offers simplicity, accrual accounting provides a more detailed picture of your business’s financial activity. Here, we’ll explain the differences between these small business accounting methods and how to choose the right approach for your needs.
Quick Overview: Cash vs. Accrual Accounting
- Cash basis accounting records income when payment is received and generally records expenses when they’re paid, making it simpler for businesses with straightforward transactions.
- Accrual accounting records revenue when it’s earned and expenses when they’re incurred, providing a fuller picture of profitability and outstanding obligations.
- Profit doesn’t always mean available cash, so businesses using either method should monitor cash flow, unpaid invoices, and upcoming bills.
- Your accounting method affects tax timing, but neither approach automatically guarantees a lower tax bill.
- The best method depends on your business, including customer payment habits, inventory, reporting requirements, and growth plans.
- An accountant can confirm tax eligibility and help you choose a method that supports accurate records and informed financial decisions.
What Is Cash Basis Accounting?
Cash basis accounting is a method of accounting that records income when your business receives payment and expenses when it pays them. Instead of recording revenue when you send an invoice or an expense when the bill arrives, you record the transaction when the payment actually occurs. It applies to payments made by cash, check, credit card, and electronic transfer.
Since cash basis accounting focuses on payments received and made, unpaid customer invoices and outstanding bills aren’t recorded as accounts receivable or accounts payable in your cash basis financial reports. You’ll still need to track them separately to know what customers owe you and which payments are coming due.
Example of Cash Basis Accounting
Let’s say you complete a $2,000 project and invoice your customer in December, but they don’t pay until January. Under cash basis accounting, you record the $2,000 as income in January, when you receive the payment.
Similarly, if you receive a $500 supplier bill in December but pay it in January, you generally record that expense in January. Even though both transactions relate to work performed in December, they appear in January’s cash basis reports because that’s when the payments occur.
What Is Accrual Basis Accounting?
Accrual basis accounting is an accounting method that records revenue when it’s earned and expenses when they’re incurred, regardless of when payment occurs. This means your business can record income before a customer pays an invoice and an expense before you pay the related bill.
To keep track of these transactions, accrual accounting uses accounts receivable for money customers owe your business and accounts payable for money your business owes suppliers or other vendors. It also helps match revenue with related expenses in the appropriate reporting period, giving you a clearer picture of how your business performed during that time.
However, with the accrual method, the recorded income doesn’t necessarily mean the money is available in your bank account. You’ll still need to monitor cash flow to make sure you can cover upcoming payments.
Example of Accrual Basis Accounting
Suppose you complete a $2,000 project and invoice your customer in December, but they don’t pay until January. Under accrual basis accounting, you record the revenue in December, when you earned it, and track the unpaid invoice in accounts receivable. When the customer pays in January, you clear the receivable rather than record the revenue again.
Similarly, if a supplier provides $500 worth of services for that project in December and you pay the bill in January, you record the expense and an account payable in December. This places the project’s revenue and related expenses in the same month, even though the payments happen later.
Cash vs. Accrual Accounting: A Quick Comparison
Simply put, cash basis accounting records revenue and expenses when business owners have the cash in hand, and the accrual method of accounting records revenue and expenses when revenue is earned, or expenses are incurred. To see the key differences between these small business bookkeeping methods, consider the following table.
| Feature | Cash Basis Accounting | Accrual Basis Accounting |
| When Revenue Is Recorded | When payment is received. | When revenue is earned, regardless of when payment is received. |
| When Expenses Are Recorded | Generally when payment is made. | When expenses are incurred, regardless of when payment is made. |
| Unpaid Customer Invoices | Tracked separately from cash basis financial reports. | Recorded as accounts receivable. |
| Outstanding Bills | Tracked separately from cash basis financial reports. | Recorded as accounts payable. |
| Bookkeeping Complexity | Generally simpler, with fewer adjustments. | Requires more detailed tracking and period-end adjustments. |
| Cash Flow Visibility | Reflects payments received and made, but doesn’t show upcoming obligations on its own. | Requires separate cash flow monitoring because recorded revenue may still be unpaid. |
| Profitability Visibility | Payment timing can make profitability fluctuate between periods. | Provides a clearer view of revenue and related expenses for each period. |
| Potential Business Fit | Businesses with straightforward transactions and customers who pay promptly. | Businesses with substantial credit sales, more complex operations, or detailed reporting needs. |
How Does Your Accounting Method Affect Business Taxes?
Your accounting method determines when you report income and expenses for tax purposes, which can affect your taxable income for a particular tax year. The main difference is timing: a payment received or an expense paid near year-end may fall into different tax years depending on whether you use the cash method or an accrual method. For example:
- Under the cash method of accounting, you report income when you actually receive it, or it becomes available to you without substantial restrictions, and generally deduct eligible expenses when you pay them
- If you use accrual accounting, you generally report income when your right to receive it is established, and the amount can be reasonably determined, even if the customer hasn’t paid
- Accrual expense deductions generally require an established liability, a reasonably determinable amount, and economic performance, meaning the relevant goods or services have been provided, or other applicable conditions met
For example, a project completed in December but paid in January will generally count toward January’s tax year under cash accounting and December’s tax year under accrual accounting. Neither method automatically produces a lower tax bill, but moving income or deductions between years can have different consequences depending on your circumstances.
How to Choose the Best Accounting Method for Your Small Business
Cash and accrual accounting offer different ways to record business transactions, but they aren’t both compliant with generally accepted accounting principles (GAAP), which require accrual accounting. Your choice doesn’t change the underlying sales you make or costs you incur, but it affects when those transactions appear in financial reports and how income and expenses are reported for taxes. Consider the following factors when choosing a method.
Consider How Customers Pay You
Using the cash basis is simpler because it focuses on recording revenue and expenses when payments occur. If you have a small business with straightforward transactions and customers who pay immediately, cash accounting may be a practical option.
However, if customers typically pay invoices several weeks or months later, accrual accounting can provide a clearer picture of the work completed during each reporting period. For example, a busy month with several unpaid invoices may show little income under cash accounting, even though you’ve earned substantial revenue. Accrual accounting records that revenue when it’s earned, while tracking the amounts customers still owe.
Look at Your Inventory and Business Expenses
If your business purchases inventory, pays suppliers on credit, or incurs costs well before receiving customer payments, consider how those transactions affect your reports. Accrual accounting can help match revenue with related expenses, making it easier to assess whether your sales are profitable.
Cash accounting may work well when expenses are straightforward, and payments occur close to the time of sale. However, large purchases or delayed payments can cause reported profits to fluctuate between periods. Businesses with inventory should also review the applicable tax rules with an accountant, since inventory can affect both method eligibility and when costs are deductible.
Evaluate Your Financial Reporting Needs
Think about how you use your financial reports. If you mainly need to review payments received and expenses paid, cash basis reports may meet your needs, provided you separately track outstanding invoices and upcoming bills.
If you need to evaluate profitability, prepare detailed budgets, or understand outstanding obligations, accrual reporting may be more useful. Lenders and investors may also request accrual financial statements or reports prepared under GAAP, so check their requirements before choosing your approach. With either method, monitor available cash separately to ensure you can cover payroll, supplier payments, and other commitments.
Think About Your Growth Plans
Your accounting needs may change as your business grows. More credit sales, longer projects, additional suppliers, and larger expenses can make cash basis reports less useful for evaluating business performance.
Consider whether the method you choose will support the decisions you expect to make over the next few years. A simple operation may benefit from cash accounting initially, while an expanding business may need the more detailed information accrual accounting provides. Accounting software and bookkeeping support can help manage that complexity.
Review Tax Requirements With an Accountant
According to the Internal Revenue Code (IRC), some companies may be required to use the accrual basis of accounting to determine tax liabilities if their gross receipts surpass $5 million. There are also proposals that have been put forward to revise the circumstances under which companies are able to use the cash basis of accounting. While you can find more information here, it’s best to work with a professional tax advisor when comparing cash vs. accrual accounting if your small business has high or complicated revenue streams.
Get Help Choosing the Right Accounting Method
There are pros and cons of cash and accrual methods, but what’s the right one for your business? The team at Del Real Tax can help you evaluate cash vs. accrual accounting and choose an approach that fits your small business’s operations, reporting needs, and tax requirements. Contact us today to discuss your accounting needs and make more informed financial decisions.
