Cash vs accrual accounting comes down to timing. Cash basis records income when money arrives and expenses when money leaves. Accrual basis records revenue when you earn it and expenses when you incur them, whether or not cash has moved. Most small businesses start on cash; any business that invoices on terms, holds inventory or wants financing usually needs accrual.
What is the difference between cash and accrual accounting?
Under cash basis accounting, a sale exists when the customer pays and a cost exists when you pay it. The books track the bank account. It is simple, it needs no receivables or payables ledgers, and it never shows profit you have not collected.
Under accrual basis accounting, a sale exists when you deliver the work or goods, and a cost exists when you receive the benefit. Invoices create accounts receivable, bills create accounts payable, an annual subscription becomes a prepaid asset released monthly, and a customer deposit becomes deferred revenue until you earn it. Costs you have used but not yet been billed for become an accrued expense.
The difference is not which numbers you record but when. Over the life of a business both methods report the same total profit. Month to month they can disagree by a lot, and that gap is the whole argument.
Cash basis also produces a thin balance sheet: cash, perhaps a loan, perhaps some equipment. Accrual adds receivables, payables, prepaid expenses, deferred revenue and accrued liabilities, which is why lenders ask for it. Those extra accounts are also where the reconciliation work lives, so accrual bookkeeping takes more time each month and needs a proper close routine.
How does the same month look under each method?
Take a small design agency. In March it invoices a client $12,000 on March 20 with 30-day terms, and the client pays on April 15. It pays a contractor $4,000 on March 5 for work done in February. It pays a $6,000 annual software subscription on March 1. It receives a $3,000 deposit on March 28 for a project it delivers in April. Rent is $2,000, paid on the first of each month.
| Item | Cash basis, March | Accrual basis, March |
|---|---|---|
| Client invoice, $12,000, paid April 15 | $0 | $12,000 revenue |
| Customer deposit, $3,000, work done in April | $3,000 income | $0 (deferred revenue) |
| Contractor, $4,000, February work paid March 5 | $4,000 expense | $0 (accrued in February) |
| Software subscription, $6,000 for 12 months | $6,000 expense | $500 expense ($5,500 prepaid) |
| Rent, $2,000 | $2,000 expense | $2,000 expense |
| March result | $9,000 loss | $9,500 profit |
The cash basis says March lost $9,000. The accrual basis says March made $9,500. April flips the other way: cash shows $12,000 collected against $2,000 rent for a $10,000 profit, while accrual shows $3,000 earned against $2,500 of costs for $500. Neither is wrong. Cash tells you what happened to the bank balance; accrual tells you whether the business made money doing the work it did that month.
Over the two months the totals converge, and over a year they meet. The problem is that owners make hiring, pricing and spending decisions monthly, not yearly, and a March that looks like a $9,000 loss leads to different decisions than a March that made $9,500.
Who is allowed to use the cash method?
For US federal tax, the rules sit in IRS Publication 538. Sole proprietors, partnerships without a C corporation partner and S corporations can generally use the cash method. C corporations and partnerships with a C corporation partner can use it only if they meet the gross receipts test in Internal Revenue Code section 448(c), and a tax shelter cannot use it at all (IRS, 2026).
That test is indexed for inflation each year. It began at $25 million under the 2017 tax law and, for tax years beginning in 2026, is met when average annual gross receipts for the prior three tax years do not exceed $32 million (IRS Rev. Proc. 2025-32, 2025). A business that meets the same test can also account for inventory as non-incidental materials and supplies or follow its book method instead of a full inventory method (IRS, 2026).
Outside the US the rules differ. In the UK, the cash basis is the standard method for sole traders and partnerships without corporate partners, while companies use accruals (GOV.UK, 2026). In Canada, business income must generally be reported on the accrual method; farmers, fishers and self-employed commission agents may use cash (CRA, 2026). In Australia, a business with aggregated turnover under $10 million can account for GST on a cash basis (ATO, 2026). None of these rules stop you from keeping accrual books for management.
When does cash basis stop working?
Cash basis breaks the moment the gap between doing the work and getting paid becomes large or uneven. Signs that a business has outgrown it:
- You invoice on terms, so revenue arrives a month or more after the work and the profit and loss swings with collections.
- You hold inventory, and a big stock purchase makes a good month look like a loss.
- You take deposits, retainers or annual subscriptions, so cash arrives before the work.
- You have payroll, loans or large annual bills that land in one month.
- A lender, investor, buyer or grant funder asks for statements that follow generally accepted accounting principles, which require accrual.
- You run more than one entity and need to match intercompany charges.
Two or more signs usually mean the management reports are already misleading, whatever the tax method says.
Can you keep accrual books and file taxes on cash?
Yes, and many small businesses do exactly that. The bookkeeper keeps accrual records so the owner sees real margins, and the tax preparer converts to cash at year-end by removing accounts receivable, accounts payable, prepaid expenses and deferred revenue. QuickBooks Online and Xero can both show a profit and loss on either basis from the same file, which makes the conversion a report setting rather than a second set of books.
The reverse also works but is rarer. Which method your return uses is a decision for your tax preparer; our role is preparation support for the books and schedules they need, and your accountant reviews and signs.
How do you switch from cash to accrual?
For the books, the switch is a project with a date. Pick a cutoff, usually the first day of a fiscal year or quarter. Build opening balances for receivables, payables, prepaid expenses, accrued expenses and deferred revenue as of that date. Set up the ledgers and recurring journals, then close the first month with a reviewer checking every new balance sheet account. Expect that first close to take longer than later ones while the opening balances are proved against invoices, bills and contracts.
For US tax, changing the method used on your return generally requires IRS Form 3115, Application for Change in Accounting Method, and many common changes qualify for automatic consent (IRS, 2026). Your preparer files it. A halfway option is modified cash, which records cash transactions but tracks large items such as loans, equipment and inventory on an accrual footing.
Which one does your business need?
Choose cash if you are a sole proprietor or very small service business, get paid at the point of sale, carry no inventory and do not need statements for a lender. Choose accrual if you invoice on terms, hold stock, bill in advance, run payroll, have investors or are preparing to sell. If you are unsure, keep accrual books and let the tax preparer choose the tax method.
Our bookkeeping service runs either basis inside your own QuickBooks Online, Xero or Zoho Books file, with a named accountant, a backup and a team lead who reviews every month-end close. Pricing depends on volume and scope, so we send a custom quote within 1 business day.
Sources
- IRS, Publication 538, Accounting periods and methods: irs.gov
- IRS, Rev. Proc. 2025-32, 2026 inflation adjustments: irs.gov
- IRS, About Form 3115: irs.gov
- GOV.UK, Cash basis: gov.uk
- Canada Revenue Agency, Accounting methods: canada.ca
- Australian Taxation Office, Choosing an accounting method for GST: ato.gov.au
Frequently asked questions
What is the difference between cash and accrual accounting?
Cash basis records income when money is received and expenses when money is paid. Accrual basis records revenue when it is earned and expenses when they are incurred, regardless of when cash moves. Accrual adds accounts receivable, accounts payable, prepaid expenses, accrued expenses and deferred revenue to the books. Both methods report the same lifetime profit; they differ in which month each sale and cost lands, which is why monthly reports can look so different.
Who can use the cash method for US taxes?
Sole proprietors, S corporations and partnerships without a C corporation partner can generally use the cash method. C corporations and partnerships with a C corporation partner must meet the section 448(c) gross receipts test, which for tax years beginning in 2026 is average annual gross receipts of $32 million or less over the prior three years (IRS Rev. Proc. 2025-32, 2025). Tax shelters cannot use the cash method. IRS Publication 538 sets out the detail.
Which is better for a small business, cash or accrual?
Cash is better for a very small business that is paid at the point of sale, carries no inventory and needs no financing, because it is simpler and tracks the bank balance. Accrual is better as soon as you invoice on terms, hold stock, take deposits, run payroll or need statements for a lender or investor, because it shows whether each month's work was profitable. Many small businesses keep accrual books and file on cash.
Can I keep accrual books and file taxes on a cash basis?
Yes. Your bookkeeper keeps accrual records for management reporting, and your tax preparer converts to cash at year-end by removing receivables, payables, prepaid expenses and deferred revenue. QuickBooks Online and Xero can display a profit and loss on either basis from the same file. The tax method is your preparer's decision; we provide preparation support and your accountant reviews and signs.
How do I switch from cash to accrual accounting?
Pick a cutoff date, usually the start of a fiscal year or quarter, and build opening balances for accounts receivable, accounts payable, prepaid expenses, accrued expenses and deferred revenue as of that date. Set up recurring journals and close the first month with a second person reviewing each new balance sheet account. If your tax return method changes too, your preparer files IRS Form 3115, and many common changes qualify for automatic consent (IRS, 2026).
Do lenders and investors require accrual accounting?
Usually, yes. Statements prepared under generally accepted accounting principles use the accrual basis, and most banks, investors and buyers ask for GAAP-style statements or at least an accrual profit and loss with a balance sheet that shows receivables, payables and deferred revenue. Small loans and some grant programs accept cash-basis reports. If financing is likely in the next two years, moving to accrual books early avoids a rushed conversion.
Sources
- IRS, Publication 538, Accounting periods and methods
- IRS, Rev. Proc. 2025-32, 2026 inflation adjustments (section 4.30, limitation on use of cash method)
- IRS, About Form 3115, Application for Change in Accounting Method
- GOV.UK, Cash basis accounting for sole traders and partnerships
- Canada Revenue Agency, Accounting methods for business income
- Australian Taxation Office, Choosing an accounting method for GST
