Cash or accrual accounting: which method tells the truth about your business

The difference in one paragraph

Cash accounting records income when you receive the money and expenses when you pay them; accrual accounting records income when you earn it and expenses when you incur them, regardless of when cash changes hands. Most very small businesses with simple finances can use the cash method for taxes, and it is easier to keep. Accrual gives a truer monthly picture once you send invoices, carry bills you pay later, hold inventory or need statements for a lender, and some businesses are required to use it.

I have this conversation with owners every week, usually right after a month that looked great on paper and felt terrible in the bank, or the other way around. The method you use decides which of those two stories your books tell. Neither is wrong. They answer different questions, and knowing which question you are asking is most of the decision.

What follows is general information, not tax advice for your company. The method you use on your tax return is a decision to make with your tax preparer.

How the same month looks under each method

Picture a remodeling contractor who finishes a large job in March and invoices the customer, who pays in April. In the same March, the contractor buys materials for an April job on a supplier account that is due in May.

On the cash method, March shows the materials only if they were paid in March, and none of the income from the finished job. March looks like a loss, and April looks like a windfall. On the accrual method, the income from the finished job lands in March, when the work was done, and the materials land in the month they were received. Each month shows the work that actually happened in it.

That is the core tradeoff. Cash tells you what came in and went out. Accrual tells you whether the work you did that month made money. A business owner managing payroll and supplier bills needs the first answer every week. A business owner setting prices or deciding whether to take on more of a certain kind of work needs the second.

• Cash method: income when received, expenses when paid
• Accrual method: income when earned, expenses when incurred
• Cash shows liquidity; accrual shows profitability by period
• Accrual requires tracking receivables and payables

What the IRS says about who may use each

IRS Publication 538 lays out the rules. It explains that under the cash method you generally report income in the year you receive it and deduct expenses when you pay them, and that under the accrual method you report income when earned and deduct expenses when incurred.

The publication also limits the cash method for certain taxpayers: C corporations, partnerships that have a C corporation as a partner, and tax shelters, with exceptions for those that pass a gross receipts test based on average annual gross receipts over the three prior tax years. That threshold is indexed for inflation from a $26 million base. In practice, most small businesses fall well under it, which means they usually have a real choice.

Two more details from Publication 538 matter. Income counts as received under the cash method when it is credited to your account or made available to you without restriction, so you cannot hold a check until January to push income into next year. And if you run separate and distinct businesses with complete, separate books, you may use a different method for each.

When cash accounting is the sensible choice

The cash method fits a business where money and work move together. If customers pay at the time of service, you pay most bills right away, and there is little or no inventory, the gap between cash and accrual is small and the simpler method costs you very little insight.

It also has a practical tax advantage for some businesses. Because income is recorded when received, a business that invoices in December and collects in January reports that income in the year it arrives. That timing can help with planning, though your tax preparer should confirm what is allowed for your situation.

• Customers pay at the time of service
• Bills are paid promptly rather than carried
• Little or no inventory
• Owner-run business with simple finances
• No lender or investor asking for accrual-basis statements

When accrual gives the clearer picture

Accrual becomes more useful the more time passes between doing the work and getting paid. Professional practices that bill after the fact, contractors with progress billing, wholesalers who sell on terms, and any business with significant accounts receivable or payable will see a distorted monthly profit on the cash method.

It also matters when someone else reads your statements. A lender reviewing a line of credit wants to see what customers owe you and what you owe suppliers; a Dallas commercial banker's guide on when a line of credit beats a loan explains why banks look closely at those numbers. And if you want to know which jobs or products actually make money, accrual is the only method that matches revenue to the costs that produced it, which is the foundation of job costing that shows which jobs pay.

You can look at both views

Here is the part many owners do not realize. Your tax method and the way you look at your books for management are related but not identical decisions. QuickBooks can show most reports on either a cash or an accrual basis, as long as invoices and bills are entered rather than just recording deposits and payments.

In practice, many of our clients enter invoices and bills so the books carry receivables and payables, read their monthly profit and loss on an accrual basis to judge performance, and look at cash reports to manage the bank balance. The tax return is then prepared on the method the business has adopted for tax purposes. The key is entering transactions in a way that supports both views; recording only deposits and payments locks you into cash.

What changes when you carry inventory

Inventory used to push many small businesses toward accrual automatically. Publication 538 now says that qualifying small business taxpayers, those that meet the gross receipts test and are not tax shelters, can choose not to keep an inventory for tax purposes, but they still have to use a method that clearly reflects income. That gives retailers, restaurants and product companies more flexibility than they once had, and it is worth discussing with your tax preparer.

For management, though, inventory is where cash accounting misleads most. Buy a large order of stock in one month and the cash view shows a heavy loss, followed by months that look unusually profitable as you sell it. If you want to know your real margin on what you sell, track inventory and cost of goods sold in the books even if the tax return uses a simpler approach. The extra entries are modest, and they tell you whether your prices actually cover your costs.

Switching methods without making a mess

Changing your method of accounting for tax purposes is not something you simply start doing in January. Publication 538 explains that changing an accounting method generally requires IRS approval, typically by filing Form 3115. Your tax preparer will handle that filing and the adjustment that keeps income from being counted twice or skipped during the transition.

On the bookkeeping side, moving to accrual means building accurate opening balances for receivables and payables: every unpaid invoice and every unpaid bill as of the switch date. If your books are behind or unreliable, fix that first. Switching methods on top of messy books just creates a more complicated mess.

• Talk to your tax preparer before the tax year in which you want to switch
• List every unpaid customer invoice and supplier bill as of the switch date
• Enter invoices and bills going forward instead of only deposits and payments
• Reconcile receivables and payables monthly once the switch is made

Mistakes I see with both methods

On the cash side, the classic mistake is reading the profit and loss as if it showed profitability. An owner sees a strong month, spends accordingly, and is surprised when the following month is thin because the strong month was really last quarter's collections. On the accrual side, the mistake is entering invoices and never applying the customer payments to them, which inflates receivables and can double-count income.

A mixed approach causes the worst problems: some invoices entered, some not, some bills tracked, others paid straight from the bank. The reports end up on neither basis. Pick an approach, enter transactions consistently, and reconcile every month. My guide to what happens during a monthly close covers the routine that keeps either method honest. Sales tax has its own timing rules, separate from your income tax method, which I cover in tracking Texas sales tax in your books.

Deciding with real numbers

The right answer depends on how you bill, how you pay, whether you carry inventory, and who reads your statements. If you are not sure, a short conversation usually settles it. In our free 30-minute consultation we look at how money actually moves through your business and recommend how to set up the books so you see both the cash and the profit clearly.

We keep books in QuickBooks for businesses across the Dallas–Fort Worth area from offices in Plano, Garland and Flower Mound, and our bookkeepers work alongside our tax preparers, so the method used in the books and the method used on the return are decided together rather than discovered at year-end.

Questions people ask me