Cash or accrual is one of the first accounting decisions a business makes, often without realizing it. It affects when income is taxed, how profitable you look, and what lenders see. It is also easier to choose well than to change later.
The two methods in plain terms
The IRS explains in Publication 538 that under the cash method, income is reported in the year it is actually or constructively received, and expenses are generally deducted in the year they are paid. Under the accrual method, income is reported in the year it is earned, whether or not payment has arrived, and expenses are deducted or capitalized in the year they are incurred, once the all-events test is met and economic performance has occurred.
A quick example
A consultant finishes a project and sends a $10,000 invoice on December 20, and the client pays on January 10. On the cash method, the income belongs to the following year. On the accrual method, it belongs to the year the work was done. The reverse applies to expenses: a bill received in December and paid in January is a December expense on the accrual method and a January expense on the cash method. Timing shifts, but over the life of the business, total income is the same.
Who can use the cash method for taxes
- The IRS says most individuals and many small businesses can use the cash method.
- Regular C corporations, and partnerships with a corporate partner, generally cannot unless they pass the gross receipts test.
- The gross receipts test looks at average annual gross receipts for the three prior tax years, against an inflation-indexed amount. Publication 538, in its January 2022 revision, gave $26 million. The amount is adjusted, so check the current figure.
- Affiliated or controlled groups must aggregate receipts.
- Qualified personal service corporations that meet function and ownership tests may use cash as well, and farming has special rules.
Inventory changes things
The IRS says that if inventory is needed to clearly show income, purchases and sales generally must be accounted for under an accrual method. Small business taxpayers that meet the gross receipts test may treat inventory as nonincidental materials and supplies or follow their financial statement or books treatment. Accepted inventory cost methods include specific identification, FIFO, and LIFO. Product businesses should discuss this with their preparer, because it affects both method and cost of goods sold. See ecommerce accounting services.
Pros and cons
- Cash method pros: simple, matches cash in the bank, and defers tax on income not yet collected.
- Cash method cons: can distort profit by timing, which hides performance and complicates job-based or multi-period work.
- Accrual method pros: better matching of revenue and costs, a clearer picture of performance, and what lenders and investors usually expect.
- Accrual method cons: you can owe tax on income not yet collected, and the bookkeeping is more complex.
Books vs tax: they can differ
Many businesses keep management books on an accrual basis for decision-making and file taxes on the cash basis, with an adjustment. This is common and legitimate when done carefully, but it requires clear reconciliation between the two. Your bookkeeper and preparer need to agree on the approach. See QuickBooks bookkeeping services.
Consistency and changing methods
- You choose a method when you file your first return.
- You must use the same method from year to year.
- Changing generally requires IRS approval, requested on Form 3115.
- A corporation or partnership that no longer meets the gross receipts test must switch to accrual, effective for the year it fails the test.
- If your method does not clearly reflect income, the IRS can recompute your income using one that does.
Which is better for you?
- 1Do you sell products from inventory? Accrual-style inventory accounting may be required or advisable.
- 2Do you bill on credit, so the gap between billing and payment is large? Accrual shows performance more clearly.
- 3Do lenders, investors, or buyers require accrual statements?
- 4Are you eligible to use the cash method for taxes, and does it fit your cash flow?
- 5How much complexity can you handle?
Related issues
Method also affects whether you can deduct unpaid customer invoices as bad debts. See accounts receivable services. For year-end timing decisions that depend on your method, see small business year-end tax planning.
A method change usually requires IRS consent and can create a one-time adjustment to income. Talk to your tax preparer before switching, even if your books already run on the other method.
Our bookkeeping service and tax planning service can help you choose and implement the right method. To discuss your bookkeeping needs, tell us your industry, whether you carry inventory, and who needs to see your financial statements.
