Accounting Methods: Cash or Accrual ?
- Amazinggracebookkeeping
- Apr 23
- 3 min read
When starting a business it may be tricky to choose between the cash basis or the accrual basis of accounting. Both of these methods will help guide you when it comes to tracking your income and expenses so it's important to know about each method and how they work.
So, in this bookkeeping post we are going to discuss the cash and accrual accounting methods since they are the most commonly used and will be a big part of when you are recording your transactions.
Let's begin shall we.
What is the Cash Method?
Let's look at a definition from the IRS to identify what the cash method is.
IRS definition:
According to the IRS, “Under the cash method, you include in your gross income all items of income you actually or constructively received during the tax year.” and “[. . . ] Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them. (IRS Pub 538)
One can see that the cash method is a very simple approach. If you receive the income meaning it hits your bank or you have access to it, you report it as income for that year. The same is true for expenses, when you pay someone (when the check has cleared or hits the bank) you report that expense in the year it was cleared. This method may work best for small businesses because of its simple approach. However, let’s look at the accrual method.
What is the Accrual Method?
Moving on to the accrual method let’s look at the IRS’s definition.
IRS definition:
According to the IRS, “Under an accrual method of accounting, you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred.” (IRS Pub 538)
So what this means for income is, if you invoice someone and even though they have not paid you, you still get to report that as income because you did the work or earned it. The same is true for expenses. For example, if you get a bill and did not pay it but you report it as an expense because you incurred it. This is where the accounts receivable and accounts payables come into the picture. It allows a business to match their income and the corresponding expenses on the day it is earned or incurred rather than waiting when it is received or paid.
It is also recommended that if your business heavily tracks inventory then you would want to use the accrual method. The accrual method is a bit more complex but may give you a clearer picture of what's actually going on in your business.
Which Method Should You Use?
It depends.
Some businesses are required to use the accrual basis method if they follow GAAP (Generally Accepted Accounting Principles).
For example, “Publicly traded companies, businesses operating in regulated industries, registered nonprofit groups, government agencies, and organizations that receive federal funding awards from the U.S. government are required to follow GAAP. Other businesses may also adopt the standards on a voluntary basis.” (https://www.accounting.com/resources/gaap).
So with that being said, if you meet any one the following requirements mentioned then you would have to use the accrual method.
Regarding the cash basis the IRS allows more small businesses to use the cash basis method. For instance, it states on IRS.gov, “The TCJA allows small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period to use the cash method of accounting.(IRS.gov)
So, if you make less than $25 million (for the prior three-years), and most of us likely do, you can choose either method according to the IRS. As long as you don’t fall into one of the categories from GAAP. Although, these numbers may change as rules and laws get updated so be aware and check back with the IRS and always consult with your tax professional.
Overall, if you desire the more simple approach then the cash method is for you but if you desire the method that tells a broader story but more complex then the accrual method is for you. It just depends on your circumstances.
*The important thing is to pick one and stay consistent with it from year to year. If you decide to change methods you will have to get approval from the IRS using form 3115.
With that, I hope this post helps you understand the cash and accrual methods when comes to your bookkeeping practices.
** DISCLAIMER : Always check with your tax professional. This blog is not intended to give you any tax or legal advice.
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