Handbook / Bookkeeping and cash

Cash vs accrual accounting for a small business, in plain terms

Every business records income and expenses using an accounting method, whether it has chosen one deliberately or not. The two common methods, cash and accrual, differ in a single question: when does a transaction count? The answer affects which tax year income falls into, how your monthly numbers look, and what you need to track. This guide explains both in plain terms, using IRS definitions.

The cash method

Under the cash method, as the Schedule C instructions describe it, you report income in the year it is actually or constructively received, in cash, property or services, and deduct expenses in the year you pay them.

IRS Publication 538 says most individuals and many small businesses use the cash method. It matches what happens in your bank account, which makes it intuitive and easy to keep.

Constructive receipt. You cannot delay income simply by not collecting it. Publication 538 says income is constructively received when it is credited to your account or made available to you without restriction, even if you do not have it in hand. A check that is available to you in December counts as December income.

Prepaid expenses. You also cannot pull future expenses into the current year just by paying early. Publication 538 says an expense paid in advance is generally deductible only in the year it applies to, unless it qualifies for the 12-month rule, which covers certain benefits that do not extend beyond the earlier of 12 months after they begin or the end of the tax year after the year of payment.

The accrual method

Under an accrual method, Publication 538 says you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred, with the goal of matching income and expenses in the correct year. Income is included when all events have occurred that fix your right to receive it and the amount can be determined with reasonable accuracy.

So an invoice issued in December for work completed in December is December income under accrual, even if the client pays in February.

A side-by-side example

A designer finishes a project on December 15 and sends a $3,000 invoice with net 30 terms. The client pays on January 12. On December 20 she buys software for next year, paying $400, and in December she receives a $500 bill for printing that she pays in January.

• Cash method: the $3,000 is income in January; the $500 printing counts in January, when paid; the $400 prepaid software falls under the prepaid-expense rules above.
• Accrual method: the $3,000 is income in December; the $500 printing is an expense in December, when incurred; the software still follows the rules for amounts that benefit a later year.

Same business, same year, different numbers.

Which methods are allowed

The Schedule C instructions say you can generally use the cash method, an accrual method or any other permitted method, as long as it clearly reflects income. They also say that unless you are a small business taxpayer, you must use an accrual method for sales and purchases of inventory items. If you sell products, read the instructions' inventory section or ask a tax professional.

Some businesses use a combination of methods, which Publication 538 also discusses.

Pros and cons

SBA's guidance on managing finances sums up the trade-off: accrual creates an immediate snapshot but is more complex to manage, while cash shows cash flow clearly and is easier to understand but limits predictive value.

For a one-person service business:

• Cash is usually simpler and matches the bank.
• Accrual can give a truer picture of how profitable a period was, especially with long payment terms or large bills.

Use both views

Many small businesses report taxes on the cash method and still track invoices outstanding. A simple list of unpaid invoices with amounts and due dates gives you the accrual-style view of what you are owed without changing your tax method. It is also essential for chasing late payments.

Choosing and changing

You choose your method when you file your first return for the business; it appears on Schedule C, line F. After that, changing generally requires IRS consent, usually by filing Form 3115. Publication 538 explains the process. Do not switch casually, and ask a tax professional first.

Cash counts money when it moves; accrual counts it when it is earned or owed. Most solo service businesses start with cash and keep a list of open invoices beside it.