Introduction
Businesses must choose between cash basis accounting and accrual accounting for financial reporting. The IRS allows small businesses with annual revenue under $27 million (as of 2025) to use cash basis accounting, while larger businesses must follow accrual accounting per IRC § 446.
This guide explains the key differences between cash and accrual accounting, their advantages and disadvantages, and how to choose the right method for your business.
What Is Cash Basis Accounting?
Cash basis accounting records transactions when cash is received or paid. It is a simpler method commonly used by small businesses and freelancers.
How Cash Basis Works
- Revenue is recorded when money is received.
- Expenses are recorded when payments are made.
Example of Cash Basis Accounting
- A business invoices a client for $5,000 in December 2025 but receives payment in January 2026.
- The revenue is recorded in 2026, when the cash is received.
Pros of Cash Basis Accounting
- Easy to track cash flow since transactions match bank activity.
- Simpler tax filing because income is only taxed when received.
- Better for small businesses with fewer transactions.
Cons of Cash Basis Accounting
- Does not show future revenue or expenses, making financial planning harder.
- Not accepted under GAAP (Generally Accepted Accounting Principles).
- Can distort profitability, as large expenses may not align with revenue timing.
What Is Accrual Basis Accounting?
Accrual accounting records revenue and expenses when they are earned or incurred, even if cash has not yet changed hands.
How Accrual Basis Works
- Revenue is recorded when a service is performed or a product is delivered, regardless of when payment is received.
- Expenses are recorded when they are incurred, even if not yet paid.
Example of Accrual Basis Accounting
- A business invoices a client for $5,000 in December 2025 and receives payment in January 2026.
- The revenue is recorded in December 2025, when it was earned.
Pros of Accrual Basis Accounting
- Provides a more accurate financial picture by matching revenue with related expenses.
- Required for businesses with over $27 million in revenue (per IRS rules).
- Improves financial planning by showing accounts receivable and payable.
Cons of Accrual Basis Accounting
- More complex and requires tracking invoices and unpaid bills.
- Can create cash flow issues if expenses are recorded before revenue is received.
- Requires adjusting journal entries for prepaid and accrued expenses.
Key Differences Between Cash and Accrual Accounting
| Factor | Cash Basis | Accrual Basis |
|---|---|---|
| Revenue Recognition | When cash is received | When earned |
| Expense Recognition | When paid | When incurred |
| Complexity | Simple | More complex |
| Tax Implications | Income taxed when received | Income taxed when earned |
| Compliance | Not GAAP-compliant | GAAP-compliant |
| Best For | Small businesses, freelancers | Larger businesses, corporations |
How to Choose the Right Accounting Method
Use Cash Basis Accounting If:
- Your business has less than $27 million in revenue and does not carry inventory.
- You want simplified bookkeeping.
- You need real-time tracking of cash flow.
Use Accrual Basis Accounting If:
- Your business has large revenue and expenses that occur at different times.
- You need accurate financial reporting for investors or lenders.
- You are required to follow GAAP standards.
How to Switch Between Cash and Accrual Accounting
Step 1: Get IRS Approval (If Needed)
- Small businesses can switch methods by filing Form 3115 (Application for Change in Accounting Method).
Step 2: Adjust Financial Records
- Convert accounts receivable, accounts payable, and prepaid expenses to the new method.
Step 3: Update Tax Reporting
- Ensure consistency between financial statements and tax filings.
IRS Forms & Compliance Checklist
- Form 1040 (Schedule C) – Cash basis reporting for sole proprietors.
- Form 1120 or 1120-S – Accrual basis for corporations.
- Form 3115 – Change in accounting method.
- Financial records – Maintain for at least three years for IRS audits.
Conclusion
Choosing between cash basis and accrual accounting depends on your business size, financial reporting needs, and IRS requirements. Cash basis is simpler but may distort financial performance, while accrual basis provides a more accurate financial picture.
For expert accounting guidance, schedule a meeting with our CPA Anshul Goyal by clicking at https://calendly.com/anshulcpa/ now.
Frequently Asked Questions (FAQs)
1 Can I switch from cash to accrual accounting?
Yes, you can file Form 3115 with the IRS to change methods.
2 Which method is better for tax planning?
Accrual accounting is better for long-term planning, while cash basis allows more flexibility in tax timing.
3 Does the IRS require businesses to use accrual accounting?
Only businesses with more than $27 million in revenue or those that carry inventory must use accrual accounting.
4 Can I use both methods for financial reporting and tax purposes?
Yes, some businesses use accrual for financial reporting and cash basis for tax filing.
5 How do I know which method is right for my business?
Consulting a CPA ensures you choose the best method for tax efficiency and financial management.
About Our CPA
Anshul Goyal, CPA EA FCA is a licensed Certified Public Accountant and an IRS Enrolled Agent (EA). He specializes in business accounting, tax planning, and financial reporting.
Schedule a consultation today with Anshul Goyal, CPA, to ensure accurate financial reporting and tax optimization.