Difference Between Cash and Accrual Basis of Accounting

An accounting basis dictates the rules a company follows to report its revenues and expenses. The two primary methods used by businesses are the cash basis and the accrual basis of accounting. Each method centers on the timing of when transactions are officially recorded in a company’s books. The choice between them affects how profit is calculated and can have implications for tax liabilities and a company’s ability to secure financing.

Understanding Cash Basis Accounting

The cash basis of accounting is a method where financial events are recorded only when money changes hands. Revenue is recognized in the accounting period when payment is received from a customer, and expenses are recorded when they are paid out to a vendor or employee. This method operates much like a personal checkbook, providing a picture of how much actual cash a business has on hand. Its simplicity makes it a common choice for small businesses, sole proprietors, and individuals.

Consider a freelance graphic designer who completes a project and sends an invoice for $1,000 to a client in December. The client pays the invoice in January. Under the cash basis, the designer does not record the $1,000 as income in December when the work was finished or the invoice was sent. The income is only recorded in January when the payment is deposited into the business bank account.

Similarly, if the designer purchases new software for $300 on credit in December but pays the credit card bill in January, the expense is recorded in January. The transaction is recognized when the cash leaves the designer’s account, not when the obligation to pay was created. This direct link between cash flow and recorded transactions is the defining feature of the cash basis method.

Understanding Accrual Basis Accounting

The accrual basis of accounting records revenue when it is earned and expenses when they are incurred, irrespective of when the actual cash transaction occurs. This method is built on the matching principle, which aims to align revenues with the expenses that generated them within the same accounting period. This provides a view of a company’s financial health and profitability over time. The accrual method is required by U.S. Generally Accepted Accounting Principles (GAAP).

A central element of accrual accounting involves tracking Accounts Receivable and Accounts Payable. Accounts Receivable represents revenue that has been earned but for which payment has not yet been received. For example, if a consulting firm completes a project and invoices a client for $10,000 in December, that $10,000 is recorded as revenue in December, even if the client pays in January. The amount is logged in Accounts Receivable on the balance sheet until the cash is collected.

Conversely, Accounts Payable represents expenses that the business has incurred but has not yet paid. If the same consulting firm receives a $1,500 bill from a subcontractor for work performed in December but schedules the payment for January, the expense is recorded in December. This amount is entered into Accounts Payable, reflecting the company’s obligation to pay. This approach provides a more accurate snapshot of profitability for the period in which the activities took place.

Key Differences in Practice

The financial picture presented by each method can vary. The cash method shows a company’s current cash flow but can misrepresent overall profitability. A business might appear unprofitable in a period where it paid many bills, even if it earned substantial revenue that has not yet been collected. Accrual accounting provides a different view of profitability by smoothing out the effects of payment timing.

Requirements for Use

The choice of accounting method is often dictated by external regulations. Generally Accepted Accounting Principles (GAAP) mandate the use of the accrual method for financial statements to be considered compliant. Publicly traded companies in the U.S. must adhere to GAAP and use accrual accounting. Lenders and investors also require accrual-basis financial statements to assess a company’s financial health.

The Internal Revenue Service (IRS) also has specific rules. C corporations and partnerships that have a C corporation as a partner are generally required to use the accrual method. An exception exists for small business taxpayers. For tax years beginning in 2025, a business qualifies as a small business taxpayer if its average annual gross receipts for the three prior tax years are $31 million or less.

Furthermore, unless they are a small business taxpayer, businesses that have inventory for sale to the public must use an accrual method for sales and purchases. This ensures that the cost of goods sold is properly matched with the revenue from those sales. A business wishing to change its accounting method must generally get approval from the IRS by filing Form 3115.