Editorial · September 19, 2022
Cash vs Accrual Accounting: Which Method Fits You
Cash vs accrual accounting is a choice about timing. It decides when you count a sale or a bill in your books. Under the cash method, you count money when it moves. Under the accrual method, you count it when you earn it or owe it. The IRS lets many small businesses pick either one, but some must use accrual.
What the cash method does
The cash method is the simpler of the two. You report income in the year you receive it. You deduct an expense in the year you pay it. If a client pays you in January for work you did in December, that income belongs to January.
The IRS also counts money as received when it is made available to you without limits. Say your bank credits interest to your account in December. You must report it that year, even if you do not look at it until later. You cannot hold a check in a drawer to push the tax into the next year.
Many people like this method because it matches the bank balance. If the account is up, you made money. If it is down, you spent it. There is little to track beyond deposits and payments.
Sources: IRS Publication 538, Accounting Periods and Methods (revised January 2022).
What the accrual method does
The accrual method follows the work, not the cash. You report income when your right to it is fixed and you can work out the amount. In most cases that is when you finish the job or ship the goods, not when the check clears. You deduct expenses in the year you incur them, even if you pay the bill later.
The goal is to match income and expenses to the same period. Suppose you bill a customer $5,000 in December and they pay in February. Under accrual, the $5,000 counts in December. The cost of the work counts in December too. The picture of that month is closer to the truth.
The price is more bookkeeping. You must track what customers owe you and what you owe others. That means keeping a list of unpaid invoices and unpaid bills.
Sources: IRS Publication 538, Accounting Periods and Methods (revised January 2022).
A side by side example
Take a design firm that finishes a $10,000 project on December 20. The client pays on January 15. It also gets a $2,000 supplier bill on December 28 and pays it on January 10.
- Cash method: both the $10,000 and the $2,000 land in the new year. The December books show nothing for the project.
- Accrual method: both land in December. The December books show $8,000 of profit.
Over a full life of the business, the totals tend to match. The difference is which year gets the income and which gets the deduction. That is why the choice matters at tax time.
Who can use the cash method
Most individuals and many small businesses use the cash method. Sole proprietors and S corporations can generally use it. A C corporation, or a partnership with a C corporation as a partner, generally cannot. A tax shelter cannot use it either.
There are two main exceptions. A corporation or partnership can use the cash method if it passes the gross receipts test. A qualified personal service corporation can use it too. That covers firms where the owners mainly provide services such as health, law, accounting or consulting.
The gross receipts test looks at the average yearly receipts for the three prior tax years. Add the three years and divide by three. For tax years that begin in 2022, the limit is $27 million, according to Revenue Procedure 2021-45. For the year before, Publication 538 uses a limit of $26 million. Related businesses may have to add their receipts together. If a business fails the test, it must change to the accrual method.
Sources: IRS Publication 538, Accounting Periods and Methods (revised January 2022); IRS Revenue Procedure 2021-45, section 3.31.
Inventory and mixed methods
Inventory adds a wrinkle. If you make, buy or sell goods, the general rule is that you must keep an inventory. You then use the accrual method for purchases and sales. There is an exception for small business taxpayers, so check whether yours qualifies before you assume the rule applies.
You are also allowed to mix methods, as long as the mix clearly reflects your income and you use it the same way each year. This is called a hybrid method. A shop might use accrual for sales and purchases of goods and the cash method for everything else.
Sources: IRS Publication 538, Accounting Periods and Methods (revised January 2022).
How to choose, and how to switch
You pick a method when you file your first tax return. You do not need IRS approval for that first choice. You must then use the method every year, and it must clearly reflect your income.
If you later want to change, you generally need IRS approval. Most changes go through Form 3115. Plan any switch with a tax professional.
Here are four questions to ask before you pick:
- Do you carry inventory?
- Are you a C corporation or a partnership with one?
- Do your average receipts stay under the limit?
- Do lenders or investors want accrual statements?
This article is general information, not tax advice. Your accountant can say which method fits your facts.
Sources: IRS Publication 538, Accounting Periods and Methods (revised January 2022).
Sources
- IRS, Publication 538, Accounting Periods and Methods, revised January 2022.
- IRS, Revenue Procedure 2021-45, 2022 inflation adjustments.