The Complete Guide to Business Accounting Methods: Cash vs. Accrual

When you start a business, you have to decide how you will track your income and expenses. This isn't just about personal preference; it's a formal choice you make when you file your first business tax return. This choice is your accounting method, and it's a set of rules that determines when you report income and expenses.

The two most common methods are the Cash Method and the Accrual Method. Let's break down how each one works, who should use them, and the critical rules you need to know.

The Cash Method: Simple and Straightforward

The cash method is the more intuitive of the two. It's based on the actual flow of money in and out of your business account.

• How it works: Under the cash method, you report income in the tax year you receive it. You deduct expenses in the tax year you pay them.
• Real-World Example: Imagine you're a consultant and you complete a project for a client in December. You send the invoice on December 15th, but the client doesn't pay you until January 10th of the next year. With the cash method, you would report that income in the new year—the year you actually received the payment.

The Accrual Method: A More Formal Picture

The accrual method isn't based on when cash changes hands, but on when the income is earned or the expense is incurred.

• How it works: You report income in the tax year you earn it, regardless of when you get paid. Likewise, you deduct expenses in the tax year you incur them, whether or not you've paid the bill yet.
• Real-World Example: Let's use the same consulting scenario. You completed the work and earned the income in December. Even though you weren't paid until January, under the accrual method, you must report that income on December's tax return. The same goes for expenses—if you receive a bill for office supplies in December but pay it in January, you deduct that expense in December.

The Deciding Factor: Inventory

For many businesses, the choice between cash and accrual is made for them by one single factor: inventory.

If your business has an inventory of items for sale, you generally must use an accrual method of accounting for your purchases and sales. The IRS defines inventories as goods held for sale in the normal course of business, as well as the raw materials and supplies that will physically become part of the merchandise you sell.

However, there is an important exception. Certain small business taxpayers may be able to use the cash method even if they have inventory. These taxpayers can account for their inventory items as materials and supplies that are not incidental. For more detailed information on this exception, the IRS directs business owners to Publication 538.

Key Rules for Any Method You Choose

No matter which method you select, you must follow a few fundamental rules:

1. Clarity is Required: You must use an accounting method that clearly shows your income. The best way to do this is to be consistent, treating all items of income and expenses the same way from year to year.
2. Books Must Match Taxes: The accounting method you use to keep your books must be the same one you use to figure your taxable income.
3. Multiple Businesses, Multiple Methods: If you own more than one business, you can use a different accounting method for each one, but only if the method for each business clearly shows its income and you keep a complete and separate set of books and records for each business.

Stuck With Your Choice? How to Change Methods

What if your business grows and the method you first chose no longer makes sense?

Once you've set up your accounting method by filing your first tax return, you must generally get IRS approval before you can change to another method. This rule applies not only to a change in your overall system (like switching from cash to accrual) but also to a change in how you treat any "material item".

The process for getting approval and examples of changes that require it are detailed in IRS Publication 538, so be sure to consult that resource before making a switch.

Choosing your accounting method is a foundational decision. It impacts your bookkeeping, how you file your taxes, and the financial picture you present to the world. By understanding the differences between the cash and accrual methods, you can make the right choice for your business from day one.

DISCLAIMER: This content is for educational purposes only and should not be considered personalized financial advice. Always consult with a qualified financial professional before making financial decisions.