Cash vs accrual accounting: Key differences explained

Published Friday 5 December 2025

Table of contents

• What's the difference between cash and accrual accounting
• What is cash basis accounting
• What is accrual basis accounting
• Cash versus accrual accounting: which should you choose
• How Xero simplifies both accounting methods
• FAQs on cash versus accrual accounting

Key takeaways

• Choose cash accounting for simple operations without inventory to track actual money flow, but switch to accrual accounting as your business grows to gain accurate insights for strategic decisions and loan applications.

• Recognize that cash accounting records transactions only when money changes hands, while accrual accounting captures income when earned and expenses when incurred, regardless of payment timing.

• Understand that the IRS requires businesses with inventory to use accrual accounting, though small business taxpayers with average annual gross receipts of $26 million or less may qualify for exceptions.

• Prepare for increased complexity with accrual accounting as you'll need to track invoices and bills beyond just bank account activity, but gain comprehensive financial data that lenders and investors prefer.

What's the difference between cash and accrual accounting?

records transactions only when money changes hands. records transactions when you earn income or incur expenses, regardless of payment timing.

The key difference is timing. Cash accounting waits for actual payment, while accrual accounting captures economic activity as it happens. Accrual provides more accurate business insights, but cash accounting offers simplicity for smaller operations.

What is cash basis accounting

Cash basis accounting recognizes income and expenses only when money actually changes hands. You record transactions when you receive payment or pay bills – not when you send invoices or receive them.

Key characteristics of cash accounting:

• Payment timing: Income recorded when received, expenses when paid
• Payment method: Works with any payment type (cash, electronic, check)
• Common users: Sole proprietors and businesses without inventory

Benefits of cash accounting

Cash accounting has several advantages if you want a simple way to track money in and out:

• Simplicity: Shows actual cash on hand without complex calculations
• Tax timing: Pay taxes only on money received, not invoices issued
• Cash flow advantage: Delay tax payments until you collect payment

Downsides of cash accounting

Cash accounting also has some limitations you need to keep in mind:

• Accuracy issues: May show false profitability when bills remain unpaid
• Limited insights: Provides only day-to-day view, not long-term trends
• Decision-making gaps: Lacks comprehensive financial picture for strategic planning

Who uses cash basis accounting?

Small businesses with simple operations typically use cash accounting:

• Sole proprietors: Service providers like consultants and freelancers
• Small retailers: Businesses without complex inventory management
• Service businesses: Companies with immediate payment collection
• Startups: New businesses with straightforward transactions

Cash accounting example

A freelance graphic designer completes a $2,000 logo project in March but receives payment in April. Under cash accounting, the designer records the $2,000 income in April when payment arrives, not March when the work was completed.

What is accrual basis accounting?

Accrual basis accounting records transactions when you earn income or incur expenses, regardless of payment timing. You record income when you invoice customers, and you record expenses when you receive bills – even if you pay them weeks later.

Benefits of accrual accounting

Accrual accounting gives you a fuller view of how your business is really performing:

• Accurate performance: Complete picture of business activity and financial health
• Better decisions: Comprehensive data supports confident strategic planning
• Financing advantage: Lenders prefer accrual statements for loan applications

Downsides of accrual accounting

There are a few trade-offs to consider with the accrual method:

• Increased complexity: Requires tracking invoices and bills, not just bank account
• Tax timing: May pay taxes on unpaid invoices (refundable if customer doesn't pay)

Who uses accrual accounting?

Larger businesses and those with complex operations use accrual accounting:

• Corporations: While many large corporations are required to use the accrual method, the IRS allows corporations to use the cash method if the company meets the gross receipts test, meaning its average annual gross receipts are $26 million or less.
• Inventory businesses: Retailers and manufacturers tracking stock
• Credit-based businesses: Companies offering payment terms to customers
• Growing companies: Businesses seeking loans or investors

Accrual accounting example

The same graphic designer using accrual accounting would record the $2,000 income in March when they complete and invoice the work, regardless of when they receive payment. This provides a clearer picture of monthly performance.

Cash versus accrual accounting: which should you choose

Choosing the right accounting method depends on your business's size, structure, and goals. Cash accounting is simpler and works well for small businesses without inventory. It gives you a clear, immediate look at your cash on hand.

As your business grows, accrual accounting becomes essential. It provides a more accurate long-term view of your profitability and financial position, which is crucial for making strategic decisions, securing loans, and attracting investors.

If your business has inventory, the IRS generally requires you to use the accrual method, although an exception exists for businesses that qualify as a small business taxpayer with average annual gross receipts of $26 million or less.

How Xero simplifies both accounting methods

Whether you use the cash or accrual method, accounting software can do most of the heavy lifting for you. Xero makes it easy to manage your finances by automating tasks like invoicing and bill tracking, giving you a clear, real-time view of your business performance.

You can even switch between cash and accrual reports to get the insights you need, when you need them. This flexibility helps you stay on top of your day-to-day cash flow while planning for long-term growth. Ready to run your business, not your books? Get one month free and see how easy it can be.

FAQs on cash versus accrual accounting

Here are answers to some common questions about cash and accrual accounting.

Who should not use accrual accounting?

Very small businesses, sole proprietors, or freelancers with no inventory might find accrual accounting unnecessarily complex. If your business operations are simple, cash basis accounting is often sufficient and easier to manage.

Do banks prefer accrual or cash basis accounting?

Most banks and lenders prefer financial statements prepared on an accrual basis. It gives them a more accurate and complete picture of your company's financial health, including outstanding debts and future revenue, which helps them assess risk.

How do I know if I'm using cash or accrual accounting?

Look at when you record income and expenses. If you record income when you receive a payment and expenses when you pay a bill, you're using the cash basis. If you record them when you send an invoice or receive a bill, regardless of when money changes hands, you're using the accrual basis.

Can I switch from cash to accrual accounting?

Yes, you can switch from cash to accrual accounting. You need approval from the Internal Revenue Service (IRS), which you get by filing Form 3115, Application for Change in Accounting Method. For non-automatic changes, the IRS normally sends an acknowledgment of receipt within 60 days. It's a good idea to work with an accountant to ensure a smooth transition.

Which accounting method is better for tax purposes?

It depends on your business. The cash method can sometimes defer tax liability, since you only pay taxes on money you've actually received. However, the IRS requires some businesses, particularly those with inventory, to use the accrual method. Always consult with a tax professional to determine the best approach for you.