Cash vs accrual accounting: How to choose the right method for your business

Published Thursday 11 September 2025

Table of contents

• What's the difference between cash and accrual accounting?
• What is cash basis accounting?
• What is accrual basis accounting?
• Cash vs accrual accounting: which is right for your business?
• Managing your accounting method with Xero
• FAQs on cash vs accrual accounting

Key takeaways

• Choose cash accounting if you run a small service business with simple transactions and want straightforward bookkeeping, but switch to accrual accounting as your business grows to get a more accurate picture of performance for better decision-making.
• The IRS mandates accrual accounting for C corporations with average annual revenue over $27 million, businesses with inventory, and partnerships with C corporation partners, while allowing cash accounting for most small businesses under the revenue threshold.
• Apply cash accounting to record income only when you receive payment and expenses only when you pay bills, which provides better cash flow visibility but may not accurately reflect your business performance during any given period.
• Implement accrual accounting to record transactions when they occur regardless of payment timing, giving you a complete view of business activity that helps with loan applications, investment decisions, and accurate financial reporting.

What's the difference between cash and accrual accounting?

Cash accounting records income and expenses only when money changes hands. Accrual accounting records transactions when they occur, regardless of when payment happens.

Here's the key difference:

• Cash method: Record revenue when you receive payment and expenses when you pay bills
• Accrual method: Record revenue when you send invoices and expenses when you receive bills

Each method suits different business needs. Your size, complexity, and legal requirements matter. For example, the Internal Revenue Service (IRS) has specific rules for partnerships. Partnerships usually need to use the majority interest tax year of their partners.

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.

Here are the main features of cash basis accounting:

• Income recorded only when payment received
• Expenses recorded only when bills paid
• Payment method doesn't matter (cash, check, electronic transfer)
• You do not track unpaid invoices or bills

Cash basis accounting works best for sole proprietors, small service businesses, and companies without inventory.

Cash accounting examples

Service business scenario: You finish a $5,000 consulting project in December and send your client an invoice. Your client pays you in January.

• Cash method: Record $5,000 income in January (when paid)
• Tax impact: Income appears on next year's tax return

Expense example: You get a $500 office supply bill in December but pay it in January.

• Cash method: Record $500 expense in January (when paid)
• Result: December shows no expense, January shows the full amount

Who should use cash basis accounting?

Cash basis accounting is available under IRS rules to sole proprietorships and single-member LLCs, partnerships without C corporation partners, S corporations, and C corporations with average annual gross receipts under $27 million for the past three years.

These requirements make it a common choice for smaller businesses with simpler financial needs.

This method is especially useful for service-based businesses like consultants, freelancers, and professional service providers.

Small retailers with little to no inventory may also find it easier to manage their books using cash accounting.

Benefits of cash accounting

Here are common benefits of cash accounting:

Simplicity: Easy to understand and track – you only record money that actually moves in or out of your business.

Cash flow advantage: You pay taxes only on money you've actually received, not on outstanding invoices.

Real-time visibility: Shows exactly how much cash you have available right now.

Keep in mind: The IRS sets rules about which businesses can use cash accounting for tax purposes. Check current regulations or talk to a tax professional to see if you qualify.

Downsides of cash accounting

Here are the downsides of cash accounting:

• It's not accurate – it could show you as profitable just because you haven't paid your bills
• It doesn't help when you're making management decisions, as you only have a day-to-day view of finances

What is accrual basis accounting?

With accrual accounting, you record transactions when they happen, even if money has not changed hands yet. This method gives you a complete picture of your business performance.

Here’s how accrual accounting works in practice:

• Income: Revenue is recognized when you send an invoice, not when the customer pays.
• Expenses: Costs are recorded when you receive a bill, not when you make the payment.
• Timing: Transactions appear right away, even if payment terms extend 30 days or more.

By aligning income and expenses with the period they occur, accrual accounting shows the true profitability of your business.

Accrual accounting examples

These examples show how accrual accounting provides a clearer view of business performance each month, rather than waiting for cash to move in or out.

• Income example: A consultant completes a $5,000 project in December and invoices the client, who pays in January. Under accrual accounting, the $5,000 is recorded as December income because that’s when the work was performed. For tax purposes, it appears on the current year’s return.
• Expense example: A business receives a $500 bill in December but doesn’t pay it until January. With accrual accounting, the $500 is logged as a December expense since that’s when the obligation was incurred. This ensures December’s financial statements accurately reflect the cost.

Who should use accrual basis accounting?

Accrual accounting isn’t optional for every business. IRS requirements mandate its use for certain types of organizations, including:

• C corporations with annual revenue above $27 million (measured over the past three years).
• Partnerships that include C corporation partners.
• Businesses that maintain inventory, with a few exceptions for smaller entities.
• Tax shelters, which must always use the accrual method.

Beyond these legal requirements, accrual accounting is also the preferred choice for many other types of businesses. It works best for companies with more complex operations, especially where cash accounting would fail to show an accurate financial picture.

Accrual accounting is particularly well suited for:

• Manufacturing and retail businesses that carry inventory and need to match income with the cost of goods sold.
• Companies seeking loans or outside investment, since lenders and investors often require accrual-based financial statements.
• Businesses with complex transactions or long payment terms, where revenue and expenses don’t align neatly with cash flow.
• Organizations that need detailed performance reporting, such as larger or growing businesses tracking profitability by month or quarter.

Benefits of accrual accounting

The main advantage of accrual accounting is accuracy. Because it records income and expenses when they occur, it provides a clear and reliable picture of business performance. This can help owners and managers:

• Gain a more accurate understanding of financial health.
• Make better-informed decisions with confidence.
• Improve their chances of securing long-term financing by presenting credible financial statements.

Downsides of accrual accounting

Accrual accounting isn’t without drawbacks. The method is more complex and requires diligent record-keeping. Business owners should be aware of the following:

• It involves extra work, since you must track invoices and bills in addition to bank balances.
• You may owe tax on income before the customer has actually paid. However, if an invoice goes unpaid, you can claim the tax back on your next return.

Cash vs accrual accounting: which is right for your business?

Choose cash accounting if you:

• Run a small service business or sole proprietorship
• Have simple transactions with immediate payment
• Want straightforward bookkeeping
• Qualify under IRS rules (generally under $27 million average annual revenue)

Choose accrual accounting if you:

• Need accurate business performance reporting
• Have inventory or complex transactions
• Seek business loans or investment
• Are required by law (C corporations, businesses over $27 million revenue)

Managing your accounting method with Xero

Your choice between cash and accrual accounting affects your taxes, business decisions, and daily operations. The right method depends on your business size, industry, and legal requirements.

You can use either accounting method in Xero online accounting software, with automated features that simplify your bookkeeping:

• Automatic transaction categorization for accurate recording
• Invoice and bill scanning that works with either method
• Real-time reporting tailored to your chosen accounting approach
• Tax-ready reports that align with your method selection

No matter which method you use, Xero online accounting software grows with your business and helps you keep your finances organized. Start a free trial of Xero online accounting software to see how easy accounting can be.

FAQs on cash vs accrual accounting

Here are some common questions about cash vs accrual accounting:

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

Check when you record your transactions. If you record income only when you get paid and expenses only when you pay them, you use the cash method. If you record income when you send an invoice and expenses when you get a bill, you use the accrual method.

Should small businesses use cash or accrual accounting?

Many small businesses start with the cash method because it's simple. As your business grows, the accrual method gives you a more accurate view of your finances. This helps you make better decisions. The best choice depends on your business size, industry, and goals.

Who cannot use the cash method of accounting?

The Internal Revenue Service (IRS) requires some businesses to use the accrual method. This usually includes C corporations and businesses with inventory. If your business has average annual gross receipts over a certain threshold, you may also need to use the accrual method. Check the latest IRS guidelines to be sure.

Can I switch from cash to accrual accounting later?

Yes, you can switch, and many businesses do as they grow. To change your accounting method, you need to file Form 3115 with the Internal Revenue Service (IRS). An accountant can help you switch methods and handle the details.