Every business has to decide when a sale or an expense "counts". The two common answers are the cash method and the accrual method. They record the same transactions, but at different moments, and that can change what your reports and your tax return show for a period.

What the IRS says

The IRS describes both in Publication 538, Accounting Periods and Methods. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses when you incur them. Publication 538 also explains that the method you choose must clearly reflect your income and expenses, that some businesses are not allowed to use the cash method, and that changing a method generally requires IRS approval unless an exception applies.

A simple example

Suppose you complete a project in December and the client pays in January. Under the cash method, the income belongs to January. Under the accrual method, it belongs to December, when it was earned. The same logic applies to a supplier invoice you receive in December and pay in January.

How each method affects your reports

Cash basis reports are easy to understand because they follow the bank. They can, however, make a month look unusually good when several clients pay at once, or unusually poor when you pay a large annual bill.

Accrual basis reports match income with the costs of earning it, so month-to-month profit is smoother and more meaningful. They require tracking receivables, payables and sometimes prepaid expenses and accrued costs.

Using one method for tax and another for management

Many small businesses file taxes on one basis but find accrual-style reports more useful for running the business. Bookkeeping software can often produce reports on either basis from the same data, as long as invoices and bills are entered rather than only bank transactions. Talk to your tax preparer before assuming you can use a particular method for your return.

Signs accrual reports would help you

  • You invoice clients and wait weeks or months to be paid
  • You hold inventory
  • You have large annual costs such as insurance or software paid up front
  • A lender or investor has asked for accrual-basis statements

Signs cash reports may be enough

  • Customers pay at the point of sale
  • You have few unpaid bills at any time
  • The business is small and simple, and your preparer has confirmed the cash method is available to you

Practical steps

Whatever method you use, enter customer invoices and supplier bills in your system rather than recording only deposits and payments. That keeps both views available and gives you a receivables and payables list you can manage.

If you are unsure what your books currently use, our accounting services include a review of method and reporting. See also our guide to what business records to keep.