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Cash accounting records revenue when money arrives and expenses when money leaves. Accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of when cash moves. The practical difference shows up on your December income statement: under cash, a vendor invoice you received in December but pay in January is next year's expense; under accrual, it is this year's. For US businesses the choice is partly yours and partly the IRS's, and the line between the two is a gross receipts test.
Cash vs accrual accounting: the short version
| Cash basis | Accrual basis | |
|---|---|---|
| Revenue recognized | When the customer pays you | When you earn it, invoice sent |
| Expense recognized | When you pay the vendor | When the goods or services are received |
| Shows accounts payable and receivable | No | Yes |
| Matches revenue to the costs that produced it | No | Yes |
| Bookkeeping burden | Low | Higher |
| GAAP compliant | No | Yes |
| Typical user | Small service businesses, sole proprietors | Companies with inventory, investors, lenders, or a board |
Which method does the IRS require?
You can generally use the cash method if your average annual gross receipts over the prior three tax years do not exceed the Section 448 threshold, which is inflation-adjusted each year and sits at $32 million for 2026 (the statute's base figure is $25 million, set by the Tax Cuts and Jobs Act, and it has been indexed upward since). Above that, a C corporation or a partnership with a C corporation partner must use accrual. There are longstanding exceptions: S corporations, partnerships with no C corporation partners, qualified personal service corporations and certain farming businesses can often use cash regardless.
Two things are worth knowing beyond the threshold itself. First, the test is a three-year average, so one enormous year does not immediately force you to switch. Second, changing your method later is not a bookkeeping preference, it is a formal accounting method change that generally requires filing Form 3115 with the IRS. Companies that expect to cross the line, raise capital, or take on a bank covenant usually move to accrual before they are forced to, precisely to avoid doing it under pressure.
Why accrual accounting shows you what cash accounting hides
Cash accounting's appeal is honest: it is simple, and your books look like your bank account. Its weakness is that it tells you nothing about obligations you have already incurred.
Picture a construction subcontractor in November. It has billed $400,000 of work and collected $250,000. It has received $180,000 of supplier invoices, none of them paid yet. On a cash basis, November shows $250,000 of revenue and almost no expense, so it looks like a spectacular month. On an accrual basis it shows $400,000 of revenue against $180,000 of costs, which is a good month but a very different one, and, importantly, an accounts payable balance of $180,000 that the owner actually owes. The cash-basis owner is looking at a healthy bank balance that is already spent and does not know it.
That is the real argument for accrual. It is not compliance. It is that a payables balance is a fact about your business whether or not your books admit it. Understanding how accruals relate to accounts payable is the piece most people miss when they make the switch.
What changes in AP when you switch to accrual
Cash-basis AP is trivial: you pay a bill and record the expense. Accrual-basis AP is a process, and three things become non-negotiable.
- Invoices have to be captured when they arrive, not when they are paid. The date on the invoice is when the expense belongs. An invoice discovered in a drawer in February and dated December belongs in December, and if the books are closed you now have a problem.
- You need a cutoff. At period end, goods or services received without an invoice still have to be recorded as an accrued liability. This is the classic received-not-invoiced problem, and it is where most understated expenses live.
- The subledger has to tie to the ledger. Your AP aging total must equal the AP control account on the trial balance. When it does not, one of them is lying. Our guide to the trial balance walks through why that break is usually a manual journal entry someone posted straight to the control account.
None of this is difficult in principle. It is difficult in practice because it depends on invoices being entered promptly and consistently by people who have other jobs. Automating the intake so every invoice is captured and coded on the day it arrives removes most of the accrual pain, which is a large part of what accounts payable software is for. Employee expense claims and receipts have the same cutoff problem at period end, and the fix is the same: capture them as they happen, with software that reads each receipt and categorizes it automatically, rather than collecting a shoebox in the last week of the month.
Modified cash basis and the hybrid method
Plenty of small US businesses run something in between, and it is legitimate. A modified cash basis keeps the cash method for most day-to-day activity but records long-term items on an accrual basis: fixed assets get capitalized and depreciated instead of expensed, and loans sit on the balance sheet rather than running through the income statement. The IRS also permits certain hybrid methods, most commonly accrual for purchases and sales when you carry inventory, with cash for everything else.
The rule that governs all of it is consistency. You must apply your method consistently from year to year, and you cannot switch back and forth to whichever gives the better tax result this year. That is exactly what Form 3115 exists to police.
Cash vs accrual for taxes
The tax appeal of cash is timing. Because you deduct expenses when paid, you can pay January's vendor bills in late December and take the deduction a year earlier, or delay invoicing until January to push revenue out. That flexibility is real, and it is why small profitable service businesses often stay on cash for as long as they qualify.
The tax cost of accrual is that this flexibility mostly disappears. You recognize income when earned regardless of collection, so you can owe tax on revenue you have not been paid for. That is a genuine cash-flow problem for a business with slow-paying customers, and it is worth modeling before you switch voluntarily rather than discovering it in April.
When should you switch to accrual?
Four triggers, and most companies hit at least one before the IRS forces the issue.
- You are approaching the gross receipts threshold. Switch on your own terms, in a quiet year, rather than in the year you cross it.
- A lender or investor asks for GAAP financials. Cash-basis statements are not GAAP, and a bank covenant that references EBITDA implicitly assumes accrual.
- You carry inventory. Matching the cost of goods to the revenue they produced is the entire purpose of accrual, and inventory is where cash accounting distorts profit most.
- You cannot answer what you owe. If nobody can tell you the payables balance without opening the email inbox, the books have stopped being a management tool.
Frequently asked questions
What is the difference between cash and accrual accounting?
Cash accounting records revenue when payment is received and expenses when they are paid. Accrual accounting records revenue when it is earned and expenses when they are incurred, no matter when the money moves. Accrual therefore shows accounts receivable and accounts payable on the balance sheet, while cash accounting shows neither, which is why it can hide obligations you have already committed to.
Can a small business use cash basis accounting?
Usually yes. Under Section 448, a business can generally use the cash method if its average annual gross receipts for the prior three years do not exceed the inflation-adjusted threshold, $32 million for 2026. S corporations, partnerships without C corporation partners, qualified personal service corporations and certain farming businesses are often eligible regardless of that limit.
Is accrual accounting required by GAAP?
Yes. Generally Accepted Accounting Principles require the accrual basis, because the matching principle depends on recording revenue and the expenses that produced it in the same period. Any company that needs audited financial statements, has outside investors, or is subject to a lender covenant referencing GAAP will have to be on accrual.
How do I change from cash to accrual accounting?
Changing your accounting method for tax purposes generally requires IRS consent, which you request by filing Form 3115, Application for Change in Accounting Method. You also have to compute a Section 481(a) adjustment so income is neither duplicated nor omitted in the year of change. It is a formal filing, not just a setting in your accounting software, so most companies do it with their CPA.
Which is better, cash or accrual accounting?
Cash is better for simplicity and for timing deductions, and it suits small service businesses with no inventory and no outside reporting. Accrual is better for understanding the business, because it shows what you are owed and what you owe. If you have inventory, investors, a lender, or more than a handful of open vendor invoices at any time, accrual gives you a picture worth having.