When you start a business, one of the biggest first decisions you’ll make will be how you handle your finances. Tracking your income and expenses are arguable the most important data that needs to be managed.
That choice usually comes down to 2 methods: cash accounting and accrual accounting. They might sound like typical accounting jargon, but the method you pick can affect everything from how much tax you owe to how investors see your business’s health.
What is Cash Accounting?
Cash accounting is the simplest method. This is an accounting method where you record when cash hits your bank account and expenses when money leaves within the same period.
Example:
You send an invoice to a client on September 25th and they pay you on October 3rd. In cash accounting, you record the income you earned in October since that’s when you physically received it.
Pros:
- Simple to understand and manage
- Easy to see actual cash flow
- Lowers bookkeeping costs for small businesses
Cons:
- Doesn’t show money owed to you (accounts receivable)
- Can make your business look less profitable depending on payment timing
- Limited use for businesses that carry inventory (IRS may require accrual)
What is Accrual Accounting?
Accrual accounting records income when it’s earned and expenses when they’re incurred, regardless of when cash is exchanged.
Example:
You send the same September 25th invoice, but under accrual accounting, you’ll record the income in September because that’s when you earned it. Even if you don’t get paid until October.
Pros:
- Gives a more accurate picture of your business’s financial health
- Helps with long-term planning and forecasting
- Recognized by GAAP (Generally Accepted Accounting Principles), which can be important if you’re looking for financing or investors
Cons:
- More complex bookkeeping
- Requires tracking receivables, payables, and deferrals
- Can show profit even if cash is tight (since the money hasn’t been collected yet)
When the IRS Says You Must Use Accrual
There are a few situations where you may be required to use the accrual accounting method. The IRS generally requires this method if:
- Your business has more than $25M in average annual gross receipts over the past 3 years
- You have inventory and produce, purchase, or sell merchandise
- You are a C corporation (with some exceptions)
How to Decide Which One is Right for You
If you don’t fall into one of the categories above, you will have the choice to decide which method is going to work best for you and your business. Some things to ask yourself are:
- Do I primarily operate on a cash basis without much delay between work and payment?
- Do I carry inventory or offer payment terms to clients?
- Am I seeking investors or financing that require GAAP-compliant statements?
Choose cash accounting if: You’re a small service provider, freelancer, or sole proprietor who values simplicity.
Choose accrual accounting if: You sell products, have longer payment cycles, or want a clearer picture of your financial position over time.
Why This Decision Matters
Switching methods mid-year can be complicated (and require IRS approval), so getting this right early saves headaches later. Plus, the accounting methods you choose directly affects:
- Taxes – especially which year income and expenses get reported
- Cash flow management – understanding when your money is coming in and going out
- Business valuation – potential investors or buyers want accurate, accrual-based numbers
While it may seem like a small decision, it will impact the way you manage your bookkeeping for the year.
There’s No One-Size-Fits-All
Cash accounting is easier to manage and may make the most sense for small businesses, while accrual accounting provides a more complete financial picture. Accrual is often necessary for growing companies.
If you’re unsure which method fits your business best, or need help switching from one to the other, we can guide you through the process and make it an easy switch.
