Cash vs accrual for small business taxes comes down to timing. Under the cash method, income counts when it is received and expenses when they are paid. Under accrual, income counts when earned and expenses when incurred. The choice can move profit between years, and who may use cash depends on an IRS gross receipts test.
What separates cash vs accrual for small business taxes?
The two methods differ only in when a transaction counts. A sale invoiced in December and paid in January is December income under accrual and January income under cash. Over the life of a business the totals end up the same. In any single year, especially near year end, they can be far apart.
IRS Publication 538, Accounting Periods and Methods, puts it in one line for each. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the year you pay them. Under the accrual method, you generally report income in the year you earn it and deduct expenses in the year you incur them, even if they are not yet paid.
What each method needs in the books
| Item | Cash books | Accrual books |
|---|---|---|
| Customer invoices not yet paid | Not recorded as income | Accounts receivable and income |
| Bills received but not yet paid | Not recorded as expense | Accounts payable and expense |
| Wages earned in December, paid in January | January expense | December expense, accrued |
| Annual software paid in advance | Expense when paid | Prepaid asset, spread over the year |
| Customer deposit for work next year | Income when received under many cash setups; ask the preparer | Liability until the work is done |
Cash books can be built almost entirely from bank and card statements. Accrual books need invoices, bills and payroll registers as well, because many of their entries have no bank line yet.
Year-end cash and accrual books for the same client, side by side
The clearest way to see the difference is to run one client's year both ways. Profit shifts by the change in what is owed to and by the business, plus any timing on payroll and prepayments. For a growing service business with December invoices outstanding, accrual profit is usually higher than cash profit.
A worked example
The client is a fictional design studio, and the figures are made up for illustration.
| Line | Cash basis | Accrual basis | Why they differ |
|---|---|---|---|
| Deposits from customers in the year | 412,000.00 | 412,000.00 | Same cash |
| Less: January deposits for last year's invoices | n/a | -18,500.00 | Earned last year |
| Plus: December invoices unpaid at year end | n/a | +27,300.00 | Earned this year |
| Income | 412,000.00 | 420,800.00 | |
| Payments to vendors and staff | 301,400.00 | 301,400.00 | Same cash |
| Less: January payments for last year's bills | n/a | -6,200.00 | Incurred last year |
| Plus: December bills unpaid at year end | n/a | +9,750.00 | Incurred this year |
| Plus: wages for the last week of December | n/a | +4,100.00 | Paid in January |
| Expenses | 301,400.00 | 309,050.00 | |
| Profit | 110,600.00 | 111,750.00 | 1,150.00 apart |
The difference here is modest because receivables and payables both grew. A client who sent a large invoice on December 28 and paid most bills before year end would see a much wider gap. The bookkeeper's job is to produce either view accurately. Which method the return uses is the preparer's decision.
Card and processor deposits
Card processors pay out net of fees, and often a day or two after the sale. Under accrual, the sale belongs to the day it happened, so year-end payouts need to be traced back to December sales. The post on 1099-K totals versus bank deposits explains why those numbers rarely agree and how to reconcile them.
Who may use the cash method for small business taxes?
Many small businesses may use the cash method, but not all. Publication 538 says corporations and partnerships can generally use cash if their average annual gross receipts for the three prior tax years do not exceed a limit that is adjusted for inflation. Other rules can apply to particular businesses, and the preparer confirms eligibility for each client.
The current dollar limit changes, so check the latest Publication 538 rather than relying on a number from an old engagement note. Publication 538 also covers businesses with inventory and other special cases, which is another reason the decision sits with the preparer.
What the bookkeeper should know
- Which method the client's last return used. Ask the preparer, and write it in the client file.
- Whether the books are kept on the same method as the return. Some clients want accrual reports for management and the return on cash, or the reverse.
- Whether the client is growing fast enough to approach the gross receipts limit. Raise that with the preparer a year early, not in March.
Publication 538 also says that changing an accounting method later generally requires IRS approval. That request is the preparer's to make.
Bank statements under accrual books
A bank statement records cash movement, so a statement-based workflow naturally produces cash books. Under accrual, statements still drive most entries, but some lines settle an invoice or bill already recorded rather than creating new income or expense. The coding has to point those lines at receivables and payables instead of revenue and expense accounts.
How statement lines change under accrual
- Customer payments are coded to accounts receivable, matched to the invoice they pay.
- Vendor payments are coded to accounts payable, matched to the bill.
- Payroll lines clear a wages payable account if wages were accrued.
- Annual prepayments go to a prepaid asset and are spread by a monthly entry.
Rules that code by payee work for both methods, as long as the target account changes. AutoBankConvert, for example, applies rules you write once plus each client's past coding, and sends uncertain lines to a review queue; an accrual client simply has rules that point customer payers at receivables rather than income. See the batch workflow.
What statements cannot show
Unpaid invoices and unpaid bills at year end never appear on a statement. Under accrual, they come from the invoicing system and from the client's pile of bills. Ask for an aged receivables report and a list of unpaid bills dated December 31 as part of the year-end request.
Entries a cash to accrual switch takes
When a client moves from cash to accrual books, the bookkeeper records the opening items the cash books never held: what customers owed, what the business owed vendors, accrued wages and prepaid expenses. Each is entered once, as of the first day on the new method, with an offsetting adjustment the preparer reviews.
Opening entries for a switch
- Accounts receivable. Record every invoice outstanding on the switch date, from the invoicing system, against an adjustment account.
- Accounts payable. Record every unpaid bill on the switch date the same way.
- Accrued wages. Record wages earned but unpaid on the switch date.
- Prepaid expenses. Move the unused portion of annual payments to a prepaid asset.
- Customer deposits. Move deposits for work not yet done to a liability.
- Review. Send the adjustment account total and its detail to the preparer before any return uses the new method.
Why the switch is not just a setting
Most accounting systems can run a cash report or an accrual report from the same data. That toggle does not make cash books into accrual books, because a cash client's file usually lacks the invoices and bills accrual needs. Before changing the default report basis, confirm that invoices and bills are actually being entered.
Pick the switch date with the preparer, and prefer the first day of a year. A switch in the middle of a year leaves one set of books holding two methods, and every report for that year then needs an explanation. Starting on January 1 keeps the opening entries in one place and makes the prior year's cash figures easy to compare.
Cash and accrual edge cases: deposits, payroll and year-end timing
Some transactions behave differently from what either method's one-line definition suggests. Customer deposits, payroll that crosses year end and checks written in December but cashed in January are the usual cases. Each needs a deliberate treatment so the year-end numbers mean what everyone thinks they mean.
Customer deposits and retainers
Money received before the work is done looks like income on the bank statement. Under accrual it is a liability until earned. Under cash, the treatment can depend on the facts, so ask the preparer. The guide to recording customer deposits gives the entries for each case.
Payroll across the year end
A payroll period that runs December 25 to January 7 and pays on January 10 splits across two years under accrual. Payroll providers build year-end forms from pay dates, so accrual books and the forms will not match line for line. The year-end payroll forms checklist shows how to reconcile the two.
Checks written in December
A check dated in December that clears in January sits between the two years on the statements. In the books, record it on the date written and show it as an outstanding item on the December reconciliation. When a large December check clears late in January, ask the client whether it was mailed in December or held, and pass the answer to the preparer, who decides which year it belongs to.