Cash-basis accounting records revenue when cash comes in and expenses when cash goes out. Accrual accounting records revenue when it is earned and expenses when they are incurred, whatever the timing of payment. Both are legitimate, but they answer different questions, and the right one depends on who reads the financial statements and what the tax rules allow.
This guide separates the two uses that get mixed up: the financial reporting basis (what the statements an accountant compiles, reviews or audits are prepared on) and the tax method (what the IRS permits on the return). It ends with a worked conversion from cash to accrual, which is the adjustment a CPA firm makes most often for small clients.
The basic difference
| Cash basis | Accrual basis | |
|---|---|---|
| Revenue recorded | When cash is received | When earned, as a right to payment arises |
| Expenses recorded | When cash is paid | When incurred, with payables and accruals |
| Receivables and payables | Not on the balance sheet | On the balance sheet |
| Prepaids and deferred revenue | Generally none | Recognized as assets and liabilities |
| Profit tracks | Cash timing | Economic activity in the period |
| Complexity | Low | Higher; estimates for allowances and accruals |
A cash-basis business that bills in December and collects in January shows no revenue for December. An accrual-basis business shows the revenue in December and a receivable on the balance sheet.
Financial reporting: GAAP is accrual-based
US GAAP is an accrual framework. Statements that claim to follow GAAP include receivables, payables, accrued liabilities and revenue recognized under ASC 606. See accrual basis accounting and ASC 606.
Cash-basis financial statements are allowed as a special purpose framework when they serve users who accept them, such as owners and some lenders. An auditor can report on them under AU-C 800 and an accountant can compile or review them under the SSARS standards, with disclosure of the basis in the statements and the report. See cash basis accounting, special purpose framework and cash and tax basis financial statements.
Lenders, investors and acquirers often require GAAP, which means accrual, so a business that outgrows cash-basis statements has to convert.
Tax: who may use the cash method?
For federal income tax, the method of accounting is a separate question. IRS Publication 538 explains the rules. In summary:
- Cash method reports income when it is actually or constructively received and deducts expenses when paid, subject to rules such as the limit on deducting prepaid expenses to the period they apply to, with a 12-month exception.
- Accrual method reports income when the all-events test is met, meaning the right to income is fixed and the amount can be determined with reasonable accuracy, and deducts expenses when the all-events test is met and economic performance has occurred.
- Who can use cash: most individuals and many small businesses. C corporations (other than S corporations) and partnerships that have a C corporation as a partner generally cannot, unless they meet the gross receipts test. Tax shelters cannot use the cash method.
- The gross receipts test: a corporation or partnership may use the cash method if its average annual gross receipts for the three prior tax years do not exceed a threshold that is adjusted for inflation. The threshold was $31 million for tax years beginning in 2025 and is $32 million for 2026, under IRS Rev. Proc. 2024-40 (section 3.31) and Rev. Proc. 2025-32 (section 3.30). Related entities in a controlled group or affiliated service group combine their receipts. Fail the test and the entity must move to accrual.
- Qualified personal service corporations (such as certain health, law, accounting and consulting corporations) can use the cash method if they meet the function and ownership tests.
- Inventory: if inventory is needed to clearly reflect income, purchases and sales are accounted for on an accrual method. A taxpayer that meets the same gross receipts test may choose not to keep inventories and instead treat inventory as non-incidental materials and supplies or follow the treatment in its financial statements.
Changing a tax method of accounting generally requires the IRS's consent, requested on Form 3115. A change forced by failing the gross receipts test is also made on Form 3115. Tax method decisions belong to the taxpayer and its tax adviser. An audit or review firm that also prepares the return should evaluate its independence for nonattest services. See nonattest services.
Book and tax methods can differ. A business can keep its books on accrual and file on the cash method where permitted, with the difference reconciled in the tax workpapers. See book-tax differences.
Which should a small business use?
- Cash suits a business that is not required to use accrual for tax, has few receivables and payables and only needs statements for owners or a bank that accepts them.
- Accrual suits a business with inventory, significant receivables or payables, deferred revenue, a lender or investor that requires GAAP, or plans to raise capital or sell.
- Hybrid methods exist in tax; they mix cash for some items with accrual for others, as permitted. A common case is accrual for inventory and cash for everything else.
Worked example: converting cash-basis income to accrual
Illustrative numbers for a service company.
Cash-basis results for the year: cash collected from customers $900,000, cash paid for expenses $700,000. Cash-basis net income: $200,000.
Balance sheet changes during the year, which the cash basis ignores:
| Item | Opening | Closing | Change | Effect on income |
|---|---|---|---|---|
| Accounts receivable | $80,000 | $130,000 | +$50,000 | Revenue earned but not collected: add $50,000 |
| Deferred revenue (customer deposits) | $10,000 | $40,000 | +$30,000 | Cash received for work not yet done: subtract $30,000 |
| Accounts payable | $40,000 | $55,000 | +$15,000 | Expenses incurred but not paid: subtract $15,000 |
| Accrued wages | $20,000 | $28,000 | +$8,000 | Wages earned but not paid: subtract $8,000 |
| Prepaid insurance | $8,000 | $14,000 | +$6,000 | Cash paid for coverage in future periods: add $6,000 |
Accrual-basis net income = $200,000 + $50,000 - $30,000 - $15,000 - $8,000 + $6,000 = $203,000.
Check: accrual revenue = $900,000 + $50,000 receivable increase - $30,000 deferred revenue increase = $920,000. Accrual expenses = $700,000 + $15,000 + $8,000 - $6,000 = $717,000. Net income = $920,000 - $717,000 = $203,000, which agrees.
The conversion needs opening balances. In the first year, the opening receivables and payables are set up as of the beginning of the period and the difference goes to equity or, for tax, to a Form 3115 adjustment. For the mechanics of a conversion engagement, see compilation engagements under AR-C 80 and the cash flow statement template.
In QuickBooks
QuickBooks Online can display reports on either basis. The basis setting on a report changes the display, not the entries. A cash-basis report from accrual books still depends on bills and invoices being entered and applied correctly. For clients on QuickBooks, confirm which basis the report used before using it as a trial balance. See auditing a client on QuickBooks Online.
Common mistakes
- Assuming the books must be on the same basis as the tax return.
- Treating a cash-basis report from an accrual file as a conversion. The underlying entries may be incomplete.
- Preparing cash-basis statements without disclosing the basis.
- Missing the move to accrual when the gross receipts test is failed, or forgetting that the test averages three prior years.
- Overlooking deferred revenue, which cash-basis books recognize as income when the deposit arrives.
Frequently asked questions
What is the main difference between cash and accrual accounting?
Timing. Cash basis records transactions when cash moves. Accrual basis records them when they are earned or incurred.
Can a business use cash basis for taxes and accrual for its books?
Yes, where the tax rules permit the cash method. The difference is reconciled in the tax workpapers.
What is the gross receipts test for the cash method?
A C corporation or partnership with a C corporation partner may use the cash method if its average annual gross receipts for the prior three tax years are at or below an inflation-adjusted threshold: $31 million for 2025 and $32 million for 2026.
Is cash basis allowed under GAAP?
No. GAAP is an accrual framework. Cash-basis statements can be issued as special purpose framework statements with the basis disclosed.
How do I change from cash to accrual for tax?
File Form 3115 under the IRS's method change procedures, as described in Publication 538 and the Form 3115 instructions.
Sources
- IRS, Publication 538, Accounting Periods and Methods, irs.gov/publications/p538
- IRS, Rev. Proc. 2024-40 (2025 inflation adjustments), irs.gov/pub/irs-drop/rp-24-40.pdf, and Rev. Proc. 2025-32 (2026 inflation adjustments), irs.gov/pub/irs-drop/rp-25-32.pdf
- IRC sections 448 and 471(c)
- AICPA, AU-C Section 800, Special Considerations: Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks
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