Cash vs accrual accounting
When a sale and a bill become income and expense, and why the bank balance will not match either story by itself.
General information, not tax or legal advice. IRS Publication 334 is the small-business discussion of accounting methods. This page is the bookkeeping difference, not a conclusion about which method you may use.
Two clocks for the same events
Cash-method books record income when you receive it and expenses when you pay them. Accrual-method books record income when you earn it and expenses when you incur them, which is often when you send the invoice or receive the bill. Publication 334 describes both methods for a sole proprietor and points at the exceptions. Some businesses are required to use accrual for tax purposes, including many that carry inventory, subject to the small-business exceptions in that publication. Do not treat the paragraph you just read as permission to pick a method. Read chapter 2 of Publication 334 or ask a preparer who can see the whole return.
One job, two sets of books in your head
You finish a $2,000 project on March 28 and the client pays on April 3. You receive a $400 contractor bill dated March 30 and you pay it on April 2.
| Cash method | Accrual method | |
|---|---|---|
| March income | $0 | $2,000 |
| March expense | $0 | $400 |
| April income | $2,000 | $0 |
| April expense | $400 | $0 |
| March profit | $0 | $1,600 |
The year can come out the same if both events fall inside it. The month will not. A break-even conversation that uses March accrual profit and the April bank deposit is two different months glued together.
What changes in the chart of accounts
Accrual needs accounts receivable, accounts payable, and often prepaid expenses and deferred revenue. Cash-basis books can live without them, because unpaid invoices are not income yet and unpaid bills are not expenses yet. They are still real. A cash-basis owner who ignores a stack of unpaid bills will overstate how much cash is free. Runway should count the bills you are about to pay even if the profit and loss has not recognized them.
Switching methods later is not a matter of flipping a setting. Publication 334 treats a change in accounting method as something you generally request from the IRS. Keep the method you actually use consistent from the month-end close through the return.
Inventory sits in the middle
Buying goods to resell is not automatically an expense on the day you pay, even in a simple set of books. Unsold goods are inventory. Cost of goods sold recognizes them when they leave. Publication 334 is where the tax inventory rules live. The calculator on this site only does the arithmetic.
Sources
- IRS Publication 334, chapter 2 — accounting periods and methods, including cash and accrual, for Schedule C filers.