What it means
Under the cash basis, a sale appears in the accounts on the day the customer's payment lands and a cost appears on the day the supplier is paid. It is simple, cheap to run and closely mirrors the bank account, which is why very small businesses and sole traders often start there.
Under the accrual basis, a sale is recorded when the goods are delivered or the service is performed, regardless of payment date, and costs are matched to the same period as the revenue they helped create. This is the method required for company accounts under both international and national accounting frameworks once a business passes a certain size.
The method matters commercially because it determines what the profit and loss statement says at any given moment. A consultancy that invoices heavily in December but collects in January will look loss-making on a cash basis and healthy on an accrual basis, and lenders, investors and tax authorities will each care about that difference.
Businesses also make narrower method choices inside the accrual framework, such as how they value inventory or how quickly they depreciate assets. Once chosen, a method should be applied consistently, and switching usually requires disclosure and sometimes approval, because inconsistency makes year-on-year comparison meaningless.
There is also a modified middle ground that many owner-managed businesses use in practice. They keep formal accrual accounts for reporting and tax, while running the business day to day from a rolling cash forecast that answers the question the accrual accounts cannot: will there be enough money in the bank on the fifteenth of next month.
Neither view is optional once a company has employees, suppliers on credit terms and a lender to satisfy.
In practice
Real-world examples.
Example
A window cleaning business with $140,000 of annual turnover files on the cash basis, so its tax bill follows the money in its bank account. When it wins a commercial contract with 60-day payment terms, its accountant recommends switching to the accrual basis so the accounts show the real trading picture.
Example
A subscription fitness studio collects annual memberships of $1,200 each in January. On the accrual basis it recognises $100 of revenue per member per month, which stops January looking like a record-breaking month and February looking like a collapse.
Example
A construction firm changes its method for recognising revenue on long contracts from completion to stage of completion. Reported revenue rises sharply in the year of the change, and the notes to the accounts explain the switch so investors are not misled.
Formula
Calculation
Cash basis profit = cash received in the period - cash paid in the period
Accrual basis profit = revenue earned in the period - expenses incurred in the period
A design consultancy finishes a project in December and issues invoices totalling $90,000. It collects $30,000 of that in December and the remaining $60,000 in January. Costs incurred on the project are $50,000, of which $35,000 is paid in December and $15,000 in January.
On the cash basis, December profit is $30,000 - $35,000 = a loss of $5,000. On the accrual basis, December profit is $90,000 - $50,000 = $40,000. The same project, the same underlying economics, and a $45,000 difference in what December's accounts report.Case study
Seen in the real world.
Harborlight Print Studio is a fictional example used purely for illustration. For its first two years it ran cash-basis books, and the owner judged each month by whether the bank balance went up.
In its third year the studio won a corporate framework agreement worth $480,000 a year, paid 45 days after invoice. On the cash basis, the first quarter under the new contract showed a $22,000 loss, because the studio had paid for paper, ink and overtime but had collected almost nothing. The owner nearly turned down a second contract on the strength of that number.
Her bookkeeper rebuilt the same quarter on the accrual basis and showed a $61,000 profit, with the difference sitting in receivables. Harborlight kept the accrual accounts for management and lender reporting, and used a separate 13-week cash forecast to manage the payment gap.
Watch out
Common mistakes.
- Assuming the cash basis is simply the wrong method, when it is perfectly appropriate for very small businesses with immediate payment and few assets.
- Changing accounting methods mid-year to make results look better, which distorts comparisons and normally has to be disclosed.
- Running accrual accounts and then managing the business as if the profit figure were spendable cash.
Questions
People also ask.
Which method do lenders and investors expect?
Almost always the accrual basis, because it shows performance in the period the work was actually done.
Can a business use the cash basis for tax and the accrual basis for management reporting?
In many jurisdictions yes, provided the tax rules allow the cash basis at that size, and many owner-managed firms do exactly this.
Does the accounting method change total lifetime profit?
No, it only changes which periods that profit falls into, since every transaction eventually appears under both methods.
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