Cash accounting records income and costs when money moves; accrual accounting records them when they're earned or incurred. Cash is simpler, accrual shows true performance. US and UK rules decide who can use which, so check with an accountant.
Cash and accrual accounting are two ways of answering the same question: when does a sale or a bill count in your books? It sounds like a technicality, but it changes what your profit looks like in any given month, when you pay tax on income and how well you can see trouble coming. Most small businesses start on one method without realising they chose it. This guide explains both in plain English, with a worked example in words, the rules that decide which you can use in the US and the UK and the questions to take to your accountant. It isn't tax advice for your business, so check your own position with a qualified adviser.
The difference in one sentence each
| Cash accounting | Accrual accounting | |
|---|---|---|
| Income counts when | The money arrives in your account | You earn it, usually when you send the invoice |
| Expenses count when | The money leaves your account | You incur them, usually when the bill arrives |
| Best at showing | Cash in the bank right now | How the business is performing over time |
| Simplicity | Simpler to keep | More bookkeeping, often done by software |
| Common with | Sole traders and small service businesses | Growing companies, businesses with stock, larger firms |
A worked example, without the numbers
Imagine you're a designer. You finish a big project at the end of March, invoice the client that day and they pay you in May. In April you also buy a new laptop on a credit card and pay the bill in June.
- Under cash accounting: the project income appears in May, when the money arrives, and the laptop appears in June, when you pay the card. March looks quiet, even though you did the work.
- Under accrual accounting: the project income appears in March, when you invoiced, and the laptop appears in April, when you bought it. March looks busy, which reflects the work you did, even though the bank balance hasn't moved yet.
Now imagine the client pays late, in July. Under cash accounting nothing shows until July. Under accrual accounting the income is already in March and the unpaid invoice sits in your accounts receivable, reminding you to chase it.
Neither picture is wrong. Cash accounting tells you what's in the bank. Accrual accounting tells you what the business earned. The trouble comes when you look at one and assume it's the other.
Why the choice matters
Tax timing
The method decides which tax year some income and costs fall into. Under cash accounting you generally don't pay tax on money you haven't received yet. Under accrual accounting, income can be taxable once it's earned, even if the client is slow to pay. That can make a real difference when a big invoice crosses the end of a tax year.
Seeing problems early
Accrual accounting shows money owed to you and money you owe, so you can spot slow payers and upcoming bills before they hit the bank. Cash accounting can hide a cash crunch until it arrives.
Borrowing and investment
Lenders and investors usually want accounts prepared on an accrual basis, because it shows the underlying performance of the business. If you plan to borrow or bring in investors, you may need accrual accounts anyway. My guide to building business credit covers what lenders look at.
The rules in the US
In the US, the IRS lets many small businesses choose the cash method, but some businesses must use accrual, such as larger corporations above a gross receipts limit and, in many cases, businesses that hold inventory, though there are exceptions for smaller businesses. IRS Publication 538 explains accounting periods and methods, and changing method later usually needs IRS approval through a specific form. Because the limits are updated for inflation and the exceptions are detailed, check the current publication or ask a tax professional before you choose.
The rules in the UK
In the UK, HMRC made the cash basis the default way for most self-employed sole traders and partnerships to work out their taxable profit from the 2024 to 2025 tax year, and you can choose to opt out and use traditional accounting instead. Limited companies generally prepare accounts on an accrual basis. Limited companies and limited liability partnerships can't use the cash basis, and some businesses with stock or long projects may prefer traditional accounting, so read HMRC's guidance on the cash basis or speak to an accountant before you decide whether to opt out. If you do opt out, you'll need to tell HMRC on your tax return. If you're self-employed, my tax tips for the self-employed cover other common questions.
Want AI doing the heavy lifting in your marketing?
I build the systems that handle the boring 80 percent, so you get your week back. Done properly, with the human kept in.
Which suits your business?
| Your situation | Often suits | Why |
|---|---|---|
| Freelancer or sole trader paid on invoice | Cash | Simple, and you pay tax on money you've received |
| Service business with quick payment | Cash | Little difference between the two methods |
| Business holding stock | Accrual, or check the rules | Stock rules can require or favour accrual |
| Business with big projects across tax years | Talk to an accountant | Timing differences can be large |
| Limited company | Accrual | Company accounts are usually prepared this way |
| Planning to borrow or raise investment | Accrual | Lenders and investors expect it |
Many businesses use both views
You don't have to choose one view of your money for every purpose. Plenty of small businesses file tax on the cash basis but run monthly management reports on an accrual basis, or keep a simple cash flow forecast alongside accrual accounts. Most accounting software can show both, so you can see what's in the bank and what you've earned side by side. My roundup of bookkeeping software for small businesses covers tools that handle this.
Terms you'll hear
- Accounts receivable: money customers owe you for work you've invoiced.
- Accounts payable: money you owe suppliers for bills you've received.
- Accrued expense: a cost you've incurred but haven't been billed for yet.
- Deferred income: money received in advance for work you haven't done yet.
- Modified cash basis: a hybrid some businesses use for internal reporting, mixing elements of both.
Switching methods
- Talk to your accountant first, because switching can create a one-off adjustment to your taxable profit.
- Check the rules for your country, including any form or election you need to file.
- Pick a clean starting point, usually the start of a tax year.
- Record everything owed to you and everything you owe on that date.
- Update your accounting software settings and reports.
- Keep notes on the change for your records.
Questions to ask your accountant
- Which method am I using now, and did I choose it on purpose?
- Would the other method change when I pay tax on a large invoice?
- Do my stock or project timings affect which method I can use?
- Should my monthly reports use a different view from my tax return?
- If I plan to borrow or form a company, should I switch now?
A short conversation with these questions can save a lot of confusion at year end. Once your method is settled, the next number to understand is your margin, which I explain in markup vs margin.
Common mistakes
- Treating a healthy bank balance as profit when big bills are waiting.
- Treating invoiced work as money in the bank when clients pay late.
- Mixing methods in the same set of tax figures.
- Forgetting that advance payments may not be income yet under accrual accounting.
- Switching method without checking the tax effect first.
Frequently asked questions
What is the difference between cash and accrual accounting?
Cash accounting records income and expenses when money moves in or out of your account. Accrual accounting records them when they're earned or incurred, usually when an invoice or bill is issued.
Is cash or accrual accounting better for a small business?
Cash accounting is simpler and suits many freelancers and small service businesses. Accrual accounting gives a truer picture of performance and is often needed by companies, businesses with stock and anyone borrowing or raising investment.
Can a small business use cash accounting in the US?
Many can. The IRS allows the cash method for many small businesses, but some must use accrual. IRS Publication 538 explains the rules, and a tax professional can confirm your position.
What is the cash basis in the UK?
It's a way for self-employed people to work out taxable profit using money received and paid. HMRC made it the default for most sole traders and partnerships from the 2024 to 2025 tax year, with an option to opt out.
Can I switch from cash to accrual accounting?
Yes, but switching can create a one-off tax adjustment and may need a form or election. Talk to your accountant and switch at the start of a tax year.
Do limited companies use accrual accounting?
Limited companies generally prepare their accounts on an accrual basis. Check the rules for your country and company type with an accountant.
