# Mastering Accounting Methods: Accrual vs. Cash Explained

![Accounting Method](https://www.investopedia.com/thmb/U7LhgkUAShQg3kkf5WatF1xXDIM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/accountingmethod_definition_final_primary-resized-005e466f5d72435fbf101c5e671b1ad5.jpg)

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## What Is an Accounting Method?

An accounting method details how companies report their revenues and expenses, with a focus on accrual versus cash accounting. Accrual accounting records transactions when they occur, while cash accounting handles them upon receiving or spending cash. Understanding these approaches is essential due to IRS requirements and their impact on financial statements.

[Cash accounting](https://www.investopedia.com/terms/c/cashaccounting.asp) reports revenues and expenses as they are received and paid through cash inflows and outflows; [accrual accounting](https://www.investopedia.com/terms/a/accrualaccounting.asp) reports them as they are earned and incurred through sales and purchases on credit and by using accounts receivable and accounts payable. [Generally accepted accounting principles (GAAP)](https://www.investopedia.com/terms/g/gaap.asp) require accrual accounting.

### Key Takeaways

*   Accounting methods determine how a company reports its revenues and expenses, with the main types being cash accounting and accrual accounting.
*   Cash accounting records transactions when cash changes hands, whereas accrual accounting records them when they are incurred, offering a clearer financial picture.
*   The IRS requires businesses with over $25 million in annual average sales to use accrual accounting, and switching methods requires IRS approval.
*   Companies may use a hybrid accounting method if they meet specific IRS criteria, although individuals must stick to one method.
*   Accurate accounting is crucial for financial management and compliance, affecting everything from tax reporting to loan eligibility.  
    

## Why Accurate Accounting Methods Matter

All businesses need to keep accounting records. Public [companies](https://www.investopedia.com/terms/c/company.asp) are required to do so. Accounting allows a business to monitor every aspect of its finances, from revenues to costs to taxes and more. Without accurate accounting, a business would not know where it stands financially, most likely resulting in its demise.

Accounting is also needed to pay accurate taxes to the [Internal Revenue Service (IRS)](https://www.investopedia.com/terms/i/irs.asp). If the IRS ever conducts an audit on a company, it looks at a company’s accounting records and methods. Furthermore, the IRS requires [taxpayers](https://www.investopedia.com/terms/t/taxpayer.asp) to choose an accounting method that accurately reflects their income and to be consistent in their choice of accounting method from year to year.

This is because switching between methods would potentially allow a company to manipulate [revenue](https://www.investopedia.com/terms/r/revenue.asp) to minimize its tax burdens. As such, IRS approval is required to change methods. Companies may use a hybrid of the two methods, which is allowable under IRS rules if specified requirements are met.

## Comparing Cash and Accrual Accounting: Key Differences

### Cash Accounting

Cash accounting is simple and commonly used by small businesses. In cash accounting, transactions are only recorded when cash is spent or received.

In cash accounting, a sale is recorded when the payment is received and an expense is recorded only when a bill is paid. Most people use cash accounting for personal finances, and it's suited for smaller businesses.  

If a business generates more than $25 million in average annual gross receipts for the preceding three years, however, it must use the accrual method, according to IRS rules.

### Accrual Accounting

Accrual accounting is based on the matching principle, which is intended to match the timing of revenue and expense recognition. The accrual method matches revenues with expenses to give a clearer picture of a company's financial condition.

Under the accrual method, transactions are recorded when they are incurred rather than awaiting payment. A purchase order is recorded as revenue immediately, and expenses are recorded even if not paid.

## Example: How Accounting Methods Impact Financial Reporting

Accrual accounting is especially valuable for large, complex businesses. For example, a construction company may undertake a long-term project and may not receive complete cash payments until the project is complete.

With cash accounting, expenses are incurred but revenue isn't recognized until the customer pays. So, the accounting book of the company would look weak until the revenue actually came in. If this company was looking for [debt financing](https://www.investopedia.com/terms/d/debtfinancing.asp) from a bank, for example, the cash accounting method makes it look like a poor bet because it is incurring expenses but no revenue.

In accrual accounting, a construction company records part of its revenue and expenses as each project phase completes. This is known as the [percentage of completion method](https://www.investopedia.com/terms/p/percentage-of-completion-method.asp). How much actual cash is coming into the company, however, would be evident in the cash flow statement. This method would show a prospective lender a much more complete and accurate picture of the company’s revenue pipeline.

## What Do the 2 Primary Accounting Methods Report?

Accrual accounting reports revenues and expenses as they are earned and incurred through sales and purchases on credit and by using accounts receivable and accounts payable.

Cash accounting reports revenues and expenses as they are received and paid through cash inflows and outflows.

## What Does the IRS Require for Accounting Methods?

The IRS requires businesses making an average of $25 million or more in sales for the preceding three years to use accrual accounting. As for individual taxpayers, the IRS mandates that they choose an accounting method that accurately reflects their [income](https://www.investopedia.com/terms/i/income.asp) and be consistent in their choice of accounting method from year to year.

## Can a Hybrid of the 2 Primary Accounting Methods Be Used?

Yes, by companies but not individuals. Companies may use a hybrid of accrual accounting and cash accounting under IRS rules if specified requirements are met. Switching between methods is not allowed because it would potentially allow a business to manipulate revenue to minimize its tax burdens.

## Conclusion: Choosing the Right Accounting Method

Choosing the right accounting method is crucial for accurately reporting revenues and expenses. Accrual accounting, preferred by large businesses and required by GAAP and the IRS for companies with substantial revenues, matches revenues with expenses incurred. Cash accounting, simpler and used by many small businesses, records transactions only when cash changes hands.

Organizations must select an accounting method that accurately reflects their financial activities and adhere to it consistently unless officially approved for change. Large businesses must use accrual accounting if annual gross receipts exceed $25 million. Understanding these methods enables companies to manage their finances effectively and comply with regulatory requirements.  

> **Article Sources**
>
> 1.  Internal Revenue Service. “[Publication 538: Accounting Periods and Methods](https://www.irs.gov/pub/irs-pdf/p538.pdf),” Page 9.