Lesson 2.2 35 min
Cash basis and accrual basis
Two ways of timing revenue and expenses, what the CRA and IRS permit, and how to convert one to the other.
Cash basis records revenue when money arrives and expenses when money leaves. Accrual basis records revenue when it is earned and expenses when they are incurred. Module 1 used accrual throughout. Many small businesses keep their day-to-day records closer to cash basis, so it is worth knowing exactly where the two differ and how to move between them.
Two clocks for the same business
Under cash basis, Northside's catering invoice for December becomes revenue in January when the customer pays. Under accrual, it is December revenue because the food was delivered in December. The same split applies to every timing difference in the business: rent paid ahead, wages owed, inventory bought but not used, gift cards sold but not redeemed.
Over the full life of a business the two methods give the same total profit. Within any one period they can be far apart, and the gap is largest when the business is growing, buying equipment, or extending credit.
What the tax authorities allow
The rules differ between Canada and the US.
In Canada, the CRA requires business income to be reported on the accrual method. Farmers, fishers and self-employed commission agents may use the cash method instead. A cafe, a plumbing company or a consultancy reports on accrual.
In the US, IRS Publication 538 explains that many small businesses may choose the cash method. A corporation or partnership (other than a tax shelter) can generally use it if its average annual gross receipts for the three prior tax years were $26 million or less, a threshold indexed for inflation. Businesses that must account for inventory have additional rules, which Publication 538 sets out.
Financial statements prepared under IFRS, ASPE or US GAAP are accrual-based regardless of what the tax return uses. A bank lending to Northside will expect accrual statements.
Why accrual gives the better picture of a period
Accrual matches each period's revenue with the costs of earning it. The difference from cash accounting is largest in three situations, each of which Northside had in 2025:
- Large purchases of long-lived assets, which cash basis treats as a one-time hit and accrual spreads over their useful life.
- Credit sales and credit purchases, where cash lags the economic event.
- Prepayments in either direction, such as rent paid ahead and gift cards sold ahead.
Cash basis still has a role. It is simple, it shows how much money actually moved, and for a business with no inventory, no credit and no large assets, it can track accrual closely. The statement of cash flows (lesson 1.4) is in effect a cash-basis report presented alongside the accrual statements.
Converting cash records to accrual
If the books are kept on a cash basis, accrual figures can be produced at month end or year end with a set of adjustments. For each type of item:
- Revenue: add receivables at the end of the period, subtract receivables at the start, subtract the increase in customer deposits or unearned revenue.
- Purchases of inventory: add payables at the end, subtract payables at the start, then adjust for the change in inventory to get cost of goods sold.
- Expenses: add accrued liabilities (wages, interest, utilities) at the end, subtract those at the start; subtract the increase in prepaids.
- Equipment: remove the purchase from expenses, add it to assets, and record depreciation.
This is the indirect method of lesson 1.4 run in reverse.
Worked case
Northside's year, three ways
Northside's bank account tells one story, its operating cash flow another, and its accrual income statement a third.
| Measure | $ |
|---|---|
| Cash in less all cash out for operations and equipment | (27,420) |
| Operating cash flow, before tax payments | 44,580 |
| Accrual income before tax | 32,680 |
A cash-basis view that treats the equipment as a 2025 expense shows a loss of $27,420. The business did not lose money in any useful sense; it converted $72,000 of cash into equipment it will use for six years. Operating cash flow of $44,580 strips out the equipment purchase but still mixes up timing. Accrual income before tax of $32,680 is the figure that answers "what did 2025's operations earn?"
The bridge from operating cash flow to accrual income:
| $ | |
|---|---|
| Operating cash flow | 44,580 |
| Depreciation, an expense with no cash this year | (12,000) |
| Catering earned but not yet collected | 3,500 |
| Inventory bought and still on the shelf, so not yet expense | 6,000 |
| Rent and insurance paid ahead | 5,400 |
| Supplies used but not yet paid for | (9,000) |
| Wages earned by staff, paid in January | (4,000) |
| Gift cards sold but not yet redeemed | (1,800) |
| Accrual income before tax | 32,680 |
Template
Cash-to-accrual converter
Enter cash receipts and payments by category, plus opening and closing receivables, payables, prepaids, accruals, inventory and deferred revenue. The workbook produces accrual revenue, expenses and income, with a reconciliation back to cash. Northside's 2025 figures are loaded.
The full working file, 2-2-cash-to-accrual.xlsx, is in the Accounting and Finance Toolkit, Part 1. The lesson above teaches the method and shows the worked numbers, so you can build it yourself in any spreadsheet.
Exercises
Work these, then open the answers
Can a Canadian plumbing corporation file its taxes on the cash method? Can a US plumbing corporation with $2 million of average gross receipts?
Answer
The Canadian corporation cannot; the CRA requires accrual for business income except for farmers, fishers and self-employed commission agents. The US corporation generally can, since it is under the gross receipts threshold in Publication 538, subject to the publication's inventory rules.
A consultant collects $8,000 in January for work done in December, and $5,000 in December for work to be done in January. What is December revenue on each basis?
Answer
Cash basis: $5,000 (the money received in December). Accrual basis: $8,000 (the work performed in December). The $5,000 received in advance is a liability at December 31.
Using the bridge in the case, which single item explains most of the gap between operating cash flow and accrual income before tax?
Answer
Depreciation of $12,000. The working capital items largely offset each other: increases in operating assets add $14,900 and increases in operating liabilities take away $14,800.
Check
4 questions
Sources
Sources
- Accounting methods, Canada Revenue Agency
- Publication 538, Accounting Periods and Methods, Internal Revenue Service
- Accounting Standards for Private Enterprises, FRAS Canada
- Principles of Accounting, Volume 1: Financial Accounting, OpenStax, Rice University