The cash basis method of accounting records revenues when received and expenses when paid out, not when earned or incurred.
The accrual method of accounting is based on U.S. GAAP rules and records revenues when earned and expenses when incurred – whether or not cash changes hands at that moment.
GAAP stands for Generally Accepted Accounting Principles and is a set of standardized rules that require the uniform preparation of financial statements. In the U.S. most businesses have to follow GAAP rules however there are some exceptions.
Small businesses up to $5M in annual revenue are not required to follow U.S. GAAP and the accrual method of accounting. Once a business reaches $5M in annual revenue, accrual method of accounting and U.S. GAAP rules must be followed. Most small businesses with revenue of less than $5M use a combination of the two which is called modified cash basis method of accounting.
While the cash basis method is an acceptable method, there are certain requirements that the IRS is enforcing and small businesses have to comply with.
- Purchase of inventory whether that is raw materials to be transformed into finished goods, or purchase of finished goods inventory for resale.
- Capital expenditures such as computers, furniture, equipment, buildings or land.
