What is Cash Basis and Accrual Basis

Two primary accounting methods, cash and accrual basis, are used to calculate taxable income for U.S.Federal Income Taxes. According to the Internal Revenue Code, a taxpayer may compute taxable income by:

1. the cash receipts and disbursements method;
2. an accrual method;
3. any other method permitted by the chapter; or
4. any combination of the foregoing methods permitted under regulations prescribed by the Secretary.

As a general rule, a taxpayer must compute taxable income using the same accounting method he uses to compute income in keeping his books.Also, the taxpayer must maintain a consistent method of accounting from year to year. Should he change from the cash basis to the accrual basis (or vice versa), he must notify and secure the consent of the Secretary. 
Cash basis taxpayers include income when it is received, and claim deductions when expenses are paid. A cash basis taxpayer can look to the doctrine of constructive receipt and the doctrine of cash equivalence to help determine when income is received. Most individuals start as cash basis taxpayers. There are three types of taxpayers that cannot use the cash basis: (1) C corporations; (2) partnerships with at least one C corporation partner; and (3) tax shelters.
Similar definition of cash basis accounting is true for financial accounting purposes.






Accrual basis taxpayers include items when they are earned and claim deductions when expenses are incurred. An accrual basis taxpayer looks to the “all-events test” and “earlier-of test” to determine when income is earned. Under the all-events test, an accrual basis taxpayer generally must include income "for the taxable year when all the events have occurred that fix the right to receive income and the amount of the income can be determined with reasonable accuracy." Under the "earlier-of test", an accrual basis taxpayer receives income when (1) the required performance occurs, (2) payment therefor is due, or (3) payment therefor is made, whichever happens earliest.Under the earlier of test outlined in Revenue Ruling 74-607, an accrual basis taxpayer may be treated, as a cash basis taxpayer, when payment is received before the required performance and before the payment is actually due. An accrual basis taxpayer generally can claim a deduction “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.”
Similar definition of accrual basis accounting is true for financial accounting purposes, except that revenue can't be recognized until it's earned even if a cash payment has already been received.