Every business has to choose how it records revenue and expenses. The two main options are cash basis and accrual basis. The choice affects your financial statements, your taxes and how well you understand your own business.
The difference in one example
Say you finish a $20,000 project in December and invoice the client. They pay in January.
- Cash basis: the $20,000 is income in January, when the money arrives.
- Accrual basis: the $20,000 is income in December, when you earned it.
The same logic applies to expenses. Under cash basis, a bill counts when you pay it. Under accrual, it counts when you incur it.
Why small businesses start on cash
- It is simple: income and expenses match your bank account
- It is easy to keep up without an accountant
- It can help with tax timing, since income is taxed when received
Where cash basis starts to mislead
As a business grows, cash basis can paint the wrong picture. A big month of sales might look like a loss because the customers have not paid yet. A quiet month might look strong because old invoices finally came in. Decisions made on those numbers can go badly wrong.
Cash basis tells you what happened in your bank account. Accrual basis tells you how the business actually performed.
Signs it is time to switch to accrual
- You carry inventory
- You invoice customers on terms and wait 30 days or more to get paid
- Lenders or investors ask for GAAP financial statements
- You need accurate monthly margins to make pricing or hiring decisions
- Your revenue is approaching the IRS gross receipts threshold for cash accounting
The tax side
For tax purposes, many small businesses can choose cash basis. Larger businesses, including C corporations above an IRS gross receipts threshold, generally must use accrual. The threshold is indexed for inflation and has been around $30 million in recent years. Changing your tax accounting method usually requires filing IRS Form 3115, so plan the switch with your tax advisor rather than doing it mid-year on your own.
You can also keep tax and management reporting on different bases. Some businesses file taxes on cash basis while running accrual-based monthly reports for decision-making.
Thinking about switching methods?
Our advisory team can model the impact on your numbers and handle the accounting side of the change.
What the switch involves
Moving from cash to accrual
- Record accounts receivable for unpaid customer invoices
- Record accounts payable for unpaid bills
- Set up accruals for expenses incurred but not yet billed
- Adjust revenue recognition for prepaid or long-term contracts
- Restate opening balances so comparisons make sense
A middle ground
Some businesses use a modified cash basis: mostly cash, with accrual treatment for a few big items like fixed assets or long-term debt. It can be a sensible step, though it is not accepted for GAAP reporting.
Frequently asked questions
Straight answers to what people ask us before they hand over the work.
Can I use cash basis for taxes and accrual for reporting?
Many businesses do exactly that. They file taxes on cash basis where allowed and use accrual-based monthly reports to run the business.
When must a business use accrual accounting?
Generally when it is above the IRS gross receipts threshold, which is indexed for inflation. Inventory and GAAP reporting requirements can also push a business toward accrual. Your tax advisor can confirm what applies to you.
How do I switch from cash to accrual?
For management reporting, you set up receivables, payables and accruals and restate opening balances. For tax, a change of method usually needs IRS Form 3115 and should be planned with your tax advisor.
Is accrual accounting more work?
Somewhat, because you track what is owed both ways and record accruals each month. For a growing business, the clearer picture is usually worth it.
The bottom line
Cash basis is fine when you are small and simple. Once you carry inventory, extend credit or need to show investors and lenders reliable numbers, accrual gives you a truer picture. Make the switch deliberately, at a clean break point and with advice on the tax side.
This article is general information, not tax advice. Talk to your tax advisor about your specific situation.