A small agency signed a $35,000 retainer in November and began work right away. On cash basis, November's P&L showed no revenue because payment was not due until December 15. Accrual accounting would show about $11,600 earned in November. Same business, different picture, based on the method used.
The cash or accrual choice is less important in year one than many owners expect. It matters more when receivables rise, payables become routine, and the gap between earning revenue and collecting it reaches 30, 60, or 90 days.
Cash Basis Accounting
Cash accounting records income when payment arrives and expenses when they are paid. An October invoice paid in December becomes December revenue. A year of software paid for in January becomes a January expense.
Cash basis is the default for many small businesses, and the IRS permits most sole proprietors, partnerships, and S corporations to use it. It follows the bank statement fairly closely: money in is income, and money out is expense. For businesses with quick-paying clients, no inventory, and few unpaid bills, it usually gives a reasonable view of financial health.
Simplicity is its main benefit. You do not need separate accounts for receivables and payables, and the books stay close to the bank statement. Bookkeeping setup is simple, and year-end taxes are easier to reconcile with actual deposits.
Accrual Accounting
Accrual accounting records income when it is earned, such as when a product ships or a service milestone is complete, regardless of payment timing. Expenses are recorded when incurred, when the obligation arises rather than when payment is made.
This method adds two balance sheet accounts that cash basis does not require: accounts receivable for unpaid invoices and accounts payable for unpaid bills. The P&L shows the period's economic activity, not just its cash movements.
Generally Accepted Accounting Principles, or GAAP, require accrual accounting. That is why businesses seeking outside investment or preparing audited financial statements must use it. Accrual also gives a clearer view of economic profitability apart from current cash levels.
When Cash Basis Misleads You
For service businesses, three patterns suggest cash basis no longer reflects reality closely enough for sound decisions.
Growing receivables: If 30 to 60 days of revenue is typically invoiced but unpaid, cash basis continually understates what you have earned. A business with $20,000 in receivables at month-end reports that revenue a month late. As receivables grow, cash basis understates profit during growth and overstates it when collections catch up.
Large prepaids or deposits: Annual software, prepaid rent, and client deposits can distort cash results. A $12,000 software contract paid in January appears as a January expense, though it covers the year. A $15,000 deposit received in June counts as income even when work has not begun.
Project revenue across periods: For agencies, consultants, and software developers on retainer, work starting in November and finishing in February represents activity across those months. Cash basis places it in the payment month, which may not match when delivery costs were incurred.
When the IRS Requires Accrual
The IRS requires accrual for some businesses. Before the Tax Cuts and Jobs Act of 2017, the threshold was average annual gross receipts above $5 million. The TCJA raised it: most businesses below $25 million in average annual gross receipts, inflation-adjusted, may use cash, even with inventory.
Businesses with significant inventory that do not qualify for this exception may still need accrual for inventory purchases and sales. Those inventory rules are separate from the general method election and depend on the inventory's nature and scale.
C corporations have a separate threshold. Under current rules, C corps above $25 million in average annual gross receipts, inflation-adjusted, generally must use accrual. The inflation-adjusted threshold for 2025 was approximately $30 million. Below it, C corps may elect cash.
For the overwhelming majority of small businesses with under $1 million in annual revenue, the IRS does not require accrual. Switching is a management decision, not a compliance requirement.
Making the Switch
Changing methods takes more than selecting a new bookkeeping setting. You must file IRS Form 3115, Application for Change in Accounting Method, and make a Section 481(a) adjustment for income and expenses treated differently under the new method.
A Section 481(a) adjustment can be positive, when cash basis deferred income or accelerated expenses, or negative, when previously reported income must be reversed. The IRS generally lets a positive 481(a) adjustment spread over four years, reducing its tax impact. A negative adjustment is usually taken in the year of change.
In practice, switch at the start of a fiscal year with a CPA's help. A mid-year change is harder to untangle. Review the decision in Q4 of the year before the planned change.
Most Small Service Businesses Can Stay on Cash Basis Longer
We work with many early-stage founders who consider accrual to appear more professional or prepare for investment discussions. For a business under $500,000 in annual revenue with typical 30-day payment terms, cash basis is usually close enough for internal decisions. Switching adds real complexity, while the accuracy gain stays modest until receivables and payables become large compared with monthly revenue.
Act when your cash basis P&L repeatedly confuses you or leads to wrong conclusions. A strong-profit month with tight cash, or a low-profit month that does not fit the work completed, suggests accrual may clarify things. The mismatch is the practical trigger, not a revenue threshold or business birthday.
This article covers general accounting methods under current US tax and accounting rules. A method change has tax consequences and calls for professional guidance. Before switching, work with a CPA to calculate the Section 481(a) adjustment and advise on timing.