The difference between cash and accrual accounting comes down to one question: when does a transaction count?
Under the cash method, income is recorded when you receive it and expenses when you pay them. Under the accrual method, income is recorded when you earn it and expenses when you incur them, regardless of when money moves.
For a business that invoices on completion and collects in 45 days, those two pictures can be very far apart.
A worked example
You finish a $90,000 job in December. Materials of $40,000 were purchased in November on a supplier account you pay in January. The customer pays you in February.
Cash method: December shows no revenue and no expense. January shows a $40,000 loss. February shows a $90,000 profit. Three months, wildly different, none of them describing what happened.
Accrual method: December shows $90,000 of revenue and $40,000 of cost, for $50,000 of gross profit — in the month you did the work.
The accrual view is the accurate one. It is also the one that will not tell you that you cannot make payroll in January, which is the cash method’s genuine strength.
Who gets to choose
Most small businesses may elect either method. The constraint is the gross receipts test under IRC §448.
A taxpayer that is not a tax shelter and whose average annual gross receipts for the three prior years fall at or below the threshold may use the cash method. That threshold was $31 million for tax years beginning in 2025 and is indexed for inflation annually, so confirm the current-year figure before relying on it.
Two points owners frequently miss. First, businesses that carry inventory were historically forced onto accrual; the small business taxpayer rules have substantially relaxed that, but inventory still requires specific treatment. Second, the test looks at a three-year average, so a single exceptional year does not immediately disqualify you — and equally, you can cross the threshold without noticing.
Publication 538 is the governing reference, and it is worth reading before assuming your current method is the one you elected.
The hybrid nobody talks about
Many owner-led businesses run what is effectively a hybrid: accrual internally for management reporting, cash for the tax return. That is legitimate and common — the tax return reflects the method you elected, while your internal statements can be prepared however is most useful.
It requires discipline. Two sets of books maintained casually become two sets of books that disagree for reasons nobody can reconstruct. Done properly, with a documented bridge between them, it gives you accurate operating information and the cash-basis deferral on the return.
The trap: profitable on paper, out of cash
The most dangerous position is a growing business on the accrual method that is not watching cash.
Growth consumes cash. You buy materials, pay crews, and carry receivables — all before the customer pays. On the accrual method the income statement records profit the moment work is complete, so the business looks healthier the faster it grows, right up until it cannot fund the next job.
This is why we insist on reading the balance sheet alongside the income statement. Growing receivables, growing inventory, and shrinking cash form a recognizable pattern, and it is invisible on the profit-and-loss.
Our working capital calculator surfaces the same picture from the balance sheet, and the cash runway calculator puts a number of months on it.
Switching methods
You cannot simply start recording things differently. Changing your overall method of accounting generally requires filing Form 3115 and computing a §481(a) adjustment — a catch-up that prevents income from being counted twice or dropped entirely in the year of change.
Many method changes qualify for automatic consent, which avoids a user fee, but the form is still required. Where the adjustment increases income, it is generally spread over four years; where it decreases income, it is typically taken entirely in the year of change. That asymmetry means timing a method change is worth planning rather than doing reactively.
How to choose
If you invoice on terms, carry inventory, or run jobs across month boundaries, use accrual internally. You cannot manage margins you cannot see, and the cash method scatters a single job across several periods.
If you are a service business paid at the point of sale with no receivables and no inventory, the two methods converge and the cash method’s simplicity wins.
For everyone in between — most contractors, most agencies, most firms with any meaningful receivable — the practical answer is accrual for decisions, cash for the return where you qualify, and a monthly look at both.