Cash vs Accrual Accounting: When a Growing Company Should Switch

Cash accounting is simple and fine at the start, but timing differences distort it as contracts and balances grow.

Say a customer pays $120,000 in December for a twelve-month subscription that begins in January: a cash-basis income statement shows $120,000 of December revenue and nothing in the following months, so December looks like a record month and the year that follows looks empty. If you keep accrual books, you record $10,000 of revenue each month as the service is delivered and hold the remainder as deferred revenue.

The same distortion applies to costs. A large vendor bill received in December and paid in January shows up as a January expense on a cash basis, although it relates to December. If prepayments grow each year, cash-basis revenue also runs further ahead of earned revenue.

Look for these triggers:

• You bill annually or multi-year in advance, or you have large customer deposits.
• You carry inventory, or your payables and receivables are large relative to monthly cash movement.
• A lender, investor or acquirer asks for accrual-basis or GAAP financial statements.
• You are preparing for an audit or review.
• Your monthly results swing in ways that do not match how the business is performing.
• Revenue recognition needs a written policy, as with bundled services or usage-based billing.

If several of these apply, accrual books will give you better decisions right away, and switching earlier is cheaper than switching under time pressure during a financing or diligence process.

Tax method and book method are related but not identical. Under the tax code, certain corporations, and partnerships with corporate partners, whose average annual gross receipts over the prior three years exceed an inflation-adjusted threshold generally must use the accrual method for tax. The threshold is indexed each year, so look up the current amount in the IRS instructions or ask your CPA. Businesses below the threshold can often keep a cash method for tax, and some inventory exceptions apply.

Many companies keep accrual books for management and lenders while filing tax returns on a cash basis where allowed, with a reconciliation of the differences. Changing a tax accounting method generally requires filing an IRS form for a method change, so do not switch your return method informally. Discuss the choice with your CPA before the year begins.

If your outside accountant will change at the same time, do it as a separate project, per the accounting firm switching checklist.

The conversion adds the balance sheet accounts that cash accounting leaves out. Do it as of a clean cutoff date, such as month-end or year-end:

1. Record accounts receivable for invoices issued but not yet paid.
2. Record accounts payable for bills received but not yet paid, and accrued expenses for services received but not yet billed.
3. Record prepaid expenses for costs paid in advance, such as annual insurance or software, and spread them over the period covered.
4. Record deferred revenue for customer payments received before the service is delivered.
5. Add accrued payroll and payroll taxes for wages earned but unpaid at the cutoff.
6. Record inventory, if you hold it, at cost.
7. Book depreciation and amortization on fixed assets and capitalized costs.
8. Record accrued interest on debt, including any interest that is added to the balance.

Then tie each new balance to support, and compare accrual results to the old cash results to explain the differences.

Accrual accounting adds monthly tasks that cash accounting skips, so build them into a close checklist: review the receivable and payable agings, book accruals and prepaid amortization, roll forward the deferred revenue schedule and reconcile every balance sheet account. A clean chart of accounts makes this easier, and chart of accounts for SaaS shows one structure.

Software helps at each stage. Entry-level packages handle basic accrual entries, and larger companies typically add close and ERP tools, compared in the close software comparison and the accounting system comparison.