Cash vs. Accrual Accounting for US Businesses: How to Choose and Change Methods

Which accounting method should your US business use?

Your choice between cash and accrual accounting is one of the most consequential decisions you'll make as a business owner. It affects when you report income and expenses, how much tax you owe, and what financial statements look like to lenders and investors. The good news: the IRS is clear about who must use which method, and switching is possible—but only with permission.

Let's walk through the rules, the practical differences, and the process for changing methods if your business grows.

---

The fundamental difference: timing

Cash accounting is simple: you report income when money arrives in your bank account, and expenses when you actually pay them. If a client pays you in December for work done in January, that income counts in December.

Accrual accounting records income when you earn it (invoice sent, work completed) and expenses when you incur them (invoice received, obligation created)—regardless of when cash changes hands. That same client invoice counts as income in January, even if they pay in December.

For many small-business owners, cash accounting feels intuitive: your tax liability mirrors your cash flow. But accrual accounting gives a truer picture of business performance and is required by larger businesses.

---

Who can use cash accounting? (The IRS rules)

The IRS allows cash-basis accounting for most small businesses, but there are important exceptions:

Sole proprietors, partnerships, and S-corporations with average annual gross receipts of less than $27.5 million (the threshold as of recent years; confirm the current figure with your tax advisor) may use cash accounting.
C-corporations with receipts below this threshold may also use cash accounting.
Businesses with inventory (retailers, manufacturers, wholesalers) must use accrual accounting for inventory purchases and sales, though they can sometimes use cash for other transactions. This is called the hybrid method.
Tax shelters and certain farming operations have their own rules.

The IRS updates these thresholds, so your accountant should confirm which applies to your current situation.

---

Why larger businesses must switch to accrual

As your business grows and reaches the gross-receipts threshold, you have no choice: you must switch to accrual accounting. The reason is sound: accrual accounting matches revenue to expenses in the same period, giving regulators, lenders, and investors an honest view of profitability. A cash-basis business might look wildly profitable one year and struggling the next, simply because of when clients pay—not because of actual performance.

If you're managing a growing business, accrual accounting also makes sense for:

Securing loans — lenders and investors expect audited or reviewed accrual-basis statements.
Planning accurately — you see true profit margins, not just cash in/out.
Raising capital — venture investors and equity partners demand accrual financials.

---

Cash accounting: advantages and limitations

When cash accounting makes sense

Simple record-keeping — you track bank deposits and cheques, nothing more.
Tax timing control — you can defer income by delaying invoices or accelerate deductions by paying bills early in the year (within rules).
Cash-flow alignment — your tax liability roughly matches your available cash.
Minimal accounting staff — a small business can manage it with basic bookkeeping.

The catch

Misleading P&L — if you invoice $100,000 in December but the client pays in January, you'll report zero revenue in December and $100,000 in January, distorting performance.
Audit risk — the IRS may question whether you're manipulating timing for tax benefit.
Lending challenges — banks often won't accept cash-basis statements for commercial loans.
No inventory tracking — if you sell products, you can't use pure cash accounting.

---

Accrual accounting: the bigger picture

When accrual accounting is required or preferred

You're above the gross-receipts threshold — legally mandated if your business passes the IRS limit.
You carry inventory — essential to match cost of goods sold to revenue in the same period.
You want to borrow money — most lenders require audited accrual statements.
You plan to sell the business or raise investment — buyers and investors expect accrual financials.
Your business has significant accounts receivable/payable — accrual gives a truer picture of obligations.

The cost

More complex bookkeeping — you need software (QuickBooks Online, Xero, Sage) and possibly a part-time bookkeeper.
Higher accounting fees — accrual-basis tax returns take more expertise and time.
Less tax-timing flexibility — you can't defer income or accelerate deductions as easily.
Requires proper cut-off procedures — at year-end, you must accrue invoices and bills for the period to ensure accuracy.

---

How to request a change in accounting method

If your business grows and you need to switch from cash to accrual (or vice versa), you must obtain IRS permission. This is not automatic.

Step 1: Determine if you need permission

If you're approaching or exceeding the gross-receipts threshold, you're likely required to switch. If you're doing it voluntarily for business reasons, permission is still required.

Step 2: File Form 3115

The IRS uses Form 3115, "Application for Change in Accounting Method," to process requests. Key points:

File it with your tax return for the year of change (usually).
Include a detailed statement of the business reason for the change.
Pay the required user fee (amounts vary; check the current IRS fee schedule).
Your tax advisor or CPA should prepare this form to ensure it meets IRS standards.

Step 3: Be ready for adjustments

When you switch, you'll likely have a Section 481(a) adjustment — a one-time correction to opening accounts receivable/payable to prevent double-counting income or deductions. Your accountant calculates this and may spread it over four years for tax purposes.

Step 4: Get it approved

The IRS will review your Form 3115 and issue a letter of approval. Don't change your method before you receive approval.

---

A practical example: the growing e-commerce business

Imagine you launch a small online retail business selling handmade goods. In year one, you gross $500,000 in revenue. You're well below the threshold, so cash accounting is fine: you report income when customers pay via credit card, and expenses when you buy inventory or pay suppliers.

By year three, you're hitting $20 million in annual sales. You now have:

$3 million in outstanding customer invoices (unpaid).
$1.5 million owed to suppliers (unpaid).
A warehouse inventory worth $2 million at cost.

With cash accounting, your tax return would show revenue only for the $2 million your customers have paid so far this year—wildly distorted. The IRS would require you to switch to accrual. You file Form 3115, make the switch, and suddenly your tax return reflects true revenue of $8 million against $6 million in actual costs, revealing your real gross margin. It may increase your tax bill that year, but lenders now see honest financials and will fund your expansion.

---

Key takeaway for your business

Start with the method that fits your size and complexity today. As you grow, expect to switch to accrual—it's not a penalty, it's the price of transparency and scale. Plan for the transition now: understand the Form 3115 process, budget for higher accounting costs, and work with a licensed CPA or EA who can model the financial impact of the change.

The method you choose shapes how you see—and how others see—your business. Choose wisely, and review it annually.

---

References and further reading

---

Ready to make the right choice?

Your accounting method is too important to guess. Every business is different, and the rules change. If you're unsure whether to use cash or accrual, or if you need to request a change, book a consultation with one of our licensed CPAs or EAs. We'll review your situation, model the tax impact, and guide you through Form 3115 if needed. Let's make sure your books work for you, not against you.

Frequently asked questions

Can I change from accrual back to cash accounting if my business shrinks?+

Yes, but only with IRS approval via Form 3115. You'll need to show a legitimate business reason. The IRS is generally more permissive about switching to accrual (for growth) than back to cash, so be prepared to explain the change clearly.

What's the gross-receipts threshold for 2024?+

The IRS threshold is $27.5 million as of recent years, but this is indexed for inflation and may change. Confirm the current figure with your accountant before relying on it for a decision.

Do I have to change my accounting method if I incorporate?+

Not automatically. Your method depends on your entity type (sole prop, S-corp, C-corp) and gross receipts. Incorporating doesn't force a change, but you should review the rules with a tax advisor, as some entity types have different thresholds.

Can I use a hybrid method—cash for some accounts and accrual for others?+

Yes, if you have inventory. You must use accrual for inventory and cost of goods sold, but may use cash for other income and expenses. This requires careful bookkeeping and IRS approval.

What happens if I change methods without IRS permission?+

The IRS may challenge your tax return and require you to file an amended return (Form 1040-X or 1120-X) with penalties and interest. Always request permission via Form 3115 before changing methods.

Want this handled properly for your business?

Book a free consultation → See pricing

← All articles