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When Does a Business Need to Switch to Accrual Accounting?

Many small businesses begin with cash-basis accounting because it is relatively simple.

Under the cash method, income is generally recorded when the business receives payment, and expenses are generally recorded when the business pays them.

For a small business with limited transactions, few customers, and little or no inventory, this approach may be practical.

However, as a company grows, cash-basis accounting may no longer provide management with an accurate picture of the business’s financial performance.

A company may have completed significant work but not yet received payment. It may have outstanding bills that have not yet been paid. It may have substantial inventory, accounts receivable, or accounts payable.

In these situations, accrual accounting may provide a more accurate picture of the company’s financial condition.

The question is not simply whether a business is growing. The more important question is whether the company’s current accounting method continues to clearly reflect its income, expenses, assets, liabilities, and overall financial performance.

At Velin & Associates, Inc., we help businesses evaluate their accounting systems, financial reporting, and tax accounting methods as they grow. This article explains when a business may need to consider switching to accrual accounting and what business owners should understand before making that decision.

What Is Cash-Basis Accounting?

Under the cash method, a business generally recognizes income when it receives payment and deducts expenses when it pays them.

Example: A consulting company completes a $20,000 project in December. The customer pays the invoice in January. Under the cash method, the revenue is generally recognized when the payment is received, subject to applicable tax rules. Similarly, if the business receives an invoice from a vendor in December but pays it in January, the expense is generally recognized when paid under the cash method, subject to applicable rules. This approach can be relatively straightforward for businesses with simple operations.

However, it may make it difficult to understand what the business actually earned or incurred during a specific period.

What Is Accrual Accounting?

Under the accrual method, income is generally recognized when earned, and expenses are generally recognized when incurred, rather than simply when money changes hands.

The purpose is to match business activity with the period in which it occurred.

Example: A business performs $100,000 of services during December. The customer does not pay until January. Under accrual accounting, the revenue may generally be recognized in the period in which the business earned the revenue, assuming the applicable recognition requirements are met. The same principle applies to expenses. A business may receive services in December but pay the related invoice in January. Under accrual accounting, the expense may generally be recognized in the period in which the liability was incurred, subject to the applicable rules.

The result is often a more accurate picture of the company’s actual financial performance.

Why Businesses Eventually Consider Accrual Accounting

Many businesses consider switching to accrual accounting when the cash method no longer accurately reflects the company’s operations.

Common reasons include:

Example: A company generates $2 million in annual revenue. However, customers frequently pay 30, 60, or 90 days after receiving invoices. The business may have completed substantial work before receiving cash. If management looks only at bank deposits, the company’s monthly performance may appear inconsistent.

Accrual accounting may provide a clearer picture of the revenue actually earned during each period.

Revenue Growth Is One of the Most Common Reasons to Reevaluate Accounting

As a business grows, the timing difference between earning revenue and receiving payment can become increasingly important.

Example: A company completes the following work:

Customers pay both invoices in February.

Under a cash-based view, the business may appear to have little or no revenue in December and January. Under an accrual-based view, the company can better evaluate the revenue associated with the work performed during each period, subject to the applicable accounting and tax rules.

This can be important for:

Accounts Receivable Can Make Cash-Basis Financial Statements Difficult to Interpret

Accounts receivable represents amounts owed to the business by customers.

Businesses with significant receivables may find that cash-basis financial statements do not accurately reflect current operating performance.

Example: A professional services company completes several large projects during the final quarter of the year. The company has earned $500,000 in revenue but has collected only $250,000. A cash-basis profit and loss statement may show only the amount collected. Management may therefore underestimate the amount of business actually generated during the period.

Accrual accounting can help present a more complete view of earned revenue and outstanding receivables.

Accounts Payable Can Also Affect the Financial Picture

The same issue applies to expenses.

A business may receive goods or services before paying the related invoices.

Example: A corporation receives $100,000 of professional services during December. The vendor’s invoice is paid in January. Under accrual accounting, the expense may generally be recorded in the period in which the obligation was incurred, subject to applicable rules.

This helps management evaluate the true cost of operating the business during that period.

Inventory Is a Major Factor

Businesses that purchase, manufacture, or sell merchandise often need to consider inventory accounting rules.

Inventory may include:

Historically, businesses with inventory generally had to use accrual accounting for purchases and sales of merchandise. However, certain qualifying small business taxpayers may use special rules and may not be required to maintain inventory in the same manner as larger businesses. The applicable rules depend on the business’s size, structure, industry, and other factors.

Example: An e-commerce company purchases $500,000 of inventory during the year but sells only $350,000 of those products. The remaining inventory may still be held by the company at year-end. Simply treating every purchase as an immediate expense may not accurately reflect the company’s cost of goods sold or profitability.

Inventory accounting should be reviewed carefully.

Businesses With Long-Term Projects May Benefit From Accrual-Based Reporting

Some businesses work on projects that span multiple months or years.

Examples include:

Example: A company signs a $1 million contract for a project lasting 12 months. The company incurs expenses throughout the project and receives payments according to a contract schedule. A simple cash-basis view may make the company’s financial performance appear unusually profitable in one month and unprofitable in another. Accrual-based financial reporting may provide management with a better understanding of project profitability over time.

Special tax rules may apply to certain long-term contracts, so the tax treatment should be evaluated separately from the company’s management accounting practices.

Rapid Growth Can Create a Need for Better Financial Reporting

A business may begin with relatively simple accounting.

As revenue grows, however, the company may add:

The business may eventually need more detailed financial reporting.

Example: A company grows from $300,000 to $5 million in annual revenue. The owner previously reviewed bank balances and basic cash-basis reports.

As the company grows, management needs to understand:

Accrual-based financial reporting may provide more useful information for these decisions.

Investors and Lenders Often Expect Accrual-Based Financial Statements

Businesses seeking financing or investment may need financial statements that present a more complete picture of the company’s financial position.

Lenders and investors may want to evaluate:

Example: A growing company applies for a significant bank loan. Its cash-basis financial statements show strong cash deposits during several months. However, the lender also wants to understand outstanding customer receivables, unpaid obligations, and inventory levels.

Accrual-based financial statements may provide information that is more useful for evaluating the company’s overall financial condition.

Accrual Accounting Can Improve Business Valuation

When a business is being sold, potential buyers generally want to understand the company’s underlying operating performance.

Cash timing can sometimes distort results.

Example: A business receives several large customer payments in December for work that was performed over several months. A cash-basis report may show unusually high December revenue. A potential buyer may want to understand when the revenue was actually earned and what expenses were associated with generating it.

Accrual-based reporting may help provide a clearer picture of normalized operating performance.

A Business May Need to Switch for Tax Purposes

A business’s tax accounting method is not always a matter of simple preference.

The Internal Revenue Code limits the use of the cash method for certain taxpayers and certain situations. For example, corporations generally cannot use the cash method if they do not qualify as small business taxpayers, and certain businesses with inventory may be required to use accrual accounting for purchases and sales of inventory. Tax shelters and certain industries are subject to additional restrictions.

For tax years beginning in 2025, the IRS instructions generally identify the small business taxpayer gross-receipts threshold under Section 448(c) as $31 million, subject to the applicable rules and inflation adjustments. The threshold and eligibility requirements should always be reviewed for the specific tax year and business structure.

Example: A corporation has grown significantly over several years. Its average annual gross receipts eventually exceed the applicable threshold for using the cash method. The corporation may need to evaluate whether it is still eligible to use its current tax accounting method. This is not a decision that should be made simply by changing bookkeeping settings.

Bookkeeping Method and Tax Accounting Method Are Not Always Identical

One important distinction is that a business may maintain internal financial records using one method while making tax adjustments for another method, depending on the applicable rules.

However, the tax method used must comply with the applicable requirements and clearly reflect income.

Example: A business maintains internal financial reports using accrual accounting to help management understand revenue and expenses. Its tax return may involve specific tax accounting adjustments. Alternatively, a business may maintain books on a cash basis but be required to use a different method for tax purposes. The relationship between book accounting and tax accounting should be reviewed carefully.

Switching Methods Can Create a Transition-Year Impact

Changing accounting methods can affect the timing of income and deductions.

Example: A business has significant accounts receivable under its existing method. When the business changes accounting methods, it may need to evaluate how previously unrecognized income or expenses are treated under the new method. The transition may affect taxable income over one or more years. This is one reason a method change should be planned rather than handled casually.

Changing the Tax Accounting Method May Require IRS Approval

A business generally cannot simply change its tax accounting method whenever it wants.

In many situations, the taxpayer must obtain IRS consent, often through Form 3115, Application for Change in Accounting Method. Certain automatic change procedures and other exceptions may apply.

Example: A corporation wants to change from the cash method to the accrual method.

Before making the change, the corporation reviews:

Proper planning can help avoid unexpected tax consequences.

Businesses Should Not Switch Simply Because They Are Growing

Growth alone does not automatically mean that every business must switch to accrual accounting.

The appropriate accounting method depends on factors such as:

Example: Two companies each generate $10 million in revenue. One is a professional services company with relatively simple billing. The other purchases and sells substantial amounts of inventory. The accounting method analysis may be different for each company.

The correct method depends on the facts of the business.

Warning Signs That Your Current Method May No Longer Be Working

A business may need to reevaluate its accounting method if:

Example: A company reports strong profitability but repeatedly struggles to pay its vendors. Management discovers that a significant amount of cash is tied up in accounts receivable and inventory.

The business may need more sophisticated financial reporting to understand the problem.

Accrual Accounting Can Improve Management Decisions

Accrual accounting is not simply a tax compliance issue.

It can help management answer questions such as:

Example: A business is considering hiring additional employees. Cash-basis reports show a large bank balance. Accrual-based financial statements reveal that much of the company’s cash is needed to pay outstanding vendor obligations and upcoming expenses.

Management may make a different hiring decision after reviewing the complete financial picture.

Common Mistakes When Switching to Accrual Accounting

Businesses sometimes make the transition incorrectly.

Common problems include:

Example: A company changes its bookkeeping system to accrual accounting. However, existing customer invoices are imported as new revenue even though they were already recorded under the prior method. The company may accidentally overstate revenue.

A controlled transition process is important.

How to Determine Whether Your Business Should Switch

Businesses considering a change should evaluate several areas.

1. Review Revenue and Payment Timing

How long does it take customers to pay?

If the business regularly waits 30, 60, or 90 days for payment, cash-basis reports may not show when revenue was actually earned.

2. Review Accounts Payable

Does the company have significant unpaid bills?

If so, management may benefit from financial statements that recognize expenses when incurred.

3. Review Inventory

Does the business purchase, manufacture, or sell products?

Inventory accounting may affect the method required for tax purposes.

4. Review Business Structure

The rules may differ depending on whether the business is:

5. Review Gross Receipts

The business’s average annual gross receipts may affect eligibility to use the cash method for tax purposes.

6. Review Financial Reporting Needs

Does the business need financial statements for:

The method that provides the most useful financial information may be different from the method the business used when it was smaller.

How Velin & Associates, Inc. Can Help

At Velin & Associates, Inc., we help growing businesses evaluate their accounting and tax reporting systems.

Our services include:

Our goal is to help businesses use accounting information not only to prepare tax returns, but also to make better financial decisions.

Final Thoughts

A business does not necessarily need to switch to accrual accounting simply because it reaches a certain revenue level or begins growing rapidly. However, growth, inventory, delayed customer payments, unpaid expenses, financing, and tax rules can all make the question increasingly important.

For some businesses, accrual accounting provides a clearer picture of actual financial performance. For others, the tax law may require a change in accounting method or impose limitations on the use of the cash method.

The key is to evaluate the business before making the change.

Changing accounting methods can affect the timing of income, deductions, inventory, and taxable income. A business should review the accounting, financial, and tax consequences before switching methods.

Need Help Evaluating Your Business’s Accounting Method?

If your business is growing, has significant accounts receivable or inventory, is seeking financing, or may no longer qualify to use its current tax accounting method, professional guidance can help you determine the appropriate next steps.

For more information about our tax planning services, contact us today: our website. 

Velin & Associates, Inc.

8159 Santa Monica Blvd STE 198/200
West Hollywood, CA 90046
📞 323-902-1000
📧 dmitriy@losangelescpa.org

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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.

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