Cash vs accrual accounting: which one a startup should use

Cash accounting records revenue when money arrives and expenses when money leaves. Accrual accounting records revenue when you deliver the service and expenses when you incur them, whenever the cash moves, and it is the basis of US GAAP, so a venture-backed startup should keep accrual books.

Taxes are a separate choice. A C corporation may compute taxable income on the cash method only while its average annual gross receipts for the three prior years stay at or under $31,000,000 for tax years beginning in 2025, and $32,000,000 for 2026. This guide covers the difference, a worked quarter both ways, the tax rules, how books and returns can differ, and when to switch.

What is the difference between cash and accrual accounting

The two methods disagree only on timing. Cash accounting puts revenue and expenses in the period the money moves. Accrual accounting puts them in the period the work is done or the obligation arises. Over a company's whole life the totals match, but in any one month or quarter they can be far apart.

The tax regulations put it plainly. Under the cash method, income is included in the year it is "actually or constructively received" and expenses are deducted in the year they are "actually made" (Treas. Reg. §1.446-1(c)(1)(i)). Under an accrual method, income is included when all the events that fix the right to receive it have occurred and the amount can be determined with reasonable accuracy, and an expense is taken when the liability is fixed and economic performance has occurred (§1.446-1(c)(1)(ii)).

For a SaaS company, three things drive most of the gap:

• Annual prepayments. A customer pays for twelve months up front. Cash shows all of it on day one; accrual spreads it over the term.
• Invoices with payment terms. You bill on net 30. Accrual counts the revenue when the month of service ends; cash waits for the payment.
• Bills you have not paid yet. A contractor invoices in December and you pay in January. Accrual counts December's work in December.

Which method does GAAP require

US GAAP rests on accrual accounting. The FASB's conceptual framework says accrual accounting shows the effects of transactions "in the periods in which those effects occur", even when cash moves in a different period, and that this is a better basis for judging performance than cash receipts and payments alone (Concepts Statement No. 8, Chapter 1, paragraph OB17).

In practice that means the standards a startup meets as it grows assume accrual books. Revenue recognition under ASC 606 is an accrual concept: a prepaid annual contract becomes revenue as you deliver it, and the unearned part sits on the balance sheet as deferred revenue, a liability that runs down month by month. An audit, a lender's covenant package and a priced round's diligence all start from GAAP statements.

Cash books are not wrong for a two-person company with no customers yet. They are wrong once they are the only books and someone outside the company has to rely on them.

A worked example: one quarter, both ways

Take a SaaS startup's fourth quarter of 2025, October 1 to December 31. Five things happen:

1. On October 1 a customer signs an annual contract for $120,000 and pays it in full.
2. Monthly customers are billed $45,000 over the quarter. The December invoices, $15,000 on net 30 terms, are paid in January.
3. On October 1 the company prepays $36,000 for twelve months of hosting.
4. Payroll for the quarter is $150,000, all paid in the quarter.
5. A contractor invoices $20,000 for December work, paid on January 15, 2026.

The annual contract is $120,000 of cash but three months of service, so accrual revenue is $120,000 × 3 ÷ 12 = $30,000, and the other $90,000 is deferred revenue at December 31. The hosting prepayment works the same way in reverse: $36,000 × 3 ÷ 12 = $9,000 of expense, and $27,000 is a prepaid asset. The contractor's $20,000 is a December 2025 expense on the accrual books, but it was paid in 2026, so it counts toward the contractor's 2026 Form 1099-NEC total.

The cash view says the company lost $36,000 in the quarter. The accrual view says it lost $104,000, a $68,000 difference. The cash result is flattered by a prepayment that pays for nine months still to come. A founder who reads $36,000 as the quarter's loss will plan a runway that the next three quarters cannot support, and an investor who reads $150,000 of revenue is reading twice what the company delivered. The gap between ARR and recognized revenue is the same timing difference seen from the metrics side.

Can a startup use the cash method for taxes

Usually, yes, for a while. IRC §448(a) bars a C corporation from computing taxable income on the cash method, but §448(b)(3) lifts the bar for any year in which the company meets the gross receipts test in §448(c) (26 U.S.C. §448).

The test looks at average annual gross receipts for the three tax years before the current one. The $25,000,000 in the statute is adjusted for inflation each year:

A company that has not existed for all three years averages over the years it has existed, and a short year is annualized (§448(c)(3)). The Form 1120 instructions call a corporation that passes the test and is not a tax shelter a "small business taxpayer" (Instructions for Form 1120 (2025)).

The cash method on a tax return can still carry exceptions for special items. The regulations list research and experimental expenditures among the items with their own treatment (§1.446-1(a)(1)), which is why the section 174 changes apply to your R&D deduction whichever overall method you use.

Can your books and your tax return use different methods

They can differ, but the return starts from the books. Section 446(a) says taxable income is computed under the method the company regularly uses in keeping its books (26 U.S.C. §446), and the regulations require records that support the return, including "a reconciliation of any differences" between books and return (§1.446-1(a)(4)).

That reconciliation is a schedule on the return itself. Form 1120's Schedule M-1 is titled "Reconciliation of Income (Loss) per Books With Income per Return", and a corporation with total assets of $10 million or more at year end files the longer Schedule M-3 instead (Instructions for Form 1120 (2025)).

So the workable setup for most seed-stage companies is accrual books for the board, investors and auditors, with your tax preparer computing the return from those books and documenting every difference. Agree on the tax method with your preparer before the first return: a company adopts its method on its first return (§1.446-1(e)(1)), and changing later takes paperwork.

When to move your books to accrual

Move the books before anyone outside the company relies on them. In practice that is the first of these to happen:

• Your first annual prepayment. One prepaid contract, like the $120,000 in the example, is enough to make cash revenue misleading.
• Invoices with payment terms. Once receivables exist, cash revenue lags what you have earned.
• A priced round. Diligence asks for GAAP statements, and restating a year of cash books under deadline is slow and expensive.
• A first audit or a lender. Both start from GAAP financial statements.

Moving the books costs a one-time cleanup: set up deferred revenue for prepaid contracts, receivables for open invoices, prepaid expenses and accrued liabilities, then close each month on that basis. If a bookkeeping firm does the work, the conversion shows up on its bill: Pilot and Kruze price accrual books differently, and Kruze's onboarding fee covers the move from cash to accrual. LedgerIt keeps deferred revenue and prepaid expenses on schedules and closes each month, so the accrual entries happen as part of the close rather than as a year-end rebuild.

Changing the method on your tax return is a separate step. A corporation generally needs IRS consent to change its overall method, requested on Form 3115 during the year of the change, and may owe a §481(a) adjustment, generally taken over 1 year if negative and 4 years if positive (Instructions for Form 1120 (2025); §1.446-1(e)(3)(i)). Section 446(e) requires that consent before taxable income is computed under a new method, so tell your preparer when the books change.

What to do this month

• Check which method your books use. If revenue equals deposits each month, they are on cash.
• List every prepaid contract and open invoice. These are the entries accrual books add first.
• Compute your three-year average gross receipts. Compare it with $31,000,000 for 2025 and $32,000,000 for 2026 to know whether the cash method stays available for tax.
• Ask your preparer which method your last return used. Keep a copy of the Schedule M-1 or M-3 reconciliation.
• Plan a change of tax method before you cross the limit. Form 3115 is filed during the year of the change, not after it.
• Report the accrual result to your board. Runway and burn built on accrual expenses match what you will actually spend.