Cash or accrual accounting: which does a startup need?

01The difference, in one sentence each#

The cash method records income when it is received and expenses when they are paid. The accrual method records income when it is earned and expenses when they are incurred, whether or not cash has moved. That is how IRS Publication 538 puts it for tax, and the financial-reporting version is the same idea: the FASB’s Concepts Statement No. 8 says accrual accounting records the financial effects of transactions “in the periods in which those transactions, events, and circumstances occur rather than only in the periods in which cash is received or paid.”

On a month with no prepayments, no unpaid bills and no unpaid invoices, the two give the same answer. A startup almost never has that month.

02A worked example: the annual plan#

A customer signs a $12,000 annual plan on December 1 and pays it the same day. On the cash method, December carries $12,000 of revenue and the next eleven months carry none. On the accrual method, the cash lands in deferred revenue, a liability, and $1,000 is earned each month: debit Cash $12,000; credit Deferred revenue $12,000 on December 1, then debit Deferred revenue $1,000; credit Revenue $1,000 at the end of each month of service.

Costs move the same way. December hosting billed on January 5 is a December expense on accrual and a January expense on cash. A $24,000 annual software contract paid up front is $24,000 of December spend on cash, and $2,000 a month on accrual through a prepaid. Read on cash, the company looks like it had a great December and a strange year. Read on accrual, it looks like what it is.

03Why the books are accrual#

US GAAP financial statements are prepared on the accrual basis, and that is the basis investors, venture lenders, valuation firms and auditors expect. Gross margin, burn and deferred revenue are accrual numbers. A cash-basis P&L in a data room is a request to rebuild the year.

Starting on accrual costs very little, because the volume of accruals at a small company is small: a handful of accrued bills, a prepaid schedule, a deferred revenue schedule. Converting later means going back through every month you already reported, finding what the cash view missed and restating it.

04What the tax rules say for a C-corp#

Taxes follow different rules from the statements, and for a C-corp they start from a prohibition:

• The rule: Section 448(a) says a C corporation’s taxable income is not computed under the cash method.
• The exception: Section 448(b)(3) lifts that for a corporation that meets the gross receipts test and is not a tax shelter.
• The test: average annual gross receipts for the three tax years before the current one do not exceed $31 million for tax years beginning in 2025, and $32 million for tax years beginning in 2026 (Revenue Procedure 2025-32, section .30).
• A young company: if the corporation has not existed for the whole three years, the test uses the period it has existed (Section 448(c)(3)).
• Related companies: entities under common control are treated as one for the test (Section 448(c)(2)).

05Keeping both, and changing later#

A company that qualifies can keep accrual books and file on the cash method. The gap between book income and taxable income is then reconciled on the return itself: Form 1120’s Schedule M-1 is titled “Reconciliation of Income (Loss) per Books With Income per Return.” Publication 538 also allows a combination of methods if the result clearly reflects income and is used consistently, and it requires the same method from year to year.

Changing the method on the return is not a setting. Publication 538 says that changing an accounting method generally requires IRS approval, and the request is made on Form 3115. Decide the tax method with your preparer when the first return is filed, keep the books accrual either way, and the question does not have to be reopened every year.