When to Move from Cash to Accrual Accounting

Cash-basis accounting records money when it moves. Accrual-basis accounting records it when it is earned or owed. For a young business the cash basis is simpler and usually right; past a certain point it starts hiding the truth about your business.

The four signals it is time

1. You invoice customers and wait. If clients pay you on net-30 or net-60 terms, cash-basis revenue lags reality by a month or two. A great sales month looks like a famine; a slow one looks like a feast.
2. You carry deferred revenue. Annual prepays, retainers, deposits — money in the bank that you have not earned yet. On a cash basis it all looks like income the day it lands, which is how owners accidentally spend their customers’ money.
3. Outside capital is involved. Lenders and investors expect accrual (GAAP) financials. So do acquirers — the first thing diligence does is rebuild your statements on an accrual basis, and surprises there cost you leverage.
4. Revenue is past roughly $1M. Around this point the distortions get big enough to affect real decisions — hiring, pricing, whether you can afford that build-out.

What the switch involves

The one-time work is building the balance-sheet accounts that cash basis ignores: accounts receivable, accounts payable, deferred revenue, prepaid expenses, and accrued liabilities. Your historicals get restated so trends stay comparable, and the monthly close gains a few steps — recognizing revenue as it is earned and matching expenses to the period they belong to.

For taxes, note that your book basis and tax basis do not have to match. Plenty of companies keep accrual books for management and investors while still filing on a cash basis (available to most businesses under $30M in average receipts). That is a conversation for your tax preparer — the books should serve the people running the company first.