Most small contractors start their businesses on cash basis accounting — income is recorded when received, expenses when paid. It’s simple, intuitive, and manageable when you’re small. But as your business grows, takes on larger projects, carries significant receivables, or approaches the IRS threshold where accrual is required, the question of switching to accrual accounting becomes important. This guide explains the difference, when the switch makes sense, and how to make the transition smoothly.
Cash Basis vs. Accrual: The Core Difference
Cash basis accounting is simple: revenue is recorded when cash is received, and expenses are recorded when cash is paid. If you complete a job in December but don’t get paid until January, that revenue appears in January’s books. If you buy materials in December on a supplier account and pay the bill in January, the expense appears in January. This makes bookkeeping straightforward but can create a distorted picture of your financial performance — especially for businesses with significant receivables or payables outstanding at any given time.
Accrual basis accounting records revenue when earned (when the work is done and you have a right to payment) and expenses when incurred (when the obligation arises, even if not yet paid). Under accrual, that December job completion generates December revenue — even if payment doesn’t arrive until January. The December material purchase creates a December expense — even if you don’t pay the supplier until January. This gives you a more accurate picture of each period’s actual financial performance.
When Does the IRS Require Accrual Accounting?
The IRS requires accrual accounting for businesses with average annual gross receipts exceeding $27 million (adjusted for inflation — this threshold changes). For most small contractors, cash basis is permissible. However, the IRS has additional rules for contractors using the Percentage of Completion Method (PCM) for long-term contracts. Contractors with long-term contracts (expected to be completed in more than one year) may be required to use PCM, which is a form of accrual accounting. Consult your CPA to determine which method is required for your specific contract types and business size.
Why Contractors Switch to Accrual Voluntarily
Even when not required, many contractors switch to accrual as they grow. Key reasons include more accurate financial reporting — your P&L reflects the economic reality of each period rather than cash timing differences; better lender credibility — lenders prefer accrual statements because they show a more complete financial picture; improved bonding capacity — surety companies use accrual-based balance sheets for bonding analysis; more accurate job costing — retainage, unbilled receivables, and accrued expenses are all visible on the balance sheet; and better management decisions — knowing your actual profit in a period, not just your cash received, leads to better operational decisions.
How to Set Up Accrual Accounting in QuickBooks Online
QuickBooks Online can run in both cash basis and accrual basis modes. You can actually run reports in either mode by simply switching the report setting — QuickBooks calculates both from the same underlying transaction data. The key is making sure your transactions are entered correctly: invoices are created when work is performed (not just when paid), bills are entered when received (not just when paid), and retainage receivables and payables are tracked in separate accounts. With proper setup, you can generate both cash basis and accrual basis reports in QuickBooks at any time.
Making the Formal Transition: What’s Involved
Formally changing your accounting method from cash to accrual requires filing IRS Form 3115 (Application for Change in Accounting Method) in the year of the change. There may be a “catch-up” adjustment in the year of change to account for items that were previously treated on a cash basis. This is a tax and accounting matter — work with your CPA to handle the formal IRS change-in-accounting-method process correctly. Doing it without proper guidance can create tax complications.
Frequently Asked Questions
Can I use cash basis for taxes and accrual for management reporting?
Yes, this is a common and legitimate approach. Many contractors maintain their books on an accrual basis (for accurate management reporting) but file tax returns on a cash basis (which is generally more favorable for tax timing). QuickBooks allows you to run reports in either mode. Your CPA handles the tax-basis adjustments when preparing your tax return.
How does the switch affect my taxes in the year of change?
The year of transition may require a “Section 481(a) adjustment” — a catch-up entry that accounts for the difference between cash basis and accrual basis income as of the beginning of the year. This can create additional taxable income or a deduction, spread over 4 years. Your CPA will calculate this and handle the Form 3115 filing to manage the tax impact.
For more information, see our guide on reading your profit and loss under accrual accounting.
For more information, see our guide on updating your QuickBooks settings.
For more information, see our guide on working with a CPA on accounting changes.
For more information, see our guide on how your financial reports will change.
Bookkeeping Champs Can Handle the Transition
Bookkeeping Champs helps contractors throughout Los Angeles and Ventura County set up and manage their books on the right accounting basis for their business stage. Call (818) 679-4451 to discuss your situation.
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