Cash vs Accrual Accounting

These are the two fundamental methods for recording financial transactions, and the choice between them affects your taxes, your financial reporting, and how you understand your business's financial health.

Cash basis accounting is the simpler method. You record income when the check hits your account and expenses when you actually pay them. If you complete a $40,000 job in November but don't get paid until January, that income shows up in January under cash basis. If you buy $10,000 in materials in December but pay the supplier in February, the expense shows up in February.

Accrual basis accounting matches income and expenses to the period when they're earned or incurred, regardless of when cash moves. That $40,000 job completed in November? It's November income under accrual, even though you haven't been paid yet. The $10,000 in December materials? December expense, even though you haven't paid the bill.

The IRS generally allows sole proprietors and small businesses (under $29 million in average annual gross receipts) to use either method. However, if you maintain inventory or have long-term contracts, there are additional rules. Most small contractors use cash basis because it's simpler and gives them more control over tax timing.

For contractors, the choice between cash and accrual can significantly impact your tax bill in any given year. Cash basis lets you control timing — if you're having a high-income year, you might delay invoicing a December job until January to push that income into next year. You can also prepay expenses (materials, insurance) in December to increase this year's deductions.

However, cash basis can mask your true financial position. You might look profitable because you received a lot of payments this month, but if you have $200,000 in unpaid bills and unfunded commitments, cash basis won't show that. Accrual gives a more accurate picture of your financial health, which is why banks and bonding companies often prefer accrual-basis financial statements.