Cash-basis books record revenue when money arrives and expenses when money leaves. Accrual books record revenue when it is earned and expenses when they are incurred. For a subscription business, the gap between the two is large: a customer paying $120,000 up front for a year is $120,000 of revenue in month one on a cash basis and $10,000 a month on an accrual basis.
Why investors expect accrual
- Revenue reflects the business. ASC 606 recognizes subscription revenue over the service period. Cash timing depends on billing terms.
- Gross margin and burn are comparable across months and across companies.
- Deferred revenue appears as a liability, showing how much service is owed to customers.
- Audits require it. GAAP financial statements are accrual-based.
One contract, two views
A customer signs a 12-month, $120,000 contract on January 1, invoiced and paid in January.
| January | February | March | Q1 total | |
|---|---|---|---|---|
| Cash basis revenue | $120,000 | $0 | $0 | $120,000 |
| Accrual revenue | $10,000 | $10,000 | $10,000 | $30,000 |
| Deferred revenue at month end | $110,000 | $100,000 | $90,000 | $90,000 |
On a cash basis, January looks like a record month and February looks like a collapse. Neither is true.
The tax method is a separate decision
The method used on the tax return does not have to match the books. Section 448 generally prohibits C corporations from using the cash method, with an exception for corporations meeting the gross receipts test (average annual gross receipts over the prior three years at or below a threshold that is indexed for inflation). Many startups qualify. Other rules then apply on top:
- Advance payments for services may be deferred for tax under the rules for advance payments, but only within limits.
- Prepaid expenses may be deductible under the 12-month rule if the benefit does not extend beyond the earlier of 12 months or the end of the following tax year.
- Changing a tax method usually requires filing Form 3115.
Keeping them in step
The usual setup: books on GAAP accrual, monthly; tax adjustments calculated at year end in a book-to-tax reconciliation (Schedule M-1 or M-3 on Form 1120). Typical adjustments for SaaS companies include deferred revenue, prepaid expenses, accrued bonuses not paid within two and a half months, stock compensation and research expenses under Section 174.
When to switch the books to accrual
If the books are on a cash basis today, switch before:
- The first priced equity round or diligence process
- Any lender relationship with financial covenants
- A first audit or review
- Board reporting on gross margin and burn
The switch means building opening balances for deferred revenue, receivables, payables, prepaid expenses and accruals, then restating prior months so trends are comparable.
We keep the books on accrual every month and prepare the tax return on the method that fits the company, with the reconciliation between them documented.
Sources
- IRS, Publication 538, Accounting Periods and Methods
- 26 U.S.C. §448, Limitation on use of cash method of accounting (Cornell LII)
- IRS, Instructions for Form 1120
- FASB Accounting Standards Codification, Topic 606, Revenue from Contracts with Customers
Questions founders ask
Can a C corporation use the cash method for tax?
Section 448 generally bars C corporations from the cash method unless they meet the gross receipts test, which is indexed for inflation each year. Many early-stage C corporations meet it; check the current threshold in the IRS guidance for the year.
Do we need accrual books if our tax return is on the cash method?
Yes, for investors, lenders and auditors. The books can be kept on GAAP accrual and the tax return prepared on another permitted method, with the differences tracked.
