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Guide

Cash or accrual: how a contractor keeps the books

The two accounting methods the IRS lets a contractor choose, when income and expenses land under each, the inventory rule and the tax year (Pubs. 334 and 583).

Published 2026-10-17

Business Finances is 15 percent of the Law and Business exam, and the Contractors State License Board’s (CSLB) study guide lists four topics under it: cash management, budget and planning, taxes, and financial reporting. None of those is in the license law. The nearest thing to a rulebook is the Internal Revenue Service (IRS), whose Publication 334, the Tax Guide for Small Business, and Publication 583, Starting a Business and Keeping Records, set out the one decision every new contractor makes before the first return: whether the books run on the cash method or an accrual method.

What an accounting method is

The IRS defines an accounting method as a set of rules used to determine when and how income and expenses are reported, and it includes not only the overall method but the accounting treatment of any material item (Publication 334, page 14). You choose it when you file your first income tax return that includes a Schedule C for the business. After that, a change generally needs IRS approval, requested on Form 3115, and a change includes both a switch from cash to accrual and a change in how you treat a material item (page 17).

Two rules hold whichever method you pick. You must use the same method to figure taxable income and to keep your books, and the method must clearly show your income (Publication 583, page 5). A method clearly shows income only if it treats every item of income and expense the same way from year to year.

The cash method

Under the cash method you include in gross income everything you actually or constructively receive during the tax year, and you generally deduct expenses in the year you actually pay them (Publication 334, pages 14 and 15). Constructive receipt means an amount was credited to your account or made available without restriction, whether or not you picked it up; the IRS example is a check mailed on December 30 and received on January 4, which is income for the new year.

The catch on the expense side is prepayment. An expense paid in advance is deductible only in the year it applies to. The publication’s example is a $1,000 one-year insurance policy paid in 2025 and running from July 1: $500 is deductible in 2025 and $500 in 2026.

Most sole proprietors with no inventory use the cash method because the records are easier to keep (page 14). For a contractor that means income is the money that came in, expenses are the money that went out, and a job finished in December but paid in February belongs to February’s year.

The accrual method

Under an accrual method you generally report income in the year it is earned and deduct or capitalize expenses in the year they are incurred, so that income and expenses match in the correct year (page 15). Two tests decide when.

Income is included in the year in which all events that fix your right to receive it have occurred and you can determine the amount with reasonable accuracy. The IRS example is a sale on December 28, billed in the first week of January and paid in February: income for the year of the sale. A contractor who completes a phase in December and invoices it in January reports it in December’s year.

An expense is deducted or capitalized when both the all-events test is met (all events fixing the fact of liability have occurred and the amount can be determined with reasonable accuracy) and economic performance has occurred, which for property or services provided to you means as they are provided. The example is supplies received and billed in December and paid in January: deductible in December’s year.

Two of the accrual method’s special rules matter more to a contractor than to most small businesses. A contract that sets a basic rate for services has to be accrued at that rate even if the customer pays a lower rate until the work is finished. And an advance payment is generally income in the year you receive it, though you may elect to postpone it to the next tax year and no further (page 15). A down payment collected in December sits under that rule.

Inventory decides for you

If the production, purchase or sale of merchandise is an income-producing factor in the business, you must generally take inventories at the beginning and end of the tax year and use an accrual method for purchases and sales (page 16). The exception is the small business taxpayer: average annual gross receipts of $31 million or less for the three prior tax years, indexed for inflation, and not a tax shelter (page 16). A small business taxpayer may choose not to keep an inventory and may treat inventoriable items as non-incidental materials and supplies, deducting them in the year they are first used or consumed.

The combination rules on page 16 close the obvious shortcut. If inventory is necessary, purchases and sales go on accrual and the rest may stay on cash; otherwise the cash method for income means the cash method for expenses, accrual for expenses means accrual for income, and a combination that includes the cash method is treated as the cash method.

The tax year

Publication 583 adds the other half of the choice. Taxable income is figured over a tax year, usually 12 consecutive months, and there are two kinds: a calendar tax year ending December 31, and a fiscal tax year ending on the last day of any other month, or a 52-53-week year (pages 4 and 5). You must use a calendar year if you keep no books or records, have no annual accounting period, or your present year does not qualify as a fiscal year. You adopt a tax year by filing the first return on it; an extension request, an application for an employer identification number or an estimated tax payment does not adopt one. Changing later means Form 1128 and, possibly, a fee.

The timing facts that get tested

The pattern to expect is a fact about timing: under which method income is reported when earned rather than when received, in which year a prepaid expense is deductible, what a business with inventory must generally use, and what a change of method requires. Each has one answer in the two publications above, and none depends on a formula.

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