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Small business compliance guide

Cash, accrual or modified cash: choosing your accounting method

Your accounting method decides when income and expenses count. Choose it with care: it is set by your first tax return, and changing it later usually needs IRS approval.

General information for 2026. Written by Prem Tax and Accounting Corp, a CPA firm. This guide explains the rules in general. It is not tax or legal advice for your situation: the answer for you depends on your entity, your state, your workers and your facts. Retainer clients can call us for information specific to their own situation. Rules have exceptions and change, and official sources are linked on each page.

Prepared by Prem Tax and Accounting Corp. Last checked against official sources on October 21, 2026.

What an accounting method is

An accounting method is the set of rules you use to decide the year in which income and expenses are reported. The same business can show a different profit in the same year under a different method. Your method must clearly reflect income, and you must use it the same way every year. If you do not, the IRS can refigure your income under a method it believes does reflect income.

The methods side by side

	Cash	Accrual	Modified cash (hybrid)
Income counts when	You receive it, or it is made available to you without restriction (constructive receipt).	All the events that fix your right to it have happened and the amount can be figured with reasonable accuracy.	Mostly when received, with some items (often sales of inventory) on the accrual method.
Expenses count when	You pay them. Some prepayments must be spread over the year they apply to (see the 12-month rule).	You owe them and economic performance has happened: the goods or services were provided.	It depends on the mix, within the restrictions below.
Often used by	Individuals and many small businesses.	Businesses with inventory, credit sales, lenders or investors who need accrual statements, and larger C corporations.	Businesses that want accrual for inventory and cash for everything else.
Watch out for	Profit can swing with the timing of payments. You cannot hold back checks you have the right to take.	You can owe tax on income you have not collected yet.	You must use the same combination every year, and it must clearly reflect income.

What "modified" basis means

You may hear "modified cash basis" or "modified accrual." For federal tax the IRS word is hybrid: any combination of cash, accrual and special methods that clearly reflects income and is used consistently. Two common versions:

Cash for most items, but accrual for sales and purchases of inventory.
Books kept on the cash basis, with year-end adjustments for receivables, payables, prepaid items and depreciation, so lenders see a fuller picture while the tax return follows the method the business has adopted.

Restrictions: if you use the cash method for income, you must use it for expenses, and if you use accrual for expenses, you must use accrual for income. If inventory is necessary, you must use accrual for purchases and sales, except for small business taxpayers. "Modified accrual" is a term from government accounting, not a tax method.

Who may use the cash method

Individuals and sole proprietors: generally yes.
S corporations and partnerships with only individual partners: yes, not limited by the gross receipts test.
C corporations and partnerships with a C corporation partner: only if their average annual gross receipts for the three prior years are $32,000,000 or less (the 2026 amount, adjusted for inflation), or if they are a qualified personal service corporation. If a business fails the test, it must change to accrual for the year it fails.
Tax shelters: no.
Businesses with inventory: accrual for purchases and sales, unless they are small business taxpayers under the same $32,000,000 test, who may choose not to keep inventory in the usual way.

How to choose

Who needs your numbers? Lenders, investors, a buyer or a franchisor may want accrual financial statements, even if your tax return is on the cash method.
Do you sell on credit or carry inventory? Accrual matches sales with costs and shows what customers owe you.
Are you near the $32,000,000 line? This matters for C corporations and partnerships with a C corporation partner.
Simplicity and cost. The cash method is simpler. Accrual needs more bookkeeping.
Planning. The cash method gives some timing choices near year-end, but not unlimited: prepaid expenses and constructive receipt have rules.
Think ahead. If you expect to sell the business or raise money, you may need to change methods later.

Changing methods

You choose your method when you file your first tax return. After that, a change from cash to accrual or the other way, a change in how inventory is valued and most other timing changes need IRS approval. The request is made on Form 3115. Some changes are "automatic": you follow a set procedure and file the form with your return. A change usually produces a section 481(a) adjustment so that income is not skipped or counted twice. Do not simply start reporting differently on your return: that is an unapproved change.

Example (made up)

You invoice a customer $10,000 on December 20, 2026. The customer pays on January 10, 2027. On the cash method the $10,000 is 2027 income. On the accrual method it is 2026 income, because you earned it and the amount was fixed in 2026, even though you had not been paid.

More background in our short guide: cash vs accrual vs hybrid.

Not sure which method fits your business? We can compare the tax result of each for your numbers. Book a 20-minute call.

Common questions

Can I use the cash method if I have inventory?

If inventory is needed to show your income, you generally must use accrual for purchases and sales. A small business taxpayer (average annual gross receipts of $32,000,000 or less for 2026, and not a tax shelter) can choose not to keep inventory in the usual way and can use the cash method for the rest.

Can an S corporation use the cash method?

Yes. The gross receipts limit applies to C corporations and to partnerships with a C corporation partner, not to S corporations or to partnerships with only individual partners. Tax shelters cannot use the cash method.

My bank wants accrual financial statements. Must my tax return be on accrual?

Not necessarily. Your financial statements and your tax return can use different bases, and the difference is reconciled. Talk to us before you decide, because the tax method you adopt must be used consistently.

What is "modified cash basis"?

It usually means cash basis books with year-end adjustments for items such as receivables, payables, prepaid items and depreciation. For tax, the IRS term is a hybrid method. It must clearly reflect income and be used consistently.

How do I change my accounting method?

Generally you file Form 3115, Application for Change in Accounting Method. Some changes are automatic if you follow the procedure, and others need a non-automatic request. A change usually comes with an adjustment so income is not skipped or counted twice.

Official sources

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