You’re optimizing profitability like a pro and paying taxes like you’re blindfolded.
Your margins look great. You’re tracking net income, hitting targets, and growing fast. You compare your numbers to other MSPs. Your accrual-based books say you’re crushing it.
But then the tax bill shows up, and it makes zero sense. You owe more than expected, or worse, there’s no cash to cover it.
The most challenging aspect of managing on the accrual basis while filing on the cash basis is planning for taxes. This is a function of the fundamental differences between cash and accrual. They are not compatible systems. You are either on one or the other. The fact that so many attempt to switch between the systems is where the trouble lies.
To effectively plan for taxes on the cash basis, you need to undo all the smoothing done for the entire year.
Accrual Accounting Isn’t A Button at the Top of the Reports Page in QuickBooks
Accrual accounting is more than recording accounts payable and accounts receivable. When you accrue expenses, you record the cost in the period you use it, regardless of when cash leaves the bank. As a result, most businesses post multiple month-end journal entries to “smooth” lumpy items like interest, wages, bonuses, taxes, and other accruals.
Here’s a simple example: a software vendor requires a $36,000 payment for a 12-month license.
On the cash basis, you record:
-
Debit: MSP Software COGS — $36,000
-
Credit: AmEx CC — $36,000
That entry can make the month’s profitability look terrible! Presenting your financials like this suggests an unexpected $36,000 hit that crushed profitability (for a software expense over the next 12 months). You can’t go to your next peer group with profitability like that.
Therefore, you record it correctly on the accrual basis:
-
Debit: Prepaid Expense — $36,000
-
Credit: AmEx CC — $36,000
After this, there are 12 monthly journal entries to move that amount of expense into the corresponding months in which the expense is used with the following entry:
-
Debit: MSP Software COGS — $3,000
-
Credit: Prepaid Expense — $3,000
While that solves the problem for your peer group and shows profitability legitimately, reporting on the cash basis of accounting requires you to undo what you’ve done for your peer group. This approach makes your financials clean and comparable for peer groups and partners. However, if you file taxes on the cash basis, you must undo those accrual adjustments.
Prepaids and deferrals are not allowed on the cash basis of accounting. Therefore, on December 31st, all the prepaid expenses, all other accrued expenses and deferred revenue need to be reversed to determine taxable income.
This is painful and will lead to unexpected results.
You need to know these numbers before your CPA adjusts your books.
Continuing our example above, let’s assume the contract is half complete by the end of December. The entry to convert your books to the cash basis would be:
-
Debit: MSP Software COGS — $18,000
-
Credit: Prepaid Expense — $18,000
That single entry reduces profitability by $18,000.
The Dark Side of the Year-End Entry
It is always convenient when the adjustment lowers the amount you need to send to the government, but sometimes it goes the other way.
Many MSPs are obsessed with matching the timing of the revenue to the exact month it is earned using deferred revenue. When they receive a prepayment or deposit of funds for a project, they record it as:
-
Debit: Cash — $100,000
-
Credit: Deferred Revenue — $100,000
That approach smooths revenue and lines it up with the expenses of delivering the work. However, if you file taxes on the cash basis, the IRS treats cash received as taxable when received. In other words, you can’t “park” cash in deferred revenue for tax purposes.
On the cash basis, the entry becomes:
-
Debit: Cash — $100,000
-
Credit: Revenue — $100,000
This is where the surprise comes in. Prepaid expense adjustments might reduce taxable income (which can feel like a win). But deferred revenue often does the opposite; it increases taxable income earlier than you expected.
For example, if a client prepays in November and the project won’t be completed until January, you may still have to recognize the full $100,000 as taxable income in the current year. As year-end approaches, be especially cautious with multi-year contracts, both prepaid expenses and deferred revenue. Ideally, you want the timing of revenue recognition and expense deductions to align; otherwise, you could pay tax on revenue this year and not deduct the related costs until next year.
If you want to estimate your tax burden accurately, you must calculate income on the cash basis.
The Objection to this Underscores the Misunderstanding of this Practice
I hear your objection, “How do I benchmark my books on the accrual basis for my peer group and also have them ready for taxes?”
This is precisely the problem.
At the core of accounting, these are two separate systems not intended to be used simultaneously. Your KPIs, depreciation, margins and balance sheet will be adjusted for a tax return.
Q4 will not look like the rest of the year.
Your CPA might just irritate you by adjusting your numbers and insisting you not change them.
While extremely common in the MSP industry and particularly among those benchmarking in peer groups, using two separate methods of accounting is not technically possible. At the end of the year, you need to report and file on the one on your tax return.
Can I Just Change My Method of Accounting?
Yes, you can. To move from cash to accrual, you file Form 3115 (Application for Change in Accounting Method) with the IRS. Then, you can align your tax return more closely with your accrual financial statements.
However, that change can also tie your hands.
Small businesses often stick with the cash basis because it offers flexibility. After all, paying tax on money you haven’t collected is frustrating, can create cash crunches, and make operations feel distorted. In addition, moving away from cash can limit certain year-end tax planning strategies, such as prepaying expenses. Those moves can distort timing and profitability on your financials; however, skilled managers use them nevertheless as “aces up the sleeve” for tax planning.
Finally, many businesses stay on cash because it typically costs less to maintain. Accrual accounting requires consistent, detailed adjustments, and it demands an accountant who understands your business, communicates well, and asks good questions. As a result, the added complexity usually increases labor costs.
If you benchmark on accrual and file taxes on cash, you’re walking a tightrope. It works until it doesn’t. Eventually, the gap between your financials and your tax return becomes too big to ignore. Then, the tax bill feels random, Q4 looks off, and your CPA’s year-end “adjustments” can feel like sabotage. They usually aren’t, they’re simply the rules of the game.
Know which system you’re playing. And don’t wait until April to find out you’ve been tracking the wrong score. If you want clean benchmarks and clean tax planning, you’ve got to build a system that speaks both languages.
Most MSPs don’t.
The smart ones do.