Accrual Accounting: Rules, Adjusting Entries, and Section 448

Accrual accounting records revenue when a business earns it and expenses when it incurs them, regardless of when cash actually changes hands. That timing rule is the whole method, and it produces financial statements that tie results to the work performed in a period rather than to the checks that happened to clear. Federal tax law requires most larger businesses to use it, the SEC effectively requires it of every public company, and the gross receipts threshold that forces C corporations and many partnerships onto the accrual method rises to $32 million for tax years beginning in 2026.¹

How Accrual Differs from Cash-Basis Accounting

Cash-basis accounting records income when payment arrives and expenses when a check goes out. Accrual accounting flips the logic. Income lands on the books when you deliver a product or complete a service, and expenses land in the period you consume the resource, even if the bill hasn’t been paid.

Consider a landscaping company that finishes a $5,000 project in March but doesn’t get paid until April. Under accrual accounting, that $5,000 is March revenue. Under cash basis, it shows up in April.

The difference matters most when someone is trying to judge how a business actually performed during a specific stretch of time. Cash-basis reports can look misleadingly good or bad depending on payment timing. A company might collect a pile of old invoices in a slow quarter and appear to be thriving, or deliver its best month of work ever and show almost nothing because clients haven’t paid yet. Accrual accounting strips out that timing noise and ties the numbers to the work itself.

When Revenue Gets Recorded

The rules for when a business can officially book revenue live in ASC 606, the standard the Financial Accounting Standards Board issued to replace the older “earned and realizable” test. ASC 606 uses a five-step process built around performance obligations and the transfer of control to the customer:²

Identify the contract. Confirm that both sides have agreed to specific terms, each side has obligations, and payment terms are defined.
Identify the performance obligations. Break the contract into distinct promises. A software company that sells both a license and ongoing support has two separate obligations.
Determine the transaction price. Figure out the total you expect to receive, adjusting for discounts, rebates, and variable consideration.
Allocate the price. Assign a portion of the total to each performance obligation based on its standalone value.
Recognize revenue when each obligation is satisfied. Record revenue as you transfer control of the promised good or service.

Control transfers either at a point in time or gradually. A retailer that ships a product transfers control on delivery. A construction firm building a custom structure transfers control over time because the customer owns the asset as it takes shape. The standard lists several indicators that control has shifted, including legal title, physical possession, and the significant risks and rewards of ownership.

Two balance-sheet categories fall out of this framework. When you’ve performed work but haven’t billed for it, the unbilled amount is a contract asset. When a customer pays before you deliver, the payment is a contract liability, usually called deferred revenue.

Revenue recognition also depends on a reasonable expectation of getting paid. If a transaction carries a high risk of non-collection, the business cannot record the full amount and must adjust for that uncertainty.³

Matching Expenses to the Revenue They Produced

Booking revenue accurately is half the job. The matching principle requires that the costs of generating that revenue appear in the same period. If a furniture manufacturer sells $80,000 worth of tables in September, the lumber, labor, and factory overhead that went into building them belong on September’s books, even if some costs were paid in August or won’t be paid until October.

Costs that tie directly to a specific sale (raw materials, commissions, shipping) follow the revenue they helped produce. General operating costs like rent, utilities, and administrative salaries can’t be traced to a single sale, so they hit the period the benefit is consumed. You don’t try to figure out how much of your office lease contributed to each transaction; you expense that month’s rent in that month.

Depreciation and Amortization

Long-lived assets create a specific matching challenge because their benefit stretches across years. A $50,000 delivery truck isn’t a single month’s expense; it will help produce revenue for years. Depreciation spreads that cost over the asset’s useful life. Under straight-line depreciation, a truck with a ten-year useful life produces $5,000 of depreciation expense each year. The same logic applies through amortization to intangible assets. A patent purchased for $20,000 with a ten-year useful life produces $2,000 of annual amortization expense.

The All-Events Test for Tax Deductions

For federal tax purposes, accrual-method taxpayers face an extra hurdle before deducting an expense: the all-events test. Three conditions must be met. All events establishing the liability must have occurred, the amount must be determinable with reasonable accuracy, and economic performance must have taken place.⁴

Economic performance depends on what the expense is for. If someone provides services to your business, economic performance occurs as those services are performed. If your business provides property or services, it occurs as you deliver. For liabilities from workers’ compensation claims or tort judgments, economic performance happens only as payments are actually made.⁴

The rule keeps businesses from claiming deductions too early. A company that signs a two-year service contract in January and pays the full amount upfront cannot deduct the whole cost in year one. The deduction follows the actual delivery of services.

Who Has to Use Accrual Accounting

Not every business gets to choose. Two separate bodies of law force the accrual method: the Internal Revenue Code for tax reporting, and SEC regulations for anyone with publicly traded securities.

The Section 448 Gross Receipts Test

Section 448 of the Internal Revenue Code prohibits three categories of taxpayer from using the cash method: C corporations, partnerships that have a C corporation as a partner, and tax shelters. The first two categories get an exemption if they pass the gross receipts test, which looks at average annual gross receipts over the three preceding tax years.⁵

The base threshold is $25 million, adjusted annually for inflation. For tax years beginning in 2025, the inflation-adjusted amount is $31 million.⁶ For tax years beginning in 2026, it rises to $32 million.¹ Stay at or below the threshold and you can keep using cash. Exceed it and accrual becomes mandatory.

Tax shelters get no reprieve. Any entity classified as a tax shelter must use accrual regardless of revenue, because the gross receipts exemption applies only to the C corporation and partnership provisions.⁷

Two categories are permanently exempt from the accrual requirement regardless of size: farming businesses, and qualified personal service corporations (firms where substantially all activities involve fields like health, law, engineering, accounting, or consulting, and where employees own substantially all the stock).⁵

Businesses that should be on accrual but aren’t face IRS penalties. The accuracy-related penalty alone is 20% of the resulting tax underpayment, with interest running on top until the balance is paid.⁸

SEC Requirements for Public Companies

Separately from tax law, the SEC requires every publicly traded company to prepare financial statements under Generally Accepted Accounting Principles. Regulation S-X states that financial statements not prepared under GAAP are “presumed to be misleading or inaccurate” regardless of any additional disclosures.⁹ GAAP is built on accrual principles, so the rule effectively mandates accrual accounting across the public markets.

Private companies aren’t legally required to follow GAAP, but lenders and investors often demand accrual-basis statements before extending large loans or making investment decisions. Accrual statements do a better job of showing whether a business can actually service its debt from operations rather than from the timing of cash collections.

The Adjusting Entries That Make Accrual Work

The daily bookkeeping in an accrual system looks a lot like any other. The distinctive work happens at period end, when adjusting entries reconcile the books with the earning-and-incurring rules.

Accrued Expenses

These capture costs the business has incurred but not yet paid for. Wages are the classic case: employees who worked during the last week of the month won’t get paid until the next month, but the labor cost belongs in the current period. The adjusting entry debits wage expense and credits a wages payable liability. When paychecks go out in the next period, the liability is reversed. The same treatment applies to interest accumulating on a loan, utilities consumed but not yet billed, and taxes owed but not yet due.

Accrued Revenue

Sometimes you’ve earned revenue but haven’t billed the customer yet. A consulting firm that completes 60 hours of billable work in June but doesn’t send the invoice until July still needs June’s statements to reflect the earned income. The entry debits accounts receivable (or a contract asset) and credits revenue. When the invoice goes out and payment arrives, the receivable clears.

Deferred Revenue

Deferred revenue is the mirror image. The customer has paid you, but you haven’t yet delivered. A software company selling annual subscriptions collects cash upfront and earns the revenue month by month as it provides access. At payment, the entry records cash and a corresponding liability. Each month, a portion of the liability shifts into revenue as the obligation is fulfilled.

Prepaid Expenses

Prepaid expenses work the same way on the cost side. When a business pays six months of insurance premiums in advance, the full payment initially goes onto the balance sheet as an asset. Each month, an adjusting entry moves one-sixth of the total from the prepaid asset account to insurance expense.

Bad Debt Expense

Not every customer who owes you money will pay. The matching principle requires estimating uncollectible accounts in the same period as the related revenue, not waiting until a specific account is written off. Under the allowance method, at each period end the business estimates the total amount of receivables likely to go unpaid, debits bad debt expense, and credits an allowance for doubtful accounts. That allowance acts as a contra-asset, reducing accounts receivable to net realizable value. When a specific account is later confirmed as uncollectible, the write-off reduces both the allowance and the receivable without any further hit to the income statement.

Switching from Cash to Accrual

A business that needs to change methods, whether voluntarily or because it crossed the gross receipts threshold, files IRS Form 3115, Application for Change in Accounting Method. Most switches from cash to accrual qualify for the IRS’s automatic consent procedures, which carry no user fee and grant consent on timely filing without a private letter ruling. The original Form 3115 attaches to the business’s timely filed federal income tax return (including extensions) for the year of the change, and a signed copy goes to the IRS National Office by the same date.¹⁰ A business that misses the deadline may qualify for an automatic six-month extension from the original return due date before extensions.¹¹

The Section 481(a) Adjustment

Switching methods mid-stream creates a problem: some income or expenses would either be counted twice or skipped entirely. The Section 481(a) adjustment fixes this by calculating the cumulative difference between what the business reported under the old method and what it would have reported under the new one. A positive adjustment (one that increases taxable income) is spread ratably over four tax years starting with the year of the change. A negative adjustment is recognized entirely in the year of the change.¹²

The four-year spread on positive adjustments softens the tax hit. If the IRS forces a method change during an examination rather than the business initiating it voluntarily, the full adjustment is recognized in a single year regardless of direction. That’s a real incentive to make the switch on your own timeline.¹²

Inventory Gets Its Own Treatment

Businesses that carry inventory face an additional requirement. Purchases and sales of merchandise generally must be accounted for on the accrual basis, even when the business otherwise uses cash-basis accounting for other transactions. This keeps cost of goods sold matched against the revenue from those sales in the same period.

Small business taxpayers that meet the gross receipts test have more flexibility. They can treat inventory the same way they treat non-incidental materials and supplies, expensing items as they’re sold or consumed rather than maintaining formal inventory accounts. Alternatively, they can conform their inventory accounting to whatever method their applicable financial statements use. The small-business exception meaningfully reduces the bookkeeping burden for businesses that stay under the threshold.

1
Internal Revenue Service. Rev Proc 2025-32
2
Financial Accounting Standards Board. Revenue from Contracts with Customers (Topic 606)
3
U.S. Securities and Exchange Commission. Codification of Staff Accounting Bulletins – Topic 13: Revenue Recognition
4
Office of the Law Revision Counsel. 26 US Code 461 – General Rule for Taxable Year of Deduction
5
Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
6
Internal Revenue Service. Rev Proc 2024-40
7
Office of the Law Revision Counsel. 26 US Code 448 – Limitation on Use of Cash Method of Accounting
8
Internal Revenue Service. Accuracy-Related Penalty
9
eCFR. 17 CFR 210.4-01 – Form, Order, and Terminology
10
Internal Revenue Service. Instructions for Form 3115
11
Internal Revenue Service. Instructions for Form 3115 (Rev December 2022)
12
Internal Revenue Service. 4.11.6 Changes in Accounting Methods