Accrual method accounting records revenue when a business earns it and expenses when it incurs them, regardless of when cash actually moves. Federal tax law requires this method for C corporations, partnerships that have a C corporation as a partner, and tax shelters whose average annual gross receipts exceed an inflation-adjusted threshold under Internal Revenue Code Section 448. For tax years beginning in 2025, that threshold is $31 million, and the IRS raises it most years. Businesses below the threshold can stay on the cash method for tax purposes, though many adopt accrual anyway because lenders and investors expect financial statements that track economic activity rather than bank deposits.
How Revenue and Expenses Are Recognized
Two principles do most of the work. Revenue is recorded when the business earns the right to be paid: a retailer books the sale when the customer walks out with the product, a consulting firm books it when the work is done or a contracted milestone is reached. Expenses are recorded in the same period as the revenue they helped produce. If a marketing campaign paid for in December drives January sales, the expense belongs in January.
Some costs pair cleanly with specific revenue. Raw materials in a finished product, sales commissions on a closed deal, and shipping on a delivered order all attach to the sale that triggered them. Costs that benefit multiple periods need a different approach.
Depreciation and Amortization
A $120,000 delivery truck used for ten years doesn’t generate revenue only in year one. Recording the full cost immediately would crater that year’s profits and make every following year look artificially cheap. Depreciation spreads the cost across the asset’s useful life, so a ten-year truck might carry $12,000 of expense each year while it’s earning revenue. Intangible assets like patents and software licenses get the same treatment through amortization.
Accruals, Deferrals, and Prepaid Items
Because cash and economic activity are on different clocks, four adjustments come up constantly. Accrued revenue captures work performed but not yet billed: a law firm that puts in 40 hours in June and invoices in July records the revenue in June with a receivable on the balance sheet. Accrued expenses do the reverse, so a December electric bill that arrives in January is a December expense. Prepaid expenses arise when a business pays before using something: a 12-month insurance policy paid in full on January 1 sits on the balance sheet as an asset, with one-twelfth moving to expense each month. Deferred revenue is the mirror image, so a customer’s up-front payment for a year of software access sits as a liability and becomes revenue month by month as the service is delivered.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
Receivables and Bad Debts
Accounts receivable and accounts payable keep the picture current while cash is still in transit. Some customers, though, never pay. For book purposes, businesses typically use an allowance method: they estimate uncollectible receivables at the end of each period based on historical write-offs and record an allowance for doubtful accounts, which pairs the loss with the revenue it came from. For tax purposes, the IRS generally requires a specific charge-off method, meaning a bad debt is deductible only when it becomes definitively worthless.
The Tax Rules That Sit on Top
The IRS uses the all-events test to fix the timing of income. Income is recognized once all events have occurred that fix the right to receive it and the amount can be determined with reasonable accuracy.2Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion The Tax Cuts and Jobs Act added a ceiling: a business with audited financial statements cannot defer income for tax purposes beyond the point it appears as revenue on those statements.
The all-events test also governs deductions, but with an added requirement: economic performance must occur before an expense is deductible.3Office of the Law Revision Counsel. 26 US Code 461 – General Rule for Taxable Year of Deduction If someone provides services or property to your business, economic performance happens as those services or goods are delivered. If your business provides them, economic performance happens as you deliver. For tort and workers’ compensation liabilities, economic performance doesn’t occur until payment is actually made. You cannot always deduct an expense just because you know you’ll owe it.
The Recurring Item Exception
Routine bills would run into trouble under a strict economic performance rule. A business that receives December utility service and pays in January technically hasn’t seen economic performance by year-end. The recurring item exception lets a business deduct such an expense in the earlier year if the all-events test is otherwise met by year-end, economic performance occurs within the earlier of the return’s filing date or 8½ months after year-end, the liability recurs from year to year, and the amount is either immaterial or better matched to the related income in the current year.4GovInfo. 26 CFR 1.461-5 – Recurring Item Exception The exception does not apply to tort liabilities, workers’ compensation, interest, or expenses of tax shelters.
Who Is Required to Use Accrual Accounting
Section 448 names three types of entities that must use the accrual method for federal tax purposes: C corporations, partnerships with a C corporation partner, and tax shelters.5Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting The main way out is the gross receipts test. A C corporation or qualifying partnership can stay on the cash method if its average annual gross receipts over the three preceding tax years are $31 million or less for tax years beginning in 2025.6Internal Revenue Service. Rev Proc 2024-40 – Inflation Adjustments for 2025 The IRS publishes an updated number each fall, so check the current revenue procedure for later years. Short tax years are annualized, and related entities under common control are aggregated.
Inventory used to force businesses onto accrual regardless of size. The TCJA relaxed that too. A business that meets the gross receipts test can now treat inventory as non-incidental materials and supplies or follow the method used on its financial statements, without being pushed onto accrual.1Internal Revenue Service. Publication 538 – Accounting Periods and Methods
Exempt Regardless of Revenue
Two categories can use cash no matter how large they get. Farming businesses, defined broadly to include crop production, ranching, and timber operations, are fully exempt. Qualified personal service corporations are also exempt: corporations where substantially all the work involves services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all the stock is held by current or former employees performing those services.
Switching to Accrual
A business that crosses the gross receipts threshold, or that chooses to switch voluntarily, has to file Form 3115 (Application for Change in Accounting Method) with the IRS.7Internal Revenue Service. Instructions for Form 3115 – Application for Change in Accounting Method Filing is not optional. If the IRS treats a method change as unauthorized, it will recompute taxable income under the old method as if the change never happened.
The mechanic to plan around is the Section 481(a) adjustment. When methods change, some income or expense could disappear or get counted twice because of timing differences, and Section 481(a) corrects that with a one-time adjustment.8Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting A positive adjustment (one that increases taxable income) is spread ratably over four years: the year of change plus the next three. A negative adjustment (one that decreases taxable income) is taken entirely in the year of change.9Internal Revenue Service. 4.11.6 Changes in Accounting Methods A business with a positive adjustment under $50,000 can elect to take it all in a single year.
This is where a switch from cash to accrual bites. Outstanding receivables the business had never recognized as income suddenly get recognized, and the resulting tax bill can be substantial. The four-year spread softens the impact but doesn’t erase it. For any change likely to produce a large adjustment, working with a CPA before filing Form 3115 is worth the cost.
What Happens If You Should Be Using Accrual and Aren’t
A business required to use the accrual method that keeps reporting on cash risks a penalty under IRC Section 6662 for substantial understatement of income tax. The penalty is 20% of the underpaid tax.10Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments An understatement is substantial when it exceeds the greater of 10% of the tax that should have been reported or $5,000. For corporations other than S corporations, the threshold is the lesser of 10% of the correct tax or $10 million.
The bigger exposure is often the method change itself. If the IRS forces the switch during an audit, the entire Section 481(a) adjustment typically hits in one tax year instead of being spread over four.9Internal Revenue Service. 4.11.6 Changes in Accounting Methods Filing Form 3115 voluntarily before the IRS raises the issue preserves the four-year spread and avoids escalating into a broader examination.
Book Accrual and Tax Accrual Are Not the Same
“Accrual accounting” on financial statements is not identical to accrual accounting on a tax return. GAAP and the Internal Revenue Code both use accrual, but they diverge on specifics. Depreciation is the clearest example: GAAP requires a useful-life estimate that reflects actual economic wear, while the tax code offers accelerated schedules and bonus depreciation that let businesses write off assets much faster. Revenue timing can also differ, because the all-events test and the GAAP framework don’t always land on the same date. The resulting book-tax differences are normal. A business can be fully compliant with both systems and still show different income on its statements and its return, as long as it keeps consistent records for each and reconciles them annually.