Accrual basis net income is the total revenue your business earned during a period minus the total expenses it incurred during the same period, regardless of when cash actually moved. To find it, add up every dollar of revenue tied to work you delivered in the period (including sales you have not yet been paid for), subtract every expense tied to that period (including bills you have not yet paid), and the difference is your net income. The method follows Generally Accepted Accounting Principles and gives a truer picture of profitability than cash accounting, which only registers money when it hits or leaves the bank.
What Counts as Earned and Incurred
Under cash-basis accounting, revenue is recorded when payment arrives and expenses when payment goes out. Accrual accounting works differently. Revenue counts when you earn it by delivering the product or finishing the job. Expenses count when you incur them by receiving the service or using the labor. A consulting firm that finishes a $15,000 project in December but is not paid until January still books that $15,000 as December revenue. If the same firm’s staff worked the last week of December but payday fell in January, those wages belong to December too.
C corporations and partnerships with C corporation partners generally must use the accrual method once their average annual gross receipts over the prior three years exceed $32 million for tax years beginning in 2026.1Internal Revenue Service. Revenue Procedure 2025-322Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting Smaller businesses can typically choose either method. Many pick accrual anyway because lenders and investors prefer statements that match revenue to the period the work was actually done.
Step 1: Pull the Source Documents
You need a complete paper trail for every economic event in the period before you can calculate anything. Sales invoices come first. Each one records the date the goods were delivered or the service was performed, and that date, not the payment date, determines which period gets the revenue. Pull every invoice issued during the period and set aside any that cover work not yet completed.
Next, collect vendor bills, purchase orders, and contractor invoices. These document what your business owes even if no check has been written. Payroll records follow. Isolate wages earned during the period, splitting any pay period that straddles two months. Finally, use bank statements to cross-reference cash movement against your invoices and to catch recurring items that lack a separate bill, such as monthly service fees or interest on a line of credit.
Digital records are fine with the IRS if your storage system produces legible copies on demand, maintains an audit trail linking the general ledger to source documents, and controls unauthorized changes.3Internal Revenue Service. Revenue Procedure 97-22 A well-organized cloud accounting system will satisfy an auditor; a folder of loose screenshots probably will not.
Step 2: Adjust for Accruals and Deferrals
Documentation shows what happened. Adjustments assign each transaction to the correct period. Four categories drive nearly every adjusting entry.
Accrued Revenue
Accrued revenue is income you have earned by completing work but have not yet billed. If your firm finished $8,000 of design work in March and will not send the invoice until April, that $8,000 belongs in March. Record it by debiting an accrued revenue receivable and crediting a revenue account. Skip this and you understate the period.
Accrued Expenses
Accrued expenses are costs you have incurred but have not paid. Utilities are the classic case: you used the electricity in March, but the bill lands in April. Interest on a business loan works the same way. On a $50,000 loan at 6%, roughly $250 accrues each month whether or not a payment is due. Debit the expense; credit an accrued liability.
Deferred Revenue
Deferred revenue is cash you have already collected for work not yet done. A $1,200 annual subscription paid up front in January puts only $100 in January’s revenue. The other $1,100 sits on the balance sheet as a liability because you still owe eleven months of service. Each month, $100 moves from the liability to revenue.
Prepaid Expenses
Prepaid expenses mirror deferred revenue. A $3,600 insurance premium covering twelve months produces only $300 of expense in the month you pay. The rest is a prepaid asset that shrinks by $300 a month as you consume the coverage.
Not every small accrual needs its own entry. Financial reporting standards let you skip adjustments for amounts so minor that including or omitting them would not change anyone’s decision. A common preliminary screen is the 5% rule of thumb, treating misstatements below 5% of a relevant line as presumed immaterial. Qualitative factors still matter: a small error that turns a loss into a profit, or hides a trend, can be material even at a trivial dollar amount.4U.S. Securities & Exchange Commission. SEC Staff Accounting Bulletin No. 99 – Materiality
Step 3: Record the Non-Cash Adjustments
Three expenses do not correspond to any cash movement during the period, and they trip up a lot of businesses.
Depreciation and Amortization
When you buy a $60,000 delivery truck, the full cost does not hit the income statement on the purchase date. You spread it over the truck’s useful life. Depreciated evenly over five years, that is $12,000 of depreciation expense per year, reducing net income each period even though no additional cash leaves the account. The same treatment applies to amortization of intangibles like patents or software.
Bad Debt Allowance
Booking revenue when you invoice means some receivables will never be collected. Accrual accounting handles this through an allowance for doubtful accounts, a contra-asset that reduces receivables on the balance sheet. Estimate the uncollectible portion from historical experience and record bad debt expense in the same period as the related revenue. When a specific account is later confirmed uncollectible, write it off against the allowance rather than recording a new expense.
Cost of Goods Sold
If you sell physical products, cost of goods sold captures the direct cost of what you actually sold during the period, not what you purchased. Calculate it as beginning inventory plus purchases minus ending inventory. Valuation method affects the number: FIFO assumes the oldest inventory sells first, LIFO assumes the newest, and weighted average splits the difference. All three are permitted under U.S. GAAP. Businesses below the $32 million gross receipts threshold may be exempt from maintaining formal inventories for tax purposes and can treat inventory as supplies.5eCFR. 26 CFR 1.471-1 – Need for Inventories
Step 4: Total Your Accrual-Basis Revenue
Pull every source of earned revenue into one figure. Start with billed sales invoices for goods delivered or services performed during the period. Add accrued revenue for work finished but not yet invoiced. Subtract any cash receipts that represent deferred revenue for future work. The result is your total accrual-basis revenue.
Double-check that no advance payment for next quarter’s work slipped into this period’s revenue. That is one of the most common errors in accrual accounting, and it inflates income in ways that create tax problems later.
Step 5: Total Your Accrual-Basis Expenses
Aggregate every expense tied to the period:
- Paid operating expenses for goods and services consumed in the period.
- Unpaid vendor bills for goods or services already received.
- Accrued liabilities such as accumulated interest and earned-but-unpaid wages.
- Depreciation and amortization.
- Bad debt expense.
- Cost of goods sold.
- The portion of prepaid items actually consumed during the period.
This is where most mistakes happen. The temptation is to count only what you have paid, which defeats the whole point of the method. A $4,000 shipment of materials received on the last day of the quarter belongs in that quarter’s expenses even if the vendor has not sent the bill.
Step 6: Subtract and Get the Number
The formula is straightforward:
Accrual basis net income = total accrual revenue − total accrual expenses
If revenue for the period is $420,000 and expenses (including depreciation, bad debt, and cost of goods sold) total $365,000, accrual basis net income is $55,000. That figure goes on the income statement and becomes the starting point for the tax calculation. The federal tax rate on corporate taxable income is 21%.6Internal Revenue Service. Publication 542 – Corporations
Book Net Income Is Not Taxable Income
Accrual basis net income on your financial statements will not automatically equal your taxable income. Book-to-tax differences are routine. Depreciation schedules often diverge between GAAP and tax rules. Certain meal costs are only partially deductible for tax. Some items that appear in book revenue, such as municipal bond interest, may be tax-exempt. The financial statement number is your starting point; reconciling to the return is a separate step.
What an Understatement Costs
Getting the accrual calculation wrong has direct tax consequences. The IRS imposes a 20% accuracy-related penalty on underpayments caused by negligence or a substantial understatement of income tax.7Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments For individuals, a substantial understatement means the correct tax was understated by the greater of 10% or $5,000. For corporations other than S corps, the threshold is the lesser of 10% of the correct tax (or $10,000 if greater) and $10 million.8Internal Revenue Service. Accuracy-Related Penalty If the IRS finds the underpayment was fraudulent, the penalty jumps to 75% of the fraudulent portion.9Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty Failing to record accrued revenue is precisely the type of error that triggers these penalties, because the income existed and had to be reported whether or not the invoice went out.