In tax terms, accrual means you report income in the year you earn it and deduct expenses in the year you owe them, regardless of when money actually moves. So a December sale collected in February counts as December income, and a bill you receive for work already done counts as a current-year deduction even if you pay it next year. That timing rule is what separates accrual from the cash method, and it drives almost everything else about how an accrual-basis return is put together.
When Income Is Considered Earned
The IRS decides when accrual-basis income hits the return using the all-events test. Under Section 451 of the Internal Revenue Code, income belongs in gross income for the tax year in which all events have occurred that fix your right to receive it and the amount can be determined with reasonable accuracy.1Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion In practice, that usually means the moment you deliver the product or finish the service. A web design firm that wraps a project on December 20 reports the fee that year even if the client’s check arrives in February.
Businesses that issue audited financial statements have an extra guardrail. Since 2018, the all-events test cannot be treated as met any later than when the income is recognized as revenue on an applicable financial statement, such as a 10-K filed with the SEC or an audited statement used for credit purposes.1Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion You cannot book revenue for shareholders in one year and defer it on the tax return until the next.
When You Can Deduct an Expense
Deductions run on a parallel but stricter rule. Under Section 461, a liability is deductible only when all events have occurred that establish that you owe the debt and the amount can be determined with reasonable accuracy.2Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction Passing that test alone is not enough. A second requirement, called economic performance, must also be satisfied.
Economic performance generally happens when the other party actually provides the services or property you’re paying for.2Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction Prepay a three-year insurance policy on December 1 and you cannot deduct the full amount in year one. Performance stretches across the coverage period, so you deduct only the portion that applies to each tax year. This is where accrual accounting catches people out: signing a contract and receiving an invoice does not trigger the deduction if the work has not yet been performed.
The 12-Month Rule for Prepaid Expenses
There is a workable exception. If you pay for something in advance and the benefit period does not extend beyond 12 months or beyond the end of the next tax year, whichever comes first, you can deduct the whole payment in the year you make it.3Internal Revenue Service. Publication 538, Accounting Periods and Methods A 12-month software subscription paid on July 1 qualifies because it expires before the end of the next tax year. A 15-month subscription paid the same day does not, and you would split the deduction across tax years.
The Recurring Item Exception
Certain recurring liabilities can be deducted before economic performance technically occurs, as long as four conditions are met: the liability passes the all-events test by year-end, economic performance happens within 8½ months after the close of the tax year, the expense is recurring in nature, and either the amount is immaterial or accruing it in the earlier year better matches expense against related income.4eCFR. 26 CFR 1.461-5 – Recurring Item Exception Utility bills, property taxes, and regular vendor invoices are the classic candidates.
Advance Payments From Customers
Advance payments create a specific headache under accrual accounting. If a customer prepays for services you will perform next year, the all-events test would normally force the full amount into income immediately, before you have done the work. The IRS offers a deferral method to soften that outcome.
Under the deferral method, you include an advance payment in income in the year of receipt only to the extent you recognize it as revenue on your applicable financial statement for that year. Without an applicable financial statement, you include it to the extent it is actually earned that year. The rest is picked up in the following tax year, giving you a one-year deferral at most.5Internal Revenue Service. Revenue Procedure 2004-34 You cannot push recognition further out than one additional year, no matter how long the service period runs.
The alternative is full inclusion, where you simply report the entire advance payment as income in the year of receipt. Most businesses prefer the deferral method to postpone the tax hit, but if advance payments are small relative to total revenue, full inclusion is simpler.
Bad Debts You Never Collect
Because accrual filers report income when earned rather than when collected, they can end up paying tax on revenue that never arrives. The tax code allows a bad debt deduction when a receivable turns out to be uncollectible, but only with documentation.
A debt becomes worthless when the facts indicate there is no reasonable expectation of repayment. You must show you took reasonable steps to collect, though going to court is not required if a judgment would clearly be uncollectible. The deduction can only be claimed in the year the debt actually becomes worthless, not when you first suspect trouble. Business bad debts carry a practical advantage: you can deduct a partially worthless business debt, writing off only the uncollectible portion while continuing to pursue the rest.6Internal Revenue Service. Topic No. 453, Bad Debt Deduction
The prerequisite is that you previously included the amount in gross income. Accrual filers do that automatically the moment they record a receivable, so they satisfy the requirement by default.
Who Is Required to Use Accrual
Not every business gets to choose. Under Section 448, C corporations and partnerships with a C corporation partner must use the accrual method unless they meet the gross receipts test.7Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting For taxable years beginning in 2026, that threshold is $32 million in average annual gross receipts over the prior three-year period.8Internal Revenue Service. Rev. Proc. 2025-32 Cross the average and you lose the ability to use the cash method. Tax shelters can never use the cash method, regardless of size.
There is a carve-out for professional service firms. A qualified personal service corporation can stay on the cash method no matter how large it grows, provided two tests are met. Substantially all of the corporation’s activities must involve services in health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. And substantially all of the stock must be owned by employees performing those services, retired employees, their estates, or heirs within two years of the employee’s death.7Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting A medical practice organized as a C corporation and owned entirely by its physicians qualifies even if revenue exceeds $32 million.
Reporting the Method on Your Return
Every entity indicates its accounting method in a specific spot on its federal return, and the IRS uses that designation to flag returns where the timing of income and deductions does not match.
- Sole proprietors select “Accrual” on Line F of Schedule C (Form 1040).9IRS.gov. Schedule C (Form 1040)
- C corporations indicate the method on Schedule K, Line 1 of Form 1120.10Internal Revenue Service. Instructions for Form 1120 (2025)
- Partnerships report the method in Item H on page 1 of Form 1065.11Internal Revenue Service. Form 1065 U.S. Return of Partnership Income
Beyond the box, an accrual return needs to reflect year-end accounts receivable (income earned but not yet collected) and accounts payable (expenses owed but not yet paid). Ledgers that track exact dates of service delivery and invoice receipt make audit reconciliation far less painful.
Changing Between Cash and Accrual
Switching from cash to accrual, or the other way, is not a matter of ticking a different box next year. The IRS requires you to file Form 3115, Application for Change in Accounting Method.12Internal Revenue Service. About Form 3115, Application for Change in Accounting Method Many common changes qualify for automatic consent, meaning you attach the completed form to your timely filed return for the year of change and send a copy to the IRS office in Ogden, Utah.13Internal Revenue Service. Where to File Form 3115 No separate approval letter is issued. Changes that do not qualify for automatic consent go through the non-automatic procedures and carry a user fee set in the annual revenue procedure governing letter rulings.14Internal Revenue Service. Instructions for Form 3115
When you switch methods, some income or expense items could end up double-counted or dropped altogether. The Section 481(a) adjustment prevents that by calculating the cumulative difference between the old and new methods and folding it into your tax picture.15Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting If the adjustment increases your taxable income, you generally spread it over four years: the year of change and the next three. If it reduces your taxable income, you take the entire benefit in the year of change. Getting this calculation wrong is one of the more common reasons the IRS rejects a Form 3115 or adjusts a return on audit, and working through it with a tax professional is usually money well spent.