Accrual basis accounting records revenue when a business earns it and expenses when a business incurs them, regardless of when cash actually moves. A company that ships $50,000 in product on March 28 books that revenue in March, even if the customer’s check arrives in April. The same logic runs in reverse for costs. This timing rule shapes quarterly profit figures, loan applications, and federal tax obligations, and the IRS requires it for many businesses averaging more than $32 million in annual gross receipts.
How Revenue Gets Recorded
Revenue is recorded the moment a business delivers a product or finishes a service. If a consulting firm completes a project on June 15 and invoices the client that day, the full fee appears as June revenue. Whether the client pays in July or August is irrelevant to the timing of the entry. The unpaid amount sits on the balance sheet as accounts receivable, an asset representing money the business has earned but not yet collected.
Cash that arrives before the work is done flips the picture. When a customer pays a deposit or prepays for a service, the business cannot count that money as revenue yet because it still owes the customer something. The payment is recorded as a liability called deferred revenue. Once the business delivers, it moves the amount from deferred revenue into earned revenue. This is where cash-basis and accrual-basis results diverge most sharply: a cash-basis business would show a spike in income the moment the deposit hits the bank, while an accrual-basis business waits until it actually fulfills the obligation.
How Expenses Get Recorded
The expense side works on the same timing logic. A cost is recorded when the business receives the benefit, not when it writes the check. If a supplier delivers $8,000 worth of raw materials on March 10 and the invoice is due April 10, the expense belongs to March. The unpaid balance appears as accounts payable on the balance sheet.
Two common situations test this rule. An accrued expense arises when a business has received a benefit but hasn’t been billed yet. A contractor who finishes work in December but doesn’t send an invoice until January creates an accrued liability for December, and the business records the estimated cost in that month to keep the financials accurate.
A prepaid expense is the reverse. The business pays now for something it will use later. An annual insurance premium paid in January covers the full year, but only one-twelfth of that cost belongs on January’s income statement. The rest sits on the balance sheet as a prepaid asset and is expensed one month at a time. Skipping this step would overstate January’s costs and understate every other month’s.
The Matching Principle
The logic holding these entries together is the matching principle: costs are reported in the same period as the income they helped produce. If a company spends $10,000 on advertising in June to drive June sales, both the ad spend and the resulting revenue appear on the same income statement. Without that link, one month can look artificially profitable while the next looks like a disaster, even though nothing about the underlying business changed.
This pairing is why accrual-basis statements are the standard under Generally Accepted Accounting Principles (GAAP) and the version lenders and investors expect to see.
Who the IRS Requires to Use Accrual Accounting
Federal tax law doesn’t require every business to use the accrual method, but it does prohibit certain entities from using cash-basis accounting. Under Section 448 of the Internal Revenue Code, three categories of taxpayers cannot compute taxable income on the cash method: C corporations, partnerships that have a C corporation as a partner, and tax shelters.1Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting
Sole proprietors, S corporations, and general partnerships without corporate partners aren’t subject to the Section 448 restriction at all, regardless of their revenue.
The Gross Receipts Exception
C corporations and partnerships with corporate partners get an escape hatch if they’re small enough. A business in either category can still use the cash method as long as its average annual gross receipts over the prior three tax years don’t exceed the inflation-adjusted threshold. The base amount in the statute is $25 million, indexed for inflation each year and rounded to the nearest million.1Office of the Law Revision Counsel. 26 USC 448 – Limitation on Use of Cash Method of Accounting For tax years beginning in 2025, the threshold is $31 million.2Internal Revenue Service. Revenue Procedure 2024-40 For 2026, the IRS has adjusted it to $32 million.
The math is straightforward. Add up your gross receipts for the three tax years before the current one, divide by three, and compare the result to the threshold. If your average falls at or below the limit, you qualify to use the cash method even though you’d otherwise be required to use accrual.
Tax Shelters Get No Exception
Tax shelters are permanently barred from cash-basis accounting with no gross receipts escape. Under the regulations, a tax shelter includes any enterprise whose interests were offered in a registered securities offering and any syndicate where more than 35 percent of losses are allocated to limited partners or similar passive investors.3eCFR. 26 CFR 1.448-1T – Limitation on the Use of the Cash Receipts and Disbursements Method of Accounting
Inventory Is No Longer an Automatic Trigger
Before the Tax Cuts and Jobs Act of 2017, businesses that sold physical goods generally had to use accrual accounting for inventory. That blanket requirement no longer applies to smaller businesses. Under Section 471(c), any taxpayer other than a tax shelter that meets the Section 448(c) gross receipts test can skip the traditional inventory accounting rules. Qualifying businesses can treat inventory as non-incidental materials and supplies, or follow whatever method their financial statements already use.4Office of the Law Revision Counsel. 26 USC 471 – General Rule for Inventories For a retailer or manufacturer averaging under $32 million in gross receipts, this is a significant simplification.
How to Switch from Cash to Accrual
A business that crosses the gross receipts threshold, or simply wants more rigorous financial reporting, needs IRS permission to change its accounting method. The vehicle for that request is Form 3115, Application for Change in Accounting Method.5Internal Revenue Service. About Form 3115, Application for Change in Accounting Method The form requires the business to calculate how the switch affects its taxable income and report the resulting adjustment.
The Section 481(a) Adjustment
Changing from cash to accrual almost always increases taxable income in the transition year. The business suddenly has to recognize revenue it earned but hadn’t collected, along with expenses it incurred but hadn’t paid. The net difference between what the business already reported and what it should have reported under the new method is called the Section 481(a) adjustment.6Office of the Law Revision Counsel. 26 USC 481 – Adjustments Required by Changes in Method of Accounting
If that adjustment increases taxable income (a positive adjustment), the IRS generally lets the business spread it over four tax years: the year of the change plus the following three.7Internal Revenue Service. 4.11.6 Changes in Accounting Methods If the adjustment decreases taxable income, the business takes the entire benefit in the year of the change. The four-year spread exists to prevent the switch from creating a single crushing tax bill.
Automatic Consent
Many cash-to-accrual changes qualify for automatic IRS consent, meaning the business files Form 3115 with its tax return and doesn’t need to wait for the IRS to approve the request. Switching an overall method from cash to accrual is on the published list of qualifying automatic changes.8Internal Revenue Service. Rev. Proc. 2024-23 List of Automatic Changes Both required switches (from exceeding the threshold) and voluntary ones qualify. If a change doesn’t fit the automatic list, the business must file Form 3115 separately and wait for IRS review.
What Happens If You Use the Wrong Method
A business that should be on accrual but keeps filing on the cash method isn’t just making a technical error. Under Section 446(b), the IRS can determine that a taxpayer’s method doesn’t clearly reflect income and impose a different one.7Internal Revenue Service. 4.11.6 Changes in Accounting Methods An examiner who catches the problem during an audit will force the change and calculate the Section 481(a) adjustment, but the business loses control over the timing. Instead of spreading a positive adjustment over four years on its own terms, it faces the adjustment on the IRS’s schedule.
IRS internal guidance also warns that failing to treat an accounting method issue as a proper method change can cause a lasting overstatement or understatement of income, not just a one-year timing mismatch. Getting ahead of the problem voluntarily gives the business more favorable treatment than waiting to be caught.
Why Lenders and Buyers Expect Accrual Reporting
Even businesses that aren’t legally required to use accrual accounting often find themselves pushed toward it by outside parties. Commercial lenders overwhelmingly prefer GAAP-based financial statements when evaluating loan applications, and accrual accounting is the only method GAAP supports. A cash-basis income statement can make a business look wildly profitable in a month when several large receivables happen to come in, then deeply unprofitable the next month when big expenses clear. Lenders want the smoothed, period-matched version that accrual provides.
The same logic applies when selling a business. Buyers and their advisors need earnings measures that depend on expenses being properly matched to the revenue they produced, and a cash-basis set of books often requires significant restatement before anyone can run a credible valuation. Businesses planning to seek financing or explore a sale in the next few years save themselves substantial accounting fees by getting onto the accrual method early rather than reconstructing their records under pressure.