When Are Expenses Recorded? Cash vs. Accrual and the 12-Month Rule

When a business records an expense depends on its accounting method. On the cash basis, you record it on the day you pay. On the accrual basis, you record it when you’re legally obligated to pay and the vendor has actually performed, whether or not any money has moved.¹ The distinction can shift thousands of dollars in deductions from one tax year to another, so the timing question is really a tax question.

Cash Basis: The Day You Pay

Cash basis is the simpler method. The expense lands in your books on the date you actually hand over money, whether by check, electronic transfer, or cash.¹ The invoice date doesn’t matter. Neither does the delivery date. What matters is when payment goes out.

This produces a clean year-end rule. An invoice that arrives in December but gets paid in January is a January expense. A check mailed on December 30 is a December expense, even if the vendor deposits it the following week.

The IRS does watch for artificial timing. The doctrine of constructive receipt, which applies mainly to income under the cash method, treats a transaction as complete when funds are credited or made available without substantial restriction, regardless of whether they’ve physically changed hands.² Genuine timing choices are fine; calendar games are not.

Accrual Basis: When You Owe and the Work Is Done

Accrual accounting separates expense recognition from your bank balance. You record an expense when two things happen: all events that fix your liability have occurred, and the amount can be determined with reasonable accuracy. That standard is the all-events test.³ Once the vendor has delivered and you know the price, the expense hits your books, even if you haven’t paid.

Federal tax law layers a second requirement on top: economic performance. How it applies depends on what you’re buying:

For services or property provided to you, economic performance happens as the vendor performs or delivers.
For your use of someone else’s property, it occurs across the period you’re entitled to use it.
For services or property you provide to others, it happens as you incur the costs of performing.

Both tests must be met before the deduction is available.³ A contractor who finishes a renovation in December generates a December expense even if the check goes out in February. A contractor who starts in December and finishes in January splits across two years to match the actual work.

One practical exception softens the rule for routine costs. For recurring items where economic performance occurs shortly after year-end, you can record the expense in the earlier year if performance happens within eight and a half months of the close of that tax year and you treat similar items the same way each year.³ That’s why you don’t have to defer your December utility bill just because the service period runs into early January.

Which Method Your Business Can Use

Not every business gets a choice. Federal law restricts the cash method for C corporations, partnerships with a C corporation partner, and tax shelters.⁴ Those businesses generally must use accrual.

The exception is a gross receipts test. A C corporation or qualifying partnership can still use cash if its average annual gross receipts over the prior three tax years don’t exceed $32 million for tax years beginning in 2026.⁵ The threshold is adjusted annually for inflation.

Sole proprietors, single-member LLCs, and S corporations that aren’t tax shelters can generally use the cash method regardless of revenue. That’s why cash basis dominates among small businesses: most simply aren’t subject to the restriction.

Prepaid Expenses and the 12-Month Rule

Paying in advance complicates the answer under both methods. A prepaid expense is generally deductible only in the year the benefit applies to, not the year the check clears.

The 12-month rule creates room to deduct the whole prepayment now. If the benefit doesn’t extend beyond the earlier of 12 months after it begins or the end of the following tax year, you can deduct the full amount in the year of payment.¹ A calendar-year business paying in July for a 12-month policy running July through June can deduct the whole premium in the year of payment. A three-year policy paid upfront fails the test, so the deduction spreads across the coverage years.

Accrual-basis businesses reach the same result through the matching principle. Prepaying 18 months of rent means sitting a prepaid asset on the balance sheet and moving cost to expense month by month as you occupy the space.

Equipment: Depreciation, Section 179, and Bonus Depreciation

Long-lived assets don’t hit expense all at once under standard rules. Instead, you spread the cost over the asset’s useful life through depreciation, matching the expense to the periods that benefit from the asset. A delivery truck that lasts eight years shouldn’t be a single expense in year one when it’s producing revenue for all eight.

Tax law offers two accelerators.

Section 179 expensing lets you deduct the full cost of qualifying business equipment in the year you place it in service, up to $2,560,000 for tax years beginning in 2026. The deduction phases out dollar-for-dollar once total equipment purchases pass $4,090,000.⁵ A separate cap limits the Section 179 deduction to your business’s active taxable income for the year, with unused amounts carrying forward.⁶

Bonus depreciation now allows a 100% first-year deduction for most qualifying business property acquired after January 19, 2025. The One, Big, Beautiful Bill made this permanent, reversing the earlier phase-down.⁷ Unlike Section 179, bonus depreciation has no income limitation and can create a net operating loss.

The two provisions work together. Many businesses use Section 179 first and then apply bonus depreciation to whatever remains.

Inventory and Cost of Goods Sold

If you sell physical products, the money you spend on merchandise isn’t an ordinary expense you deduct when paid. It sits on your balance sheet as inventory until you sell the goods. When a sale happens, the cost moves to cost of goods sold and offsets the revenue for that period. The expense of producing a product and the revenue from selling it land in the same period.

Businesses that produce, buy, or sell merchandise generally must keep inventory and use accrual accounting for purchases and sales, even when the rest of the books are on cash basis.⁸ Small businesses with average annual gross receipts of $32 million or less for 2026 can opt out of formal inventory accounting.⁵ If you qualify and elect out, you treat inventory items as supplies and deduct their cost when you first use or sell them.

That same threshold exempts small businesses from the Uniform Capitalization rules, which would otherwise force certain indirect costs like warehouse rent or equipment depreciation into inventory instead of allowing current deductions.

Getting the Year Wrong

Recording an expense in the wrong year understates one year’s tax and overstates another’s. The IRS focuses on the year that was underpaid. If the mistake meets the substantial-understatement threshold or reflects negligence, the accuracy-related penalty is 20% of the underpayment.⁹

1
Internal Revenue Service. Publication 538 – Accounting Periods and Methods
2
eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income
3
Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction
4
Office of the Law Revision Counsel. 26 U.S. Code 448 – Limitation on Use of Cash Method of Accounting
5
IRS.gov. Rev. Proc. 2025-32
6
Office of the Law Revision Counsel. 26 U.S.C. 179 – Election to Expense Certain Depreciable Business Assets
7
Internal Revenue Service. One, Big, Beautiful Bill Provisions
8
Internal Revenue Service. Tax Guide for Small Business
9
Internal Revenue Service. What Kind of Records Should I Keep