Cash vs Accrual Accounting: IRS Rules and Worked Examples

Core differences between cash and accrual accounting

An accounting method is a set of rules used to determine when and how income and expenses are reported on your tax return. You choose your accounting method when you file your first tax return. Once chosen, you must use the same method from year to year so that it clearly reflects your income.

The difference between the two primary methods comes down to timing. Under the cash method, you report income in the tax year you actually or constructively receive it, and you deduct expenses in the tax year you actually pay them. Under the accrual method, you report income in the tax year you earn it and deduct or capitalize expenses in the tax year you incur them, regardless of when payment happens. The purpose of the accrual method is to match income and expenses in the correct year.

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

How the cash method works (and the constructive receipt rule)

Most individuals and many small businesses use the cash method. When figuring gross income under the cash method, you include all cash, property, and services you actually or constructively received during the tax year. If you receive property or services, you must include their fair market value in income.

Constructive receipt means an amount is credited to your account or made available to you without restriction. You do not need to have physical possession of the money. If you authorize an agent to receive income for you, you are considered to have received it when your agent receives it. You cannot hold checks at the end of December or postpone taking possession of property from one tax year to another to delay paying tax.

For example, suppose you are a calendar-year taxpayer and your bank credits and makes available interest to your bank account in December 2021. Even if you do not withdraw the money or enter it into your books until 2022, you must include that amount in your gross income for 2021.

On the expense side, you deduct business expenses in the tax year you actually pay them. However, an expense you pay in advance is deductible only in the year to which it applies, unless it qualifies for the 12-month rule. Under the 12-month rule, you are not required to capitalize prepaid amounts for rights or benefits that do not extend beyond the earlier of 12 months after the right or benefit begins, or the end of the tax year after the tax year in which the payment is made.

Compare these two worked examples for a calendar-year taxpayer:

• 1-year policy (qualifies for the 12-month rule): You pay $10,000 on July 1, 2021, for a business insurance policy effective for 1 year beginning July 1, 2021. The 12-month rule applies, so you can deduct the full $10,000 in 2021.
• 3-year policy (does not qualify for the 12-month rule): You pay $3,000 in 2021 for a business insurance policy effective for 3 years (36 months) beginning July 1, 2021. Because the benefit extends beyond 12 months, only the portion that applies to each tax year is deductible. You deduct $500 (6/36 of $3,000) in 2021, $1,000 (12/36) in 2022, $1,000 (12/36) in 2023, and the remaining $500 in 2024.

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

How the accrual method works (all-events test and economic performance)

Under an accrual method, you include an amount in gross income for the tax year in which the all-events test is met. The all-events test for income is met when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy.

If you have an Applicable Financial Statement (AFS), the AFS income inclusion rule requires you to report an amount in gross income on the earliest of five events: when you receive payment, when the income amount is due to you, when you earn the income, when title passes, or when it is included as revenue in your AFS. If you receive an advance payment for goods or services under the accrual method, you generally report it in the year received, or you can elect to postpone including the unrecorded portion until the next tax year, but no further.

To deduct or capitalize a business expense under the accrual method, both of the following requirements must be met:

• The all-events test is met: All events have occurred that fix the fact of the liability, and the liability can be determined with reasonable accuracy.
• Economic performance has occurred: If the expense is for property or services provided to you, economic performance occurs as the property or services are provided or used.

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

Worked example: Year-end expenses and recurring items under accrual vs cash

The IRS rules illustrate how economic performance changes the tax year of a deduction. Suppose you are a calendar-year taxpayer who buys office supplies in December 2020. You receive the supplies and the bill in December, but you pay the bill in January 2021.

Under the accrual method, you deduct the expense in 2020. Receiving the supplies and the bill in December fixed the liability, established the exact amount, and satisfied economic performance in 2020. Under the cash method, generally, you deduct expenses in the tax year in which you actually pay them.

What if the office supplies were billed in December 2020, but not delivered until January 2021? Normally, economic performance has not occurred until delivery. However, accrual taxpayers can use the recurring item exception. Under this exception, a recurring item is treated as incurred in the current tax year if the all-events test is met, the item is recurring and treated consistently, it is either not material or accruing it results in a better match against income (where Generally Accepted Accounting Principles, or GAAP, are an important factor), and economic performance occurs by the earlier of 8 months after the close of the year or the date you file a timely return (including extensions).

One strict limitation applies to related parties. If an accrual-basis business owes business expenses or interest to a related person who uses the cash method, the accrual taxpayer cannot deduct that expense until the payment is actually made and included in the related person's gross income.

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

IRS eligibility rules and exceptions: Gross receipts, PSCs, and inventory

While sole proprietors, S corporations, and partnerships without C corporation partners can generally choose the cash method, the Internal Revenue Code restricts three categories of entities from using the cash method (or any hybrid method that includes cash): C corporations, partnerships with a C corporation partner, and tax shelters as defined in section 448(d)(3).

Tax shelters are never allowed to use the cash method. However, C corporations and partnerships with a C corporation partner can use the cash method if they meet one of the official IRS exceptions:

• The Gross Receipts Test: A corporation or partnership (other than a tax shelter) meets the test if its average annual gross receipts for the 3 prior tax years were at or below the statutory limit. This base threshold is $26 million or less (indexed for inflation). In the Instructions for Form 3115, the inflation-adjusted amount for tax years beginning in 2022 is $27,000,000 (per Revenue Procedure 2021-45). You figure your 3-year average by adding the gross receipts for the 3 prior tax years and dividing by 3. Members of a controlled group or affiliated service group must aggregate their gross receipts. If an entity fails the test in any tax year, it must switch to an accrual method effective for that tax year and file Form 3115.
• Qualified Personal Service Corporations (PSCs): A C corporation can use the cash method regardless of revenue if it meets both the function test and the ownership test. The function test requires at least 95% of activities to be in health (including veterinary services), law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts, or consulting. The ownership test requires substantially all stock to be owned directly or indirectly at all times during the year by active or retired employees performing services in those qualifying fields (or their estates, or heirs for a 2-year period beginning on the date of death).
• Farming Businesses: Taxpayers in the trade or business of farming can generally use the cash method, though certain farming corporations and partnerships with a corporate partner must meet the gross receipts test.
• The Small Business Taxpayer Inventory Exception: Generally, when the production, purchase, or sale of merchandise is an income-producing factor, you must keep an inventory and use an accrual method for purchases and sales. However, if you qualify as a small business taxpayer (meeting the 3-year average annual gross receipts test and not a tax shelter), you can choose not to keep an inventory. Instead, you can treat inventory as non-incidental materials and supplies, or conform to the treatment of inventory in your AFS (or in your books and records if you do not have an AFS).

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

Combining both with the hybrid accounting method

You can use a hybrid method that combines cash, accrual, and special methods of accounting, as long as the combination clearly reflects your income and you use it consistently from year to year. For example, you can use an accrual method for purchases and sales of merchandise while using the cash method for all other items of income and general operating expenses. However, the IRS enforces strict matching rules on hybrid methods:

• If you use the cash method for reporting your income, you must use the cash method for reporting your expenses.
• If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
• Any combination that includes the cash method is treated as the cash method for the section 448 restrictions on C corporations and tax shelters.
• You can use different accounting methods for business and personal items, or for two or more separate and distinct businesses if you maintain a complete and separate set of books and records for each and do not shift profits or losses between them.

• IRS: Publication 538 (01/2022), Accounting Periods and Methods
• IRS: Instructions for Form 3115 (12/2022)

How to switch between cash and accrual (Form 3115 and Section 481(a))

Changing from the cash method to an accrual method (or vice versa) after your first tax return requires IRS approval on Form 3115 (Application for Change in Accounting Method). Correcting a math or posting error does not require Form 3115, but changing the timing of when any material item of income or deduction is recognized does.

Automatic change procedures: If your business meets the eligibility rules in the IRS List of Automatic Changes (such as Designated Change Number 122 for overall cash-to-accrual changes, or DCN 233 for small business taxpayers switching to cash), no user fee is required. You generally qualify only if you have not made or requested an overall method change during any of the 5 tax years ending with the year of change, and it is not the final year of your business. You file Form 3115 in duplicate: attach the unsigned original to your timely filed federal income tax return (including extensions) for the year of change, and mail or fax a signed copy to the IRS in Ogden, Utah (or fax to 844-249-8134) no earlier than the first day of the year of change and no later than the date you file the return.

Non-automatic change procedures: If you do not qualify for an automatic change, you must file with the IRS National Office in Washington, DC, during the tax year for which the change is requested, and pay a user fee via Pay.gov.

When you switch methods, you must calculate a Section 481(a) adjustment on Part IV and Schedule A of Form 3115 so that no income or expense is counted twice or omitted. The form instructions provide a worked example for ABC Corporation switching from cash to accrual on January 1, 2022:

• IRS: Instructions for Form 3115 (12/2022)
• IRS: Publication 538 (01/2022), Accounting Periods and Methods

Checklist: How to spread your Section 481(a) adjustment

In the IRS example above, ABC Corporation has a positive Section 481(a) adjustment of +$120,000. By our calculation from the Instructions for Form 3115, spreading that +$120,000 positive adjustment equally across the standard 4-year adjustment period adds $30,000 per year to taxable income in the year of change and the next 3 tax years, rather than taxing all $120,000 in year one.

Use this checklist written by our team to verify your Section 481(a) adjustment period and filing steps:

• Negative net adjustment (reduces taxable income): The adjustment period is 1 tax year. Take the entire deduction in the year of change.
• Positive net adjustment (increases taxable income): The adjustment period is generally 4 tax years (the year of change and the next 3 tax years).
• Under $50,000 de minimis election: If your positive adjustment is less than $50,000, you can elect on Form 3115 (Part IV, line 28) to take the entire amount in 1 tax year.
• Under IRS examination: If your business is under examination without a specific window exception, a positive adjustment period is shortened to 2 tax years.
• Duplicate filing for automatic changes: Attach the unsigned original Form 3115 to your timely federal return and send the signed copy to the IRS Ogden address or fax number on or before your return filing date.

• IRS: Instructions for Form 3115 (12/2022)
• IRS: Publication 538 (01/2022), Accounting Periods and Methods

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• IRS: Publication 538 (01/2022), Accounting Periods and Methods