Accrual Method of Accounting

An accrual method of accounting reports income and expenses by reference to when the underlying obligation becomes fixed rather than to when money moves. Publication 538 states the object plainly: "the purpose of an accrual method of accounting is to match income and expenses in the correct year," and under such a method "you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred."

The indefinite article in that sentence is not a stylistic accident, and it is the naming point worth knowing. Section 446(c)(1) names "the cash receipts and disbursements method," with a definite article, because there is one. Section 446(c)(2) names "an accrual method," and Publication 538 follows suit throughout. There is a family of accrual methods rather than a single one: the general regulations under sections 451 and 461, the long-term contract methods under section 460, and the variants that turn on whether the taxpayer keeps an applicable financial statement. So a business is not simply "on accrual"; it is on a particular accrual method, and the difference is visible in the timing rules that apply to it.

The method is set by the books, not by an election. Section 446(a) computes taxable income under the method the taxpayer regularly uses in keeping their books, and changing it later needs the IRS's consent.

The all-events test for income, and the rule that qualifies it. Publication 538's general rule is that an amount is included in gross income for the year in which the all-events test is met, and "this test is met when all events have occurred which fix your right to receive the income and you can determine the amount with reasonable accuracy." A December invoice for work already delivered is therefore income in December, whether or not it is paid.

Then comes the qualification that most short summaries omit, and it is the reason "accrual means income when earned" is incomplete. Publication 538: "if you have an applicable financial statement (AFS), you include the amount in income no later than when the item of income is reported in your applicable financial statement." That is the AFS income inclusion rule, and under it income is reported 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; and when it is included as revenue in your AFS, if you have one. For a business that keeps audited or otherwise applicable financial statements, a decision about book revenue recognition is therefore a decision about the timing of taxable income. The regulations at 26 CFR 1.451-3 govern the detail, including a hierarchy of which financial statements count and an optional AFS cost offset method for inventory sales, and a business in that position is not reading its way to an answer from a publication.

Advance payments, and the ceiling on the deferral. The general rule is that an advance payment for goods, services or other items is income in the year received. An accrual-method taxpayer may elect to postpone part of it, and Publication 538 states the limit in the same breath: "you can elect to postpone including the advance payment in income until the next year. However, you cannot postpone including any payment beyond that tax year." One year, not the life of the contract. Three conditions gate the deferral method: full inclusion in the year of receipt must be a permissible method for the taxpayer; a portion of the payment must be included in revenue in the AFS for a later year, or earned in a later year where there is no AFS; and the payment must be for goods, services or other items the Secretary has identified. Certain gift card sales qualify as advance payments; certain prepayments, including some rent and insurance premiums, are excluded from the definition and cannot use the deferral at all. Where an estimate is included and the exact amount later differs, the difference is taken into account in the year the determination is made.

The expense side needs three things, and the third is the one people drop. Publication 538 requires that the all-events test be met, meaning all events have occurred that fix the fact of liability and the liability can be determined with reasonable accuracy, and that economic performance has occurred. Economic performance is a rule about delivery rather than about invoicing: where the expense is for property or services provided to you, performance occurs as they are provided; where it is for property or services you provide to others, as you provide them. For workers' compensation and tort liabilities it occurs as payments are made, which is a cash rule sitting inside an accrual method. The publication's own illustration is an office-supplies order received with its bill in December and paid in January, deductible in December because all three requirements were satisfied then.

A recurring item exception softens the third requirement, and it has four conditions rather than one. The all-events test must be met; economic performance must occur by the earlier of eight and a half months after the close of the year or the date a timely return including extensions is filed; the item must be recurring in nature and treated consistently as incurred in the year the all-events test is met; and either the item is not material or accruing it in that year results in better matching against the related income. One exclusion travels with it and it is the obvious one to miss: Publication 538 states that the exception "does not apply to workers' compensation or tort liabilities," which are exactly the liabilities whose economic performance is already tied to payment.

The answer to "I have to report income I was never paid." Section 448(d)(5) is headed "Special rule for certain services," and the regulations call it the nonaccrual-experience method. A person using an accrual method for amounts to be received for the performance of services "shall not be required to accrue any portion of such amounts which (on the basis of such person's experience) will not be collected," provided either that the services are in the qualified personal service corporation fields, or that the person meets the section 448(c) gross-receipts test for all prior taxable years. Section 448(d)(5)(B) contains the gate that removes it from most commercial arrangements: the paragraph does not apply to any amount if interest is required to be paid on it or there is any penalty for failure to pay it on time. So the relief reaches uncollectible fee income and not a receivable carrying late charges.

Who has to use an accrual method. Section 448(a) bars the cash method for a C corporation, a partnership with a C corporation as a partner, and a tax shelter, subject to the exceptions in 448(b) for a farming business, a qualified personal service corporation, and an entity meeting the gross-receipts test. Separately, and regardless of entity type, Publication 538 provides that "generally, if you produce, purchase, or sell merchandise, you must keep an inventory and use an accrual method for sales and purchases of merchandise," subject to a small-business exception. An entity that fails the gross-receipts test must change to an accrual method effective for the year it fails, and files Form 3115 to do so. Changing method is never a matter of simply recording things differently: section 446(e) requires the IRS's consent, and the change brings a section 481(a) adjustment so that no item is counted twice or dropped.

For income and for expenses the questions are different, and both run in order.

Income. Have all events occurred that fix the right to receive it, and can the amount be determined with reasonable accuracy? If there is an applicable financial statement, has the item been reported there yet? The earliest of the five triggers governs.

Expenses. Is the fact of the liability fixed? Is the amount reasonably determinable? Has economic performance occurred, or does the recurring item exception cover it?

A hypothetical example of the advance-payment ceiling, which is where the one-year limit does visible work. Assume a calendar-year taxpayer with no applicable financial statement, using the deferral method.

On December 1 of year 1, Priyanka's maintenance company receives $27,000 in advance for an 18-month service contract running from that date to May 31 of year 3. The revenue is earned evenly, so $27,000 ÷ 18 = $1,500 a month.

Year 1. One month of the contract falls in year 1, so the amount earned is $1,500. That is the portion included in income in the year of receipt.

Year 2. Twelve months fall here, worth $18,000 of service. But the deferral cannot run past the tax year following receipt, so the entire remaining $27,000 − $1,500 = $25,500 is included in year 2.

Year 3. Five months of the work, worth 5 × $1,500 = $7,500, is performed in year 3. None of it is income in year 3, because it was all pulled into year 2 by the ceiling.

So $7,500 of income is taxed a full year before the work that earns it is done, and the company has no election that fixes it. Had Priyanka simply used the full inclusion method, all $27,000 would have been income in year 1, which is worse by $25,500 in that year. The choice is between one year of acceleration and two, not between accrual and reality.

Pros

• It matches income to the period that earned it, which is what makes month-to-month figures comparable and makes a business valuable to a lender or a buyer.
• The expense side gives real timing benefits, because a liability fixed and economically performed is deductible whether or not it has been paid.
• The recurring item exception allows an accrual for items whose delivery slips just past year end, within a defined window.
• The nonaccrual-experience method relieves a service business of accruing fee income its own experience says it will not collect.
• It is what formal financial statements use, so one set of books can serve both the return and the statement.

Cons

• It can produce taxable profit on money that has not arrived, which is a cash flow problem the tax return does not care about.
• For a business with an applicable financial statement the income trigger can be book recognition, so a financial-reporting decision moves the tax year.
• The one-year ceiling on deferring an advance payment means a multi-year prepaid contract is taxed well ahead of the work.
• Economic performance is a separate requirement that defeats a deduction which otherwise satisfies the all-events test.
• It costs more to maintain, because receivables and payables have to be tracked to produce a return at all.
• It is not optional for everyone. A C corporation over the gross-receipts test, a partnership with a C corporation partner, or a business holding inventory can be required to use it.