How to Report an Accrual to Cash Adjustment on a Tax Return

An accrual-to-cash adjustment is a change in how a business reports its financial activities for tax purposes. Under the accrual method, income is recorded when it is earned and expenses when they are incurred, regardless of when money actually changes hands. Switching to the cash method means income is reported only when payment is received, and expenses are deducted only when they are paid. This change can simplify bookkeeping and align tax payments more closely with cash flow.

A business might make this change to gain more control over the timing of its taxable income. For instance, using the cash method, a company can delay sending invoices at the end of the year to push income recognition into the next tax year. Similarly, it can prepay expenses to accelerate deductions into the current year.

Eligibility for the Cash Method

To switch from the accrual to the cash method of accounting for tax purposes, a business must meet criteria set by the Internal Revenue Service (IRS). The primary path for eligibility is through the small business taxpayer exception, which is available to businesses that pass a gross receipts test. A business qualifies if its average annual gross receipts for the three preceding tax years do not exceed an inflation-adjusted threshold.

For tax years beginning in 2025, the threshold is $31 million. This test allows many small businesses, including sole proprietorships, partnerships, and S corporations, to use the cash method even if they have inventory. Certain businesses are barred from using the cash method, regardless of their gross receipts, including tax shelters and C corporations or partnerships with a C corporation as a partner that do not meet the gross receipts test.

Businesses that are required to use the accrual method for financial reporting under U.S. Generally Accepted Accounting Principles (GAAP) can still use the cash method for tax purposes, but this requires maintaining two separate sets of books.

Calculating the Section 481(a) Adjustment

When changing from the accrual to the cash method, a business must calculate a Section 481(a) adjustment. This calculation is necessary to prevent any item of income or expense from being counted twice or omitted entirely due to the change. The adjustment is a one-time reconciliation of the differences between the two methods as of the beginning of the tax year of the change.

The calculation begins by subtracting all income that was recognized under the accrual method but not yet received in cash. This amount, primarily the accounts receivable balance at the start of the year, is subtracted because this income was already taxed when it was earned under the accrual system. This prevents it from being taxed a second time when the cash is collected.

Next, all expenses that were deducted under the accrual method but not yet paid must be added back to taxable income. This includes the accounts payable balance at the beginning of the year and the cost of any previously deducted inventory on hand. These expenses are added back to prevent a double benefit that would occur if they were deducted again when paid under the cash method.

For example, assume a business has $50,000 in accounts receivable and $30,000 in accounts payable at the beginning of the year. The net Section 481(a) adjustment would be a negative $20,000 ($30,000 – $50,000). A negative adjustment results in a one-time deduction that decreases taxable income in the year of the change. Conversely, if accounts payable exceeded accounts receivable, the adjustment would be positive, increasing taxable income. To ease the burden of a positive adjustment, the IRS allows the additional income to be spread over a period of up to four years.

Required Documentation and Form Completion

The central document for reporting a change from the accrual to the cash method is IRS Form 3115, Application for Change in Accounting Method. This form is mandatory for requesting the change and reporting the Section 481(a) adjustment. Taxpayers should download the most current version of Form 3115 from the IRS website to ensure compliance.

The taxpayer must identify their business, including its name, address, and taxpayer identification number. The form requires a description of both the present (accrual) and proposed (cash) methods of accounting. This includes specifying the Designated Automatic Accounting Method Change Number, which is found in the IRS’s List of Automatic Changes.

The calculated Section 481(a) adjustment must be reported on the form, showing the net amount and whether it is positive or negative. The form also requires a breakdown of the adjustment’s components, such as accounts receivable and accounts payable. Attaching a separate statement that shows the calculation of the adjustment is a common practice.

The Filing Process for the Accounting Method Change

The filing process involves a dual-filing requirement. The taxpayer must attach the original, signed Form 3115 to their timely filed federal income tax return for the year in which the accounting method change takes effect. This includes filing by the original due date or the extended due date of the return.

In addition to filing with the tax return, a separate copy of the completed Form 3115 must be filed with the IRS national office. Filers should consult the latest instructions for Form 3115 on the IRS website for the correct mailing address. The deadline for filing this duplicate copy is the same as the deadline for filing the tax return itself.

For many businesses, this change qualifies for the automatic consent procedure. This means the IRS grants automatic approval for the change, provided the Form 3115 is filed correctly and on time. The taxpayer does not need to wait for an approval letter before implementing the cash method in the year of change.