How to Tell if a Tax Return Is Cash or Accrual Method

Businesses use either the cash or accrual accounting method for tax reporting, which affects how income and expenses are recorded. Identifying the method used is essential for accurate financial analysis and tax compliance.

There are key indicators within a tax return that reveal whether it follows the cash or accrual method. By examining specific sections, you can determine which approach was used.

Checking for the Accounting Method Entry

The most direct way to determine the accounting method is by locating the selection on the tax return. For businesses filing Form 1120 (corporations), Form 1120-S (S corporations), or Form 1065 (partnerships), this information appears near the beginning of the form. On Form 1120 and 1120-S, it is listed in Schedule K, while Form 1065 includes it in Schedule B. Sole proprietors using Schedule C of Form 1040 will find it in Part I.

If a business has filed Form 3115 (Application for Change in Accounting Method), it indicates a switch between methods. This form is particularly relevant for businesses exceeding the $27 million gross receipts threshold (as of 2024) and required to use accrual accounting under IRS rules.

Reviewing How Revenue Is Reported

How revenue appears on a tax return provides insight into whether the cash or accrual method is in use. The key difference lies in the timing of income recognition. Under cash accounting, revenue is recorded only when payment is received, while accrual accounting recognizes revenue when earned, regardless of when payment occurs.

Accounts receivable can indicate the accrual method. If reported revenue exceeds cash received, it suggests income is recorded before funds are collected. This is common for businesses with long billing cycles, such as consulting firms or manufacturers extending credit terms. Accrual-based businesses must also report unearned revenue, representing payments received for goods or services not yet delivered.

Another indicator is the treatment of advance payments. Accrual accounting allows businesses to defer recognizing certain advance payments under IRS guidelines, spreading income across multiple tax years. Cash-basis taxpayers, however, must recognize advance payments as income in the year received. This distinction is particularly relevant for subscription-based businesses, landlords, and service providers collecting payments upfront.

Examining Inventory Treatment

How a business accounts for inventory provides a strong indication of its accounting method. Accrual-based businesses recognize inventory costs when incurred, recording purchases as assets until sold, at which point they become cost of goods sold (COGS). Cash-basis businesses may deduct inventory costs when purchased if they qualify for IRS simplified treatment.

For small businesses with average annual gross receipts under $27 million (as of 2024), the IRS allows inventory to be treated as non-incidental materials and supplies, permitting deductions when items are used or sold. Businesses exceeding this threshold must follow accrual-based inventory tracking, ensuring costs are matched with revenue in the correct periods.

Looking at Balance Sheet Items

A company’s balance sheet can indicate its accounting method. Accrual accounting requires tracking liabilities such as accounts payable, representing expenses incurred but not yet paid. If a tax return includes a balance sheet listing these obligations, it suggests the accrual method is in use. Cash-basis businesses do not record unpaid expenses, as costs are only recognized when payments are made.

Deferred revenue is another indicator of accrual accounting. This liability arises when a business receives payment for goods or services it has yet to deliver. For example, a software company selling annual subscriptions would record unearned revenue upon receiving payment and recognize income incrementally. Cash-basis entities do not report these obligations, as income is recorded immediately upon receipt.

Prepaid expenses also signal accrual accounting. Businesses using this method capitalize costs such as rent, insurance, and service contracts when paid and allocate them over the benefit period. Cash-basis taxpayers deduct these costs in the year paid, regardless of the coverage period.

Confirming With IRS Schedules

Supporting IRS schedules provide additional confirmation of a business’s accounting method. These schedules detail income, deductions, and adjustments, offering insight into how transactions are recorded.

Schedule L, the balance sheet attached to Forms 1120, 1120-S, and 1065, is a strong indicator. If it includes accounts receivable, accounts payable, or deferred revenue, the business is likely using accrual accounting. Cash-basis taxpayers generally do not report these items. However, smaller businesses may be exempt from completing Schedule L, so its absence does not necessarily confirm cash accounting.

Schedule M-1, which reconciles book income with taxable income, can also provide insight. Businesses using accrual accounting often report temporary differences, such as accrued expenses deductible for financial reporting but not yet deductible for tax purposes. Adjustments related to unearned revenue or accrued liabilities further support the use of the accrual method. Reviewing these schedules alongside the main tax return ensures a comprehensive assessment of the accounting method applied.