Publication 538: Accounting Periods and Methods Explained

The IRS requires businesses to use a consistent accounting period and method to report income and expenses. These choices determine how financial activities are recorded and when taxes are paid, making them essential for compliance and financial planning.

Types of Accounting Periods

Businesses must establish a fixed timeframe for measuring financial performance, which dictates how income and expenses are reported each year. The IRS allows several options, each with different tax and financial implications.

Calendar Year

A calendar year runs from January 1 through December 31 and is the default reporting period for many businesses, including sole proprietorships, partnerships that do not elect a different period, and S corporations. The IRS generally requires individuals and entities without an approved alternative to use this structure.

Using a calendar year simplifies tax reporting for business owners who file their business income on personal returns. It also aligns with financial institutions, as banks and lenders typically follow this period. However, businesses with seasonal revenue fluctuations may benefit from a different structure.

To adopt a calendar year, a company reports income and expenses using this timeframe on its first tax return. No IRS approval is needed unless switching from another period.

Fiscal Year

A fiscal year is any 12-month period ending on the last day of any month except December. For example, a company may choose a fiscal year running from July 1 through June 30. This option is often used by corporations and partnerships that align their reporting with industry trends, production cycles, or government contracts.

Businesses with seasonal revenue patterns may benefit from a fiscal year. Retailers, for instance, may close their fiscal year after the holiday shopping season to better reflect annual profits. Agricultural businesses might align their reporting with planting and harvest cycles.

To adopt a fiscal year, businesses must file their first tax return using the selected timeframe. Certain entities, such as S corporations and personal service corporations, can only use a fiscal year if they meet IRS requirements or obtain approval by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year.

52-53 Week Year

Some businesses use a 52-53 week year instead of a standard month-end closing. This method is common in industries where weekly operations drive financial performance, such as retail and hospitality.

Under this system, a business selects a closing date based on a consistent weekday, such as the last Saturday of October each year. This approach ensures each period includes the same number of operating weeks, avoiding distortions caused by calendar variations.

To adopt a 52-53 week year, businesses must specify their closing date when filing their initial tax return. Changes to or from this method generally require IRS approval, which can be requested using Form 1128.

Methods of Accounting

The IRS requires businesses to use a consistent accounting method to track income and expenses. This choice affects when revenue is recognized and when deductions can be claimed, impacting taxable income and cash flow.

Cash

Under the cash method, income is recorded when received, and expenses are deducted when paid. This approach is straightforward and commonly used by small businesses, sole proprietors, and entities with average annual gross receipts of $29 million or less (as of 2023) that do not maintain inventory.

This method closely follows cash flow, making it easier to track available funds. For example, if a business invoices a client in December but receives payment in January, the income is reported in the following tax year. Similarly, expenses are only deductible when actually paid, regardless of when they were incurred.

However, this method may not accurately reflect long-term financial performance, especially for businesses with significant accounts receivable or payable. The IRS restricts its use for certain entities, such as C corporations and partnerships with C corporation partners exceeding the gross receipts threshold. Businesses that maintain inventory may also be required to use accrual accounting unless they qualify for an exception under Section 471(c) of the Internal Revenue Code.

Accrual

The accrual method records income when earned and expenses when incurred, regardless of when cash is received or paid. This approach is required for businesses with inventory (unless they qualify for an exception) and for corporations or partnerships with C corporation partners exceeding the $29 million gross receipts threshold.

This method provides a clearer picture of financial health by matching revenue with related expenses. For example, if a company delivers goods in December but receives payment in January, the income is reported in December. Similarly, expenses are deducted when incurred, even if payment is made later.

Accrual accounting aligns with Generally Accepted Accounting Principles (GAAP) and is preferred by investors and lenders because it provides a more accurate view of profitability. However, it requires businesses to track accounts receivable and payable, adding complexity. Additionally, tax liabilities may arise before cash is collected, which can create cash flow challenges. Businesses switching to this method must follow IRS procedures, including filing Form 3115, Application for Change in Accounting Method.

Hybrid

The hybrid method combines elements of both cash and accrual accounting, allowing businesses to use different approaches for different types of transactions. This method is often used by businesses that maintain inventory but want to use the cash method for other income and expenses.

For example, a retailer might use accrual accounting for inventory purchases and sales while using the cash method for operating expenses like rent and utilities. This flexibility can provide tax advantages by deferring income recognition while accelerating deductions. However, businesses must ensure consistency and compliance with IRS regulations, as improper application can lead to penalties or required adjustments.

The IRS allows the hybrid method as long as it clearly reflects income and is applied consistently. Businesses using this approach must maintain detailed records to track which transactions follow each method. If a company wants to change its hybrid accounting structure, it may need to file Form 3115 and obtain IRS approval.

Selecting a Period or Method

Choosing the right accounting period and method affects how a business tracks profitability, manages tax obligations, and prepares financial statements. The decision should align with operational needs, industry practices, and regulatory requirements.

For businesses with steady cash flow and predictable revenue, a straightforward accounting structure may be sufficient. However, companies with fluctuating income, long-term contracts, or significant inventory must assess how different approaches impact financial reporting and tax liabilities. The timing of income recognition can affect taxable income from year to year, influencing when deductions are claimed and how net earnings appear on financial statements.

Industry norms also play a role. Construction companies, for instance, often use the percentage-of-completion method to recognize revenue over time rather than at project completion. Subscription-based businesses may need to defer income to match revenue with service periods. Understanding how competitors and peers structure their accounting can provide insights into best practices and potential advantages.

Tax planning is another key factor. A business anticipating future growth may benefit from an approach that defers taxable income, while one expecting lower profits in subsequent years might prefer a method that accelerates deductions. Businesses expanding internationally must also account for differences in reporting standards, as U.S. tax rules may not align with foreign accounting regulations.

Obtaining Approval for Changes

Modifying an established accounting period or method requires IRS approval in most cases. Approval is granted through formal requests, often involving the submission of Form 1128 for tax year changes or Form 3115 for accounting method adjustments. These filings must demonstrate that the proposed change accurately reflects income and adheres to regulatory requirements under Section 446 and Section 481 of the Internal Revenue Code.

When requesting a change in accounting method, businesses must consider the impact of Section 481(a) adjustments, which account for differences between the old and new methods. If the change results in additional taxable income, the IRS typically allows the adjustment to be spread over four years. If the adjustment reduces taxable income, the full benefit may be recognized in the year of change. The approval process distinguishes between automatic and non-automatic changes, with the former allowing streamlined acceptance if IRS guidance, such as Revenue Procedure 2023-24, is followed. Non-automatic changes require a user fee and a more detailed review.

Recordkeeping Obligations

Maintaining accurate financial records is essential for IRS compliance and tax filings. Proper documentation helps substantiate income, deductions, and credits while also serving as a safeguard in the event of an audit.

For tax purposes, records related to income, expenses, and deductions should generally be kept for at least three years from the date a return is filed. If a business underreports income by more than 25%, the IRS can audit up to six years back. In cases of fraudulent returns or failure to file, there is no statute of limitations, meaning records should be retained indefinitely. Payroll records must be kept for at least four years to comply with IRS and Department of Labor requirements.

Beyond tax compliance, maintaining organized financial records is vital for business operations. Lenders and investors often require financial statements, bank statements, and tax returns when evaluating creditworthiness. Digital recordkeeping solutions, such as accounting software and cloud storage, help businesses manage documents efficiently while ensuring accessibility and security.