When Is Accrual Accounting Required for Tax Purposes?

The Internal Revenue Service (IRS) provides taxpayers with two primary methods for recording income and expenses: the cash-basis and the accrual-basis of accounting. Under the cash method, income is recognized when money is actually received, and expenses are recorded when they are paid. This method offers a straightforward view of a company’s cash flow.

The accrual method, in contrast, requires income to be recorded when it is earned and expenses to be recognized when they are incurred, regardless of when the actual cash transaction takes place. This approach provides a more accurate picture of a company’s financial health over a specific period. While many businesses prefer the simplicity of the cash method, the IRS has established specific rules that mandate the use of the accrual method in certain situations.

The Gross Receipts Test

A primary factor determining if a business must use the accrual method is the gross receipts test, which is based on a three-year average of annual gross receipts. For tax years beginning in 2025, a business must use the accrual method if its average annual gross receipts for the three preceding tax years exceed $31 million. This threshold is adjusted periodically for inflation. To calculate this average, a business would sum its gross receipts for the three prior taxable years and divide the total by three.

For example, if a company had gross receipts of $30 million, $32 million, and $34 million over the last three years, its average would be $32 million, placing it over the threshold. The IRS defines “gross receipts” broadly to include total sales, net of returns and allowances, as well as income from investments, and other miscellaneous income. Businesses that fall below this threshold are permitted to use the cash method.

This test is an annual determination, so a business’s status can change from one year to the next. If a business is part of a group of related entities treated as a single employer, the gross receipts of all related entities may need to be aggregated for this test.

Requirements for Businesses with Inventory

Historically, the presence of inventory was a significant trigger for requiring the accrual method of accounting. The underlying tax principle was that to clearly reflect income, the costs associated with inventory should be matched with the revenue generated from its sale. This matching principle is a core concept of accrual accounting. The Tax Cuts and Jobs Act (TCJA) introduced a major exception to this long-standing rule for small business taxpayers that meet the gross receipts test.

Under this exception, these businesses are not compelled to use the accrual method simply because they hold inventory. The alternative is to treat their inventory as non-incidental materials and supplies. This means that instead of capitalizing the inventory costs and deducting them only when the goods are sold, the business can deduct the cost of the inventory in the year it is either used or consumed in the business operations.

Mandated Use for Specific Business Entities

Certain business structures are required to use the accrual method of accounting for tax purposes. C corporations that do not qualify for the small business exemption under the gross receipts test are mandated to use the accrual method. Prior to the TCJA, a much lower threshold applied, but now C corporations with average annual gross receipts under the inflation-adjusted amount can use the cash method.

The requirement extends to partnerships that have a C corporation as a partner, which must adopt the accrual method unless it meets the gross receipts test exemption. This rule prevents C corporations from circumventing the accrual method requirement by operating through a partnership structure. Finally, all tax shelters must use the accrual method, without any exceptions related to gross receipts.

Changing to the Accrual Method

A business that determines it must switch from the cash to the accrual method of accounting cannot simply begin filing its tax returns using the new method. The change requires formal consent from the IRS, which is obtained by filing Form 3115, Application for Change in Accounting Method.

A central component of this change is the calculation of a Section 481(a) adjustment. This adjustment is necessary to prevent any items of income or expense from being duplicated or omitted as a result of the transition. For example, income that was earned but not yet received under the cash method would be missed entirely if not accounted for in the year of the change.

The adjustment is a one-time calculation that reconciles the differences between the old and new accounting methods, ensuring a clean transition. The adjustment can result in either additional income or a deduction for the taxpayer, which is typically spread over a period of years to mitigate the immediate tax impact. The process of filing Form 3115 and accurately calculating the adjustment can be complex.