Accrual accounting is the method of reporting a period’s results by recording income when it is earned and expenses when they are incurred, whatever period the cash moves in. The phrase covers two regimes that need not agree on the same transaction: the accrual basis behind financial statements prepared under US generally accepted accounting principles, and an accrual method of accounting adopted for tax, which is one of the methods a taxpayer may use in computing taxable income (26 U.S.C. 446(c)). Each regime fixes those two moments its own way, and for tax it is a pair of tests, not the bank feed, that decides the year.
What Accrual Accounting Does on the Books
The book concept is stated in the FASB’s conceptual framework, and it is a statement about timing rather than about paperwork. Accrual accounting depicts the effects of transactions, and other events and circumstances on a reporting entity’s economic resources and claims in the periods in which those effects occur, even if the resulting cash receipts and payments occur in a different period (FASB Statement of Financial Accounting Concepts No. 8, Chapter 1, paragraph OB17).
The Two Tests That Decide the Tax Year
For tax, an accrual method is not a description of intent. It is a pair of timing tests, and income and deductions do not get the same one.
When Income Is Earned
The default rule is receipt. Any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period (26 U.S.C. 451(a)). An accrual method is what makes it a different period.
Under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy (26 CFR 1.446-1(c)(1)(ii)(A)). Fixing the right to receive is the operative event, so a delivered engagement can be income before an invoice has been raised.
There is also a ceiling on how late that moment can fall. For a taxpayer whose taxable income is computed under an accrual method, the all events test with respect to any item of gross income is not treated as met any later than when that item is taken into account as revenue in an applicable financial statement of the taxpayer, or in such other financial statement as the Secretary may specify (26 U.S.C. 451(b)(1)(A)). Applicable financial statement is itself a defined term, keyed to certification, audit and regulatory filing rather than to whether a business has statements at all (26 U.S.C. 451(b)(3)). That ceiling does not apply to a taxpayer which has neither an applicable financial statement nor a Secretary-specified one for the taxable year, or to any item of gross income in connection with a mortgage servicing contract (26 U.S.C. 451(b)(1)(B)), so it reaches only taxpayers that already carry one of the two.
When a Cost Is Incurred
The deduction side starts in the same place and is then narrowed twice. The amount of any deduction or credit allowed by this subtitle is taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income (26 U.S.C. 461(a)).
The first narrowing is the all events test, and it is worded differently from the income version. The all events test is met with respect to any item if all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy (26 U.S.C. 461(h)(4)). The income test fixes a right to receive. The deduction test fixes the fact of a liability.
The second narrowing has no counterpart on the book side. In determining whether an amount has been incurred with respect to any item during any taxable year, the all events test is not treated as met any earlier than when economic performance with respect to such item occurs (26 U.S.C. 461(h)(1)). An entry can therefore be correct on the ledger and premature on the return, and where that gap opens on an ordinary supplier balance is set out in accounts payable.
Who Has No Choice About Using It
Some taxpayers are put on an accrual method rather than picking one.
Inventory is the clearest route. In any case in which it is necessary to use an inventory, the accrual method of accounting must be used with regard to purchases and sales, unless the taxpayer qualifies as a small business taxpayer for the taxable year under section 471(c) or is otherwise authorized (26 CFR 1.446-1(c)(2)(i)).
The other route is exclusion from the alternative. The Code names entities that may not compute taxable income on the cash method at all, then lets qualifying ones back out through a gross receipts test, though not every category on that list can (26 U.S.C. 448). Both the bar and the test are worked through in the accrual to cash adjustment.
Where the Method Shows Up in a Firm’s Work
The method is a declared position rather than an implied one. A sole proprietorship states it on Schedule C at line F, which offers cash, accrual or other (IRS, Schedule C (Form 1040), line F), and a corporation states it on Form 1120 at Schedule K, line 1 (IRS, Form 1120, Schedule K, line 1).
The balance sheet is where the position becomes visible. Balances such as accounts receivable, accounts payable and deferred revenue exist because the period recognized something the cash had not settled yet.
Once a return has been filed on a method, moving off it is not a journal entry. It needs the Commissioner’s consent (26 CFR 1.446-1(e)(2)(i)), and the route that consent takes is worked through in the accrual to cash adjustment.
A Worked Example
Say a firm finishes a block of client work in December and collects part of the fee before the year ends, and a supplier bills it for December work that it does not pay until January. On those inputs the December figures fall out like this.
Work delivered and earned in December 40,000
Cash collected before the year end 34,000
Accounts receivable at the year end 6,000
Supplier cost incurred in December 9,000
Cash paid before the year end 0
Accounts payable at the year end 9,000Both closing balances are creatures of the method. A cash-basis ledger for the same month reports only what was collected and only what was paid, so neither balance exists and December resolves to a different result.
What Accrual Accounting Is Not
An Accrual Entry
An accrual is a step inside the method rather than the method itself. Accrual is the accounting process of recognizing assets or liabilities and the related changes in revenues, expenses, gains, losses, or equity for amounts expected to be received or paid, usually in cash, in the future (FASB Statement of Financial Accounting Concepts No. 8). A firm can post an accrual on a client’s books and still file that client’s return on the cash method, because the entry is a bookkeeping act and the method is a reporting position.
The Cash Method
The two methods put different questions to the same invoice. An accrual method asks when the right to the money was fixed and when the liability was incurred. The cash method asks when the money moved. That is why one ledger carries balances between those two moments and the other has nothing to carry.
Common Questions
The framework’s own examples are purchases and sales of goods or services on account, and not-yet-paid interest, rent, wages and salaries, and taxes (FASB Statement of Financial Accounting Concepts No. 8). Each is a period recognizing an amount it expects to receive or pay in a later one.
Accrued revenue and accrued expense. One recognizes income the business has earned and not yet billed or collected. The other recognizes a cost it has incurred and not yet been invoiced for or paid. A deferral runs the other way, holding back an amount already invoiced or paid until the period it belongs to, and where all of them land in a period’s work is in the month-end close checklist.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own period-end accrual work through a trial task before anything client facing depends on it.
