9045 / What is the accrual method of accounting?

Editor’s Note: Under the 2017 tax reform legislation, if the taxpayer uses the accrual method of accounting, the “all events test” with respect to any item of income is not treated as met any later than when the item (or a portion of it) is taken into account as revenue in a financial statement of the taxpayer.¹ See below.

Taxpayers who use the accrual method of accounting generally report income in the year that it is earned, rather than in the year it is received.² Under this method, income is recognized in the year when (1) all events have occurred to fix the taxpayer’s right to receive the income and (2) the amount of income that the taxpayer will be entitled to receive can be determined with reasonable accuracy. Because the relevant inquiry is when the income is earned, rather than when the income is received, compensation agreed upon with respect to the performance of future services is not recognized until those services have actually been performed (at the time the taxpayer has earned the compensation).³

Planning Point: Generally speaking, the accrual method of accounting normalizes, or smooths out, the revenues and expenses of a business, making it easier to do year over year comparisons and forecasts. A company that wins a large deal may get paid an up-front cash amount for products that are delivered for years to come. Accrual tax accounting allows the tax obligations to be paid over longer periods of time, giving the business owner more choice and control over how, and when, taxes are paid.

Pursuant to the “all events test,”⁴ income is recognized when all of the events that are required for the taxpayer’s right to the income to be vested have occurred so that the amount of the taxpayer’s entitlement can be determined with reasonable certainty.⁵ It is possible for a taxpayer to report income although no payment has yet been received.⁶

Under the 2017 tax reform legislation, the “all events test” with respect to any item of income is not treated as met any later than when the item (or a portion of it) is taken into account as revenue in a financial statement of the taxpayer.⁷ A financial statement, for this purpose, includes one that is prepared in accordance with GAAP and is a 10(k) that will be filed with the SEC, or an audited financial statement used for credit, reporting or other significant non-tax purposes if there is no 10(k) that will be filed with the SEC.⁸ If the taxpayer does not have a 10(k) or an audited financial statement, any financial statement that is filed with a federal agency for non-tax purposes may be used.⁹