Self-Employed View:

How to Use the Accrual Method

The purpose of the accrual method of accounting is to match income and expenses in the same year. Using the Accrual Method, income is generally reported in the year it is earned and expenses are deducted or capitalized in the year they are incurred. Generally speaking, you include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy.

Advance payments for services to be performed in a later tax year as income must be reported in the year you receive the payments. If the payment is for a service that you have agreed to perform by the end of the next tax year, you can choose to pay it in the year the payment was received or in the next year, when the service will be performed. You cannot however postpone including the payment beyond that tax year.

Advance payments for sales have special rules that apply. If the advance payments are made for a contract that entails both sales and services of goods, the two may have to be treated as two separate agreements. Generally speaking, advance payments of incomes must be report in the tax year in which you receive them.

Business expenses can generally be deducted or capitalized when it meets the following conditions:

  • All events have occurred that fix the fact of liability
  • The liability can be determined with reasonable accuracy
  • Economic performance has occurred

Economic performance occurs as the property or services are provided.

Inventories are necessary to clearly show income when the production or sale of merchandise is an income-producing factor in your business. The accrual method of accounting is necessary when you must account for inventory in your business.