Accrual Method of Accounting

Under the accrual method of accounting, generally the taxpayer reports income in the year it is earned and deducts or capitalizes expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.
Generally, the taxpayer includes an amount in gross income for the tax year in which all events that fix his or her right to receive the income has occurred and he or she can determine the amount with reasonable accuracy. Under this rule, the taxpayer reports an amount in his or her gross income on the earliest of the following dates:

• When he or she receives payment;
• When the income amount is due to him or her;
• When he or she earns the income;
• When title has passed.

Generally, the taxpayer reports an advance payment for services to be performed in a later tax year as income in the year he or she receives the payment. However, if the taxpayer receives an advance payment for services he or she agrees to perform by the end of the next tax year, the taxpayer can elect to postpone including the advance payment in income until the next tax year. However, he or she cannot postpone including any payment beyond that tax year. The taxpayer can postpone reporting income from an advance payment he or she receives for a service agreement on property he or she sells, leases, builds, installs, or constructs. This includes an agreement providing for incidental replacement of parts or materials.  However, this applies only if the taxpayer offers the property without a service agreement in the normal course of business. Generally, a taxpayer cannot postpone an advance payment in income for services if either of the following applies:

• He or she is to perform any part of the service after the end of the tax year immediately following the year he or she receives the advance payment;
• He or she is to perform any part of the service at any unspecified future date that may be after the end of the tax year immediately following the year he or she receives the advance payment.

Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods held primarily for sale to customers in the ordinary course of a taxpayer's trade or business. However, the rules do not apply to a payment (or part of a payment) for services that are not an integral part of the main activities covered under the agreement. An agreement includes a gift certificate that can be redeemed for goods. Amounts due and payable are considered received. 

Generally, include an advance payment in income in the year in which the taxpayer receives it. However, the taxpayer can use the alternative method. Under the alternative method, generally include an advance payment in income in the earlier tax year in which the taxpayer:

• Includes advance payments in gross receipts under the method of accounting he or she uses for tax purposes;
• Includes any part of advance payments in income for financial reports under the method of accounting used for those reports. Financial reports include reports to shareholders, partners, beneficiaries, and other proprietors for credit purposes and consolidated financial statements.