A calendar-year S corporation, formed in 2023, has maintained gross receipts averaging $27 million for 2023-2025. For 2026, its receipts are projected to be $32 million. What accounting method is it permitted to use for 2026? Most candidates see the gross receipts are below the threshold and immediately choose "cash method." That's the correct answer, but for the wrong reason. The real trap isn't the number; it's the entity type. What if it were a tax shelter? The answer changes completely, even with the same revenue.
Accounting methods and periods are the tax rules defining when a business recognizes income and expenses. The EA exam tests your ability to select the correct method (cash, accrual, hybrid) based on entity type and gross receipts, determine the required tax year, and apply for changes using Form 3115.
Key facts
- Controlling Code Sections: IRC §441-443 (Periods), §446-448 (Methods), §451 (Year of Inclusion)
- Gross Receipts Test (2025): $30 million average for the prior 3 years
- Key Form: Form 3115, Application for Change in Accounting Method
- Required Year (Partnership): Follows partners' years (majority, principal, or least aggregate deferral)
- Required Year (S Corp): Generally a calendar year unless a business purpose is established
- Prepaid Income Deferral: Limited to one year under Treas. Reg. §1.451-5
Which Accounting Method is Required? Cash vs. Accrual
The choice of accounting method dictates the timing of taxable income and is governed by strict IRS rules. For the EA exam, you must determine which method a business is permitted or required to use.
The Cash Method
The cash method recognizes income when it is actually or constructively received and expenses when they are actually paid. It's simple and offers flexibility.Eligibility is the key testing point. A business can generally use the cash method if its average annual gross receipts for the three preceding tax years do not exceed an inflation-adjusted threshold. For tax year 2025, that threshold is $30 million.
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However, some taxpayers are explicitly barred from using the cash method under IRC §448, regardless of their receipts. These include:
- C corporations that fail the gross receipts test.
- Partnerships with a C corporation partner that fail the gross receipts test.
- Tax shelters. This is an absolute prohibition.
A common exam trap involves Personal Service Corporations (PSCs). Many candidates mistakenly believe PSCs are exempt from the gross receipts test. They are not. A PSC is subject to the $30 million test to use the cash method. The special rule for PSCs is that they are not forced to use accrual just because they have inventory, but they still must pass the gross receipts test.
The Accrual Method
The accrual method recognizes income when the "all events test" is met: all events have occurred that fix the right to receive the income, and the amount can be determined with reasonable accuracy. Expenses are recognized when the all-events test is met and economic performance has occurred.This method is mandatory for taxpayers who are ineligible for the cash method. It provides a more accurate picture of profitability by matching revenues with the expenses incurred to generate them.
For exam purposes, pay close attention to prepaid income. Under Treasury Regulation §1.451-5, an accrual taxpayer can defer recognizing advance payments for services (and some goods) to the next succeeding tax year, but only for one year. Try VoraPrep's free EA practice questions to see how this one-year deferral rule is tested.
Cash vs. Accrual Method: A Comparison
| Feature | Cash Method | Accrual Method |
|---|---|---|
| Income Recognition | When cash is received | When earned (all-events test met) |
| Expense Recognition | When cash is paid | When incurred (economic performance) |
| Eligibility | Small businesses (avg. receipts ≤ $30M) | Required for large businesses |
| Inventory | Allowed if gross receipts test is met | Generally required if receipts > $30M |
| Prepaid Income | Taxed upon receipt | Taxed when earned; one-year deferral possible |
| Complexity | Simpler, less record-keeping | More complex, better matching |
How Do Tax Years and Periods Work?
A taxpayer's tax year is their annual accounting period for keeping records and reporting income. Once established, changing it requires IRS consent.
Required Tax Years for Pass-Throughs
To prevent owners from deferring income, pass-through entities have strict rules:- S Corporations: Must use a calendar year unless they establish a business purpose for a fiscal year or make a special election under IRC §444. (IRC §1378)
- Partnerships: The rules follow a strict hierarchy under IRC §706:
- The tax year of the majority of its partners.
- If no majority, the tax year of all its principal partners.
- If neither, the year that results in the least aggregate deferral of income.
C corporations, by contrast, can generally choose any calendar or fiscal year they want.
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Short Tax Years
A short tax year is any period less than 12 months. It occurs when a business is not in existence for a full year or when it changes its accounting period. For example, if a C corporation's S election becomes effective on April 1, the C corporation must file a short-year return for the period its C status was active (e.g., Jan 1 - Mar 31).When filing for a short period due to a change in accounting period, income often must be annualized to prevent the taxpayer from benefiting from lower tax brackets on a partial year's income. (IRC §443)
Worked Example: Accrual Method and Prepaid Income
Let's apply these rules to a common exam scenario.
Scenario: Aero Dynamics, a calendar-year C corporation, provides drone maintenance services. It uses the accrual method of accounting. On October 1, 2025, Aero Dynamics receives a $120,000 payment from a client for a 24-month service contract running from October 1, 2025, to September 30, 2027. Question: How much of the $120,000 payment must Aero Dynamics include in its gross income for the 2025 tax year? Step-by-step Solution:- Identify the Accounting Method: The problem states Aero Dynamics uses the accrual method. This means income is recognized as it is earned, subject to special rules for prepayments.
- Calculate Income Earned in the Current Year (2025): The contract is for 24 months at $120,000, which is $5,000 per month ($120,000 / 24). The services provided in 2025 are for October, November, and December.
- 3 months * $5,000/month = $15,000.
- This portion is earned in 2025 and must be recognized in 2025.
- Apply the One-Year Deferral Rule (Treas. Reg. §1.451-5): The regulation allows an accrual taxpayer to defer the portion of prepaid income that is not earned in the year of receipt, but only until the next tax year.
- Total payment: $120,000
- Earned in 2025: $15,000
- Remaining prepayment: $105,000
- Income to be earned in 2026: 12 months * $5,000/month = $60,000.
- The rule allows deferral of the $105,000, but only to the extent it will be recognized in the next year (2026). The full amount to be earned in 2026 ($60,000) can be deferred to 2026. The remaining portion ($105,000 - $60,000 = $45,000) relates to 2027.
- The Trap: The deferral is for one year only. This means any income earned beyond the next tax year must be recognized in that next tax year. So, the $60,000 for 2026 and the $45,000 for 2027 are both recognized in 2026.
- Therefore, in 2025, Aero recognizes only the $15,000 earned in 2025. In 2026, it will recognize the remaining $105,000.
Let's correct the analysis.
- Income Earned in 2025: $15,000. This is recognized in 2025.
- Income to be Earned After 2025: $105,000.
- Under the one-year deferral, the entire remaining portion ($105,000) is recognized in the next tax year, which is 2026. The rule does not allow deferral into a third year (2027).
- Final Answer for 2025: Aero Dynamics must recognize $15,000 in 2025.
Another wrong answer is $75,000 ($15,000 for 2025 + $60,000 for 2026). This misinterprets the deferral rule, thinking you can only recognize one full year's worth of future income. The rule is simpler: recognize what's earned this year, and recognize all the rest next year. The VoraPrep adaptive learning engine has questions that specifically test this nuance.
A 7-Day Sprint to Master Accounting Methods and Periods
Use this intensive plan to conquer this topic in one week.
Day 1: Foundations & Eligibility (4 hours)- Action: Read IRC §446 and §448. Create a flowchart for determining if a business can use the cash method. Focus on the $30M gross receipts test and the absolute prohibitions (tax shelters).
- Checkpoint: Can you explain, without notes, why a PSC with $35M in revenue cannot use the cash method?
- Action: Read IRC §441, §706, and §1378. Diagram the partnership tax year hierarchy (majority -> principal -> least aggregate deferral).
- Checkpoint: Given a partnership's ownership structure and the partners' tax years, can you determine the partnership's required tax year?
- Action: Skim the instructions for Form 3115. Understand the difference between an automatic change and an advance consent change.
- Checkpoint: When does a business need to file Form 3115?
- Action: Read the summary of Treas. Reg. §1.451-5 (prepaid services). Understand the one-year deferral. Review the rule allowing small businesses to treat inventory as non-incidental materials.
- Checkpoint: Can you calculate the income recognized in Year 1 and Year 2 for a 3-year service contract paid in advance?
- Action: Complete every practice question on Accounting Methods and Periods in the VoraPrep EA question bank.
- Checkpoint: For every incorrect answer, write down the specific rule you missed. This is where our detailed explanations shine.
- Action: Re-work the questions you got wrong on Day 5. Connect the concepts: how does the choice of accounting method affect a business's Net Operating Loss (NOL) calculation?
- Study Tip: Read our guide on EA Business Taxation: Business income and expenses to see how these timing rules directly impact what is deductible.
- Action: Use flashcards or your notes to quiz yourself on the key numbers and rules: $30M threshold, Form 3115, S Corp/Partnership year rules, and the one-year deferral.
- Checkpoint: Can you recite the key rules from memory? You're ready.
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