Accounting Methods

In general, figure taxable income using the method of accounting regularly used in keeping the corporation’s books and records. In all cases, the method used must clearly show taxable income. Permissible overall methods of accounting include cash, accrual, or any other method authorized by the Internal Revenue Code.

Generally, the following rules apply. For more information, see Pub. 538, Accounting Periods and Methods.

• A corporation cannot use the cash method of accounting unless it is a small business taxpayer (defined later). A tax shelter (defined in section 448(d)(3)) may never use the cash method. See sections 448(a)(1) through (a)(3). However, see Nonaccrual experience method for service providers in the

instructions for Section II, line 1a, later;

• Unless it is a small business taxpayer (defined below), a corporation must use an accrual method for sales and purchases of inventory items. See the instructions for Form 1125-A;

• A corporation engaged in farming must use an accrual method. For exceptions, see section 447 and Pub. 225;

• Special rules apply to long-term contracts. See section 460.

• Dealers in securities must use the mark-to-market accounting method. Dealers in commodities and traders in securities and commodities may elect to use the mark-to-market accounting method. See section 475.

Small business taxpayer. For tax years beginning in 2025, a corporation qualifies as a small business taxpayer if it (a) has average annual gross receipts of $31 million or less for the 3 prior tax years, and (b) is not a tax shelter (as defined in section 448(d)(3)). A small business taxpayer can account for inventory by (a) treating the inventory as non-incidental materials and supplies, or (b) conforming to its treatment of inventory in an applicable financial statement (as defined in section 451(b)(3)). If it does not have an applicable financial statement, it can use the method of accounting used in its books and records prepared according to its accounting procedures.

Change in accounting method. Generally, the corporation must get IRS consent to change either an overall method of accounting or the accounting treatment of any material item for income tax purposes. To obtain consent, the corporation must generally file Form 3115, Application for Change in Accounting Method, during the tax year for which the change is requested. See the Instructions for Form 3115 and Pub. 538 for more information and exceptions. Also, see the Instructions for Form 3115 for procedures that may apply for obtaining automatic consent to change certain methods of accounting, non-automatic change procedures, and reduced Form 3115 filing requirements.

Section 481(a) adjustment. If the corporation’s taxable income for the current tax year is figured under a method of accounting different from the method used in the preceding tax year, the corporation may have to make an adjustment under section 481(a) to prevent amounts of income or expense from being duplicated or omitted. The section 481(a) adjustment period is generally 1 year for a net negative adjustment and 4 years for a net positive adjustment. Also, see the Instructions for Form 3115.

Exceptions to the general section 481(a) adjustment period may apply. Also, in some cases, a corporation can elect to modify the section 481(a) adjustment period. The corporation may have to complete the appropriate lines of Form 3115 to make an election. See the Instructions for Form 3115 for more information and exceptions.

If the net section 481(a) adjustment is positive, report the ratable portion on Form 1120-F, Section II, line 10, as other income. If the net section 481(a) adjustment is negative, report the ratable portion on line 27 of Section II as a deduction.