Accounting Methods and Inventories for Businesses

Under the cash method, income generally is reported when actually or constructively received and expenses when paid, subject to capitalization, prepayment and other exceptions. A customer check made available without substantial restriction can matter before deposit. A capital asset bought with cash does not become fully deductible merely because the cash method is used.

Under the accrual method, income generally follows when the right to receive it is fixed and the amount can be determined with reasonable accuracy, with applicable financial-statement and special timing rules also considered. Expenses generally require the all-events test, reasonable accuracy and economic performance. Recording an estimate or receiving an invoice alone does not satisfy every condition. Different rules can govern advance payments, related parties and recurring items.

Under an ordinary inventory system, cost of goods sold begins with opening inventory, adds costs included in inventory and subtracts closing inventory. Purchases remaining unsold generally stay in inventory. Inventory costing can include more than the supplier’s invoice, depending on the applicable capitalization rules. A physical count, ownership of goods in transit and the treatment of returns can change the closing amount.

If ending inventory is understated, cost of goods sold is overstated and income is understated, all else equal. That direction check is a useful exam shortcut after the underlying facts are understood. It also explains why deducting all purchases is not generally equivalent to deducting the cost of goods sold. The method used to identify and value inventory must be permitted and consistently applied.

Qualifying small-business taxpayers can have exceptions to ordinary inventory and accrual requirements, but eligibility depends on the applicable gross-receipts test, aggregation and tax-shelter restrictions. Publication 538 contains older indexed amounts, so do not use an older dollar threshold as a 2025 figure. Even an exception requires a permitted treatment, such as treating inventory as nonincidental materials and supplies or following an eligible books-and-records method.

Changing from one overall method or material-item treatment to another can require IRS consent and Form 3115. A section 481 adjustment may be needed to prevent income or deductions from being duplicated or omitted in the transition. An arithmetic correction is not automatically a method change, and filing an amended return is not a universal substitute for the change procedure. Identify whether the issue is an error, a new item or a consistent timing practice.