There are two accounting methods for recording income and expenses, called the cash and accrual methods. These are two sets of rules for the timing of income and expenses.
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A venture's income and expenses must ordinarily be reported in the year in which they occur. (Normally the period is a calendar year, but for a few businesses it may be a fiscal year that doesn't end on December 31.)
EXAMPLE: Monique buys $7,000 in supplies for her hairdressing salon in January 2004. Monique hasn't filed her 2003 income taxes yetâ€”can she deduct the $7,000 expense on her 2003 tax return? No, because the expense was incurred in 2004.
Less clear-cut is the question: What if Monique had bought the supplies in 2003, but didn't pay for them until 2004? In which year does Monique take the deduction? To answer, you need to know the difference between cash and accrual methods of accounting and which one Monique's business uses.
Cash Method Accounting
Cash method refers to recording an item of income or expense when it is paid. Don't take the word cash here literally; it covers any kind of paymentâ€”checks, barter, credit cardsâ€”as well as the green stuff. Most businesses that sell services use the cash method of accounting for income and expenses. The cash method makes sense even to us non-accountants. You simply report income in the year you receive it and an expense in the year you pay it.
The cash method seems simple, but there are a few special tax rules to watch out for. One is the legal doctrine of constructive receipt, which requires counting some items as income before you actually receive them. This means you have income, for tax purposes, as soon as it is available or credited to your accountâ€”even if you don't take it.
EXAMPLE: Ray gets a $3,000 check for consulting in early December 2003, but doesn't deposit it until January 2004. Because Ray could have cashed it in 2003â€”the banks were open and the check was goodâ€”2003 is the tax year in which Ray constructively received the $3,000.
Conversely, you are not allowed to take a deduction in the current year for items paid for but not yet received.
EXAMPLE: Ray got a special deal on Consulting Times, a monthly business publication. He paid $360 for a three-year subscription in July of 2001. He can deduct only $60 in 2001 (1/6 of the total); the balance must be prorated over the term of the subscription. Ray can deduct $120 (1/3) in 2002, $120 (1/3) in 2003 and $60 (1/6 in 2004.
Watch the calendar. The IRS does allow some flexibility in prepaying and deducting expenses at the end of the year. The last week of every December, I review the year's income and expenses of my law practice to see if I can shave some money off my tax bill. For instance, if I pay January's office rent on December 27, I'll get the deduction a year earlier. (As long as you don't prepay an expense more than 30 days in advance, you're okay.) Or, if I had an especially good year (meaning a big tax bill), I can stock up on office supplies or buy new equipment to write off under Section 179 before December 31. Or maybe the converse is trueâ€”my late December accounting shows a disappointing year. In that case I put off new purchases or paying creditors until January.
Accrual Method Accounting
Many C corporations, manufacturers and businesses with inventories of goods must use the accrual method of accounting or a hybrid method. The accrual method requires some getting used to.
With accrual accounting, income is treated as received when it is earnedâ€”regardless of when it is actually received. On the other side, an expense is recorded at the time the obligation aroseâ€”which is not necessarily when it is paid. In accountant's lingo, business expenses and income accrue the moment they become fixed. Though it sounds complicated, the example below shows that this is not rocket science.
Accrued income and expenses must meet what the tax code calls the all events test to become fixed. This means that everything requiredâ€”all eventsâ€”to secure a right to receive the income, or to cause a liability for the expense, must have happened. At that point in time the income or expense becomes fixed, whether or not any cash has changed hands.
EXAMPLE: George's Foundry, which uses the accrual method, receives a $4,500 deposit in 2003 for custom ironwork to be manufactured in 2004. George won't report $4,500 as income in 2003 because it hasn't been earned yet. On the expense side, if the foundry incurs a $250 charge in 2003 for lawyer's fees relating to the contract, it is accrued and tax deducted in 2003â€”even if not paid for until 2004.
Get help setting up accrual accounting. If your operation keeps inventories, manufactures goods or is a C corporation, consult a tax pro before setting up your accounting system. Find someone familiar with your industry, whether it is a gas station, a loan company or a medical practice. Software programs such as QuickBooks (Intuit) allow you to use the accrual method (as well as the cash method or a hybrid method).
Hybrid and Special Accounting Methods
It may make sense to use a combination of the cash and accrual methods. For instance, Waldo's electronics store may sell and repair items. Waldo may use the cash method for repairs, but Waldo's inventory, under tax code rules, must be accounted for on an accrual basis. So both methods may be used, creating a hybrid accounting system.
Other special accounting methods, beyond the scope of this book, apply to farmers and certain businesses working on long-term contracts, manufacturers and building contractors.
You may need permission from the IRS to adopt a hybrid or special method of tax accounting. (See a tax pro or IRS Publication 538, Accounting Periods and Methods.) If your business's gross receipts are less than $5 million, you don't need permission (IRS Notice 2001-76).
Changing Accounting Methods
A business must choose an accounting method and tell the IRS which method it is using on its tax return (a box on the form must be checked). Once chosen, that method must usually be used in all subsequent tax returns unless the IRS grants you permission to switch to another accounting method.
The IRS is concerned that whenever an accounting method is changed the business could obtain an unfair tax advantageâ€”or some expenses or income could get lost in the transition. So, if you want to change your venture's accounting method, ordinarily you need permission from the IRS.
To get IRS permission for changing methods, file Form 3115, Application for Change in Accounting Method. File it within 180 days before the end of the year for which you want to make the change. There is a $500 application fee, but the IRS may waive the fee in some circumstances. (See Rev. Proc. 97-27 or a tax pro for further details.)
Exception: if there is a fundamental change in the operation of your businessâ€”say, from selling goods to offering only servicesâ€”then IRS permission is not required.
EXAMPLE: Kate’s Lamp Repair Service, which had been using the cash method, starts stocking and selling lamps. Kate now has an inventory, so she must use an accrual accounting method for her retail sales. Permission from the IRS is not required because there was a fundamental change in operation.