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Accounting Methods

What Is an Accounting Method?

An accounting method is a set of rules that determine:

When income must be reported, and
When expenses may be deducted

The rules you must follow depend on the accounting method you use.

Types of Accounting Methods

There are three commonly used accounting methods:

The Cash Method

This is the most common method used by small businesses, particularly service businesses.

Under the cash method:

Income is reported only when it is actually or constructively received
Expenses are reported when actually paid.

Who Uses the Cash Method?

Most individuals and small businesses, especially service businesses, use the cash method because of its simplicity and flexibility in reporting income and expenses.

Can You Use the Cash Method if You Carry Inventory for Resale?

Although the general rule is if a business carries inventory for resale it must use the accrual method, there is an exception that allows most small businesses to use the cash method even if they carry inventory.

The Exception is This...

Under an exception via Revenue Procedure 2002-28, if inventory is an income-producing factor, the cash method can still be used if average annual gross receipts for the previous three years did not exceed $10 million.

Who May Not Use the Cash Method?

Certain types of businesses are not permitted to use the cash method.

For example:

Tax shelters may not use the cash method.
C-corporations (other than qualified personal service corporations) with average annual gross receipts over $5 million may not use the cash method.
Partnerships with a C-corporation as a partner with average annual gross receipts over $5 million may not use the cash method.

How to Figure Gross Income Under the Cash Method

To determine gross income for a tax year under the cash method, add up the following items:

Cash receipts
Checks received
Charge slips for items paid with a credit card
The fair market value (FMV) of property and services received for the year
Income constructively received (e.g., interest credited to your business account in December, checks received in December even if you didn't cash them until the following tax year)

Fair market value:

The price at which property changes hands between a willing buyer and seller, both having reasonable knowledge of all material facts.

Expenses Paid By Credit Card Under the Cash method:

Payments you make with a credit card are deducted in the year charged.

Expenses Paid Via Pay-By-Phone Payments Under the Cash method:

Payments you make via pay-by-phone accounts through a bank are deducted when the bank sends the check. See your monthly bank statement for these payments.

Prepaid Interest Rule for Individuals and Businesses

Points paid to secure a mortgage is an example of prepaid interest.

Individuals:

For individuals, points ARE deductible in full in the year paid.

Businesses:

For businesses, points are NOT deductible in full in the year paid.
A business must deduct points ratably over the term of the loan.
- Example: Your business paid $3,600 in points to secure a 30-year mortgage (360 months). The monthly deduction is $10 ($3,600/360). Your maximum annual deduction is $120 (12 x $10). However, if the mortgage is paid off early, you may deduct the full amount of the remaining points.

Advantages of the Cash Method

1) Simplicity

Since the cash method does not get involved in the more complex rules of accounting or the computations necessary to carry out accrual accounting, the cash method is much simpler to administer.

Under the cash method, income is reported only when it is actually or constructively received. Expenses are reported only when they are actually paid.

The balance sheet, under the cash method, does not report accounts receivable or accounts payable.

For example, if you make a sale on December 29, 2011 but don't get paid for that sale until sometime in the following year, 2012, under the cash method you would only record only one entry in 2012 when payment is received. No entry would be required for that sale in 2011.

The journal entry for 2012 would be:

Debit the Cash account
Credit the Sales account

On the other hand, under the accrual method you would have to record two sets of entries: One in December 2011 when the sale was originally made (when income was earned) and another in 2011 when payment is received.

2011-set up accounts receivable and record the sale:
- Debit the Accounts Receivable (this increases the amount in the Accounts Receivable account). This account shows what is owed to your business.
- Credit the Sales Account (this increases the amount in the Sales account). Since the income was earned in 2011, it must be reported in your gross sales under the rules of the accrual method.
2012-record receipt of the payment for the sale made in December 2011:
- Debit the Cash account (this increases the amount in the Cash account)
- Credit the Accounts Receivable account (this decreases the amount in the Accounts Receivable account)

2) Cash Conservation

Under the accrual method, you must report income in the year it is earned regardless of when you actually get paid. This puts you in the position of having to pay taxes on income before for you actually get paid. No so great for cash flow.

Under the cash method you only report income when it is actually or constructively received. Because of this rule, you have the opportunity to manipulate to reporting of income.

For example, a common year-end strategy is to put off billing clients/customers for income earned in the last month of the year until the first month of the following year. By doing this, you defer having to pay income taxes on those sales until the filing season of the following tax year.

For example, if you performed $10,000 worth of services for a client in December 2011, you could simply put off billing your client until some time in January 2012. This way, the $10,000 you earned in December 2011 would be reported in your gross income on your 2012 return. And your 2012 return would not be due until April 2013, 15 1/2 months after the December 2011 sale.

Disadvantages of the Cash Method

1) Inaccurate financial reporting

The main disadvantage of the cash method is that it does not attempt to match income with related expenses in the correct year.

As a result, wide swings in net income can occur over two or more accounting periods causing a distortion of financial results for each period.

For example, $5,000 of income earned in December 2011 but not paid until January 2012 will cause income earned in 2011 to be understated by $5,000 and income in 2012 to be overstated by $5,000.

Inaccurate financial information is not conducive to effective financial management of your business.

2) Does not comply with generally accepted accounting principles (GAAP)

The accrual method complies with GAAP. The cash method does not.

Banks and other lenders may have less confidence in your financial statements if they are prepared under the cash method, making it more more difficult for you to secure financing.

GAAP (Generally accepted accounting principles): A body of principles and standards developed over many years by professional accountants for compiling, organizing, and reporting financial information.

How to Elect an Accounting Method on Schedule C

If you're a sole proprietor, you choose an accounting method when you file your first income tax return that includes Schedule C, Profit or Loss From Business.

On page one of Schedule C, above Part 1, there are three boxes designated for the selection of an accounting method.

Cash method
Accrual method and
Other

Place a checkmark in the box that applies to you when you file Schedule C.

More Than One Business

If you have more than one business you can use a different accounting method for each one as long as you maintain a complete and separate set of books for each business.

Changing Your Accounting Method

If you decide to change your accounting method you need IRS approval.

File Form 3315, Application for Change in Accounting Method.

Accounting Methods-Cash Method: Constructive Receipt; Cancellation of Debt

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