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What Is An Accounting Method
An accounting method is a set of rules used to determine how and when income and expenses are reported. Timing can make a difference in your tax liability.
The IRS says you must consistently use an accounting method that clearly shows your income and expenses for the tax year. You must use the same accounting method to figure your taxable income and to keep your books.
The are three accounting methods:
- Cash Basis
- Accrual Basis
- Hybrid Method
Cash Basis
Because of its simplicity, many small businesses, individuals, and certain professionals, such as doctors, lawyers, and accountants, use the cash basis of accounting to maintain their books and records.
Under the cash basis, revenues for the sale of goods or services are recorded in the books and reported on your tax return in the year actually or constructively received and expenses are reported in the year paid.
Constructive receipt takes place when income is made available to you without restriction. Physical possession is not required. For example, your bank account receives a $100 credit for interest December 31, 2021. You do not withdraw the interest until January 5, 2022. The $100 interest must be reported in tax year 2021.
Accrual Basis
Accrual basis accounting achieves a more accurate measurement of a business's periodic net income because it attempts to match revenues and expenses of the same accounting period.
Accrual-based accounting is based on two accounting principles:
- The Revenue Realization Principle: This principle states that revenue should be recorded in the period in which it is earned, regardless of when payment is received. In contrast, under cash-basis accounting, revenue is recorded when payment is receivedregardles of the date it was earned.
- The Matching Principle: This principle attempts to match income with the expenses that produced the income. In contrast, the cash method does not attempt to match income with the expenses that produced the income. In other words, under the accrual method, the idea is to report income and related expenses in the correct year to provide a more accurate presentation of financial results.
Example:
You started a consulting business during November 2020. You had one client during December 2020 and provided consulting services to that client. You billed your client $1,000 on December 31, 2020. You received the $1,000 January 10, 2021. You paid $700 rent for office space on December 30, 2020.
2020 Results Under the Accrual Method:
Net income, $300 (gross revenues earned, $1,000 during 2020 minus $700 rent paid in 2020). The accrual method matched income earned in December 2020 ($1,000) with expenses of the correct period ($700 rent paid in December), resulting in an accurate 2020 net income.
2020 results under the Cash Method:
Net Loss of $700 (gross receipts zero and $700 rent paid in December).
Although you earned the $1,000 in 2020, your client paid you in 2021. Therefore, you don't report the $1,000 on your 2020 tax return, you report it in 2021, the year it was received. The rent expense was paid in 2020, and therefore, is reported in 2020.
While accrual basis accounting is more complex than cash basis accounting, it has the advantage of providing management with more accurate financial information which may be used to more effectively manage the business.
Hybrid Method
The hybrid method of accountng combines both the accrual and cash methods of accounting. For example, accrual-based accounting could be used to account for inventory held for resale, while using the cash method to account for business expenses.
The IRS says, whichever method of accounting you use in your business, it should be used consistently from year to year.
How to Elect an Accounting Method on Schedule C
You choose your accounting method for tax purposes by simply filing your first income tax return. For example, if you're a sole proprietor, you choose your accounting method when you file your first income tax return that includes Schedule C, Profit or Loss From Business (or Schedule F for farmers). If you want to change your accounting method, you must generally get IRS approval.
Changing Your Accounting Method
To change your accounting method, you must get IRS approval. File Form 3115, Application for Change in Accounting Method.
On page 1 of Schedule C, above Part 1, there are three boxes designated for the selection of an accounting method:
- Cash method
- Accrual method
- Other
You select an accounting method by placing a check mark in the box that applies to you when you file Schedule C.
More Than One Business
If you operate more than one business, you may use a different accounting method for each, as long as you maintain a complete and separate set of books for each business.
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 under Revenue Procedure 2002-28 that allows most small businesses to use the cash method.
Under 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 businesses may not use the cash method, such as:
- Tax shelters
- C corporations (other than qualified personal service corporations) with average annual gross receipts over $5 million.
- Partnerships with a C corporation as a partner with average annual gross receipts over $5 million.
How to Figure Gross Income Under the Cash Method
Under the cash basis, net income for the period would be the difference between cash receipts from revenues and cash payments for expenses.
To determine gross receipts for a tax year under the cash method, add up the following items:
- Cash receipts
- Checks received that cleared your bank within the tax year it was received.
- Charge slips for items paid with a credit card.
- Income constructively received.
- The fair market value (FMV) of property and services received for the year.
- Fair market value is the price at which property changes hands between a willing buyer and seller, both having reasonable knowledge of all material facts.
Expenses You Pay By Credit Card Under the Cash method
Payments you make with a credit card are deducted in the year charged. Although this contradicts the rule that cash basis accounting allows you to only deduct expenses in the year actually paid, this is the rule. So, if you charge a busines expense on your business credit card on December 31, 2020 you get to deduct that expense in 2020.
Expenses Paid Using Pay-By-Phone Payments Under the Cash method
Payments you make using pay-by-phone accounts through a bank are deducted when the bank sends the check. See your monthly bank statement for dates of these payments.
Prepaid Interest Rule for Individuals and Businesses
Points paid to secure a mortgage are an example of prepaid interest. For individuals, points are 100% deductible in the year paid. However, a business must deduct points ratably over the term of the loan.
For example, if a mortgage is taken out under the business name and your business paid $3,600 in points to secure a 30-year mortgage (360 months), the monthly deduction would be $10 ($3,600/360). Your maximum annual deduction would be $120 (12 x $10).
If the mortgage is paid off early, you may deduct the full amount of the remaining points.
Advantages of the Cash Method
Simplicity: The cash method avoids the more complex rules of accounting for income and expenses required under the accrual method.
Shifting Income to Defer Taxes: A common strategy for conserving cash is to defer taxes by shifting income from the current tax year to the following tax year. This is accomplished toward the end of your tax year. You simply ensure your customers/clients aren't invoicee until the beginning of the following tax year.
Disadvantages of the Cash Method
Income and expenses of an accounting period are not accurately matched, which can result less effective financial management of the business.
The cash method does not comply with generally accepted accounting principles (GAAP). When applying for a business loan, banks and other lenders like to see GAAP compliant financial statements because they tend to have more confidence in them.
GAAP is a body of principles and standards developed over many years by professional accountants for compiling, organizing, and reporting financial information.