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11 Most Overlooked Tax Deductions

Updated for 2011

Accounting Methods

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The Accrual Method

Under the accrual method income is reported in the year it is earned without regard to when the income is actually received.

Expenses are reported in the year they are incurred regardless of when they are actually paid.

Determining When Income is Earned and Expenses are Incurred:

Under the accrual method you report income in the year its earned and expenses in the year they are incurred.

To determine when income has been earned and expenses have been incurred there are two tests which must be met:

  1. The All Events Test
  2. The Economic Performance Test

1)The All Events Test

This occurs when two things happen:

First, all events have occurred that fix the fact of liability.

This normally occurs when you perform a service or provide merchandise to a client/customer, or when you receive a service or merchandise.

Second, the liability can be determined with reasonable accuracy.

Usually you'll know the cost of the service or property provided. However, if you don't know the exact cost, you can use an estimate to record the transaction.

Then, when you find out the actual cost, you just make the appropriate adjustment in your books.

2)The Economic Performance Test

This normally occurs when the property or service is provided.

Examples:

All examples assume a calendar year (January 1 through December 31).

Reporting income under the accrual method:

Result:

Reporting expenses under the accrual method:

Result:

Receiving Advance Payments Under the Accrual Method:

Generally, if you are prepaid for services to be performed in a later year you include such payment in your gross income in the year the payment is received.

However, the IRS allows a limited deferral for accrual method taxpayers.

Limited Deferral for Accrual Method Taxpayers:

If you are prepaid to perform a service in a later year, the IRS allows you to postpone reporting the prepayment until the following year.

However, you cannot defer a prepayment beyond the year following the year of payment even if you contracted to perform the service for a longer period.

See Revenue Procedure 2004-34 for more information.

EXAMPLE:

Result:

If your contract was to extend into 2013, and you gave 50 lessons in 2011, 50 lessons in 2012 and 50 lessons in 2013, you would report one third of the income (50/150) in 2011 and the remaining two-thirds (100/150) in 2012.

Remember, the deferral period is limited to just one year after the year of the original advance payment no matter how long it takes you to complete the contract or how many years you contracted for to complete the service.

Advantages of the Accrual Method

1) Matches income and related expenses:

Accurate, timely, and reliable information is crucial for the effective management of a business. To this end, the accrual method is a more useful tool than the cash method.

Here's why:

The chief advantage of the accrual method is that it matches income and related expenses in the correct year. As a result, a more accurate and consistent presentation of net income and balance sheet values is provided from period to period.

The accrual method provides financial information that may be compared from period to period. This is important for identifying positive and negative trends as well as deviations from budgeted amounts.

By having this information available monthly, or at least quarterly, you have the ability to analyze the causes of negative or positive trends. The results of your analysis can help you understand what actions need to be taken to stem or stop negative trends and take advantage of positive trends, which may help to boost profits and cash flow.

2) Complies with generally accepted accounting principles (GAAP):

The accrual method complies with generally accepted accounting principles. Banks and other lenders give more credence to financial statements that comply with GAAP since they tend to be more reliable. Therefore, the accrual method may help make it easier for you to secure financing.

Disadvantages of the Accrual Method

1) Complexity:

The accrual method is more complex than the cash method. You must understand the rules regarding the recognition of income and expenses and may have to perform certain computations at the end of each accounting period to determine accrual amounts to record in the books of account. For example, recording a payroll from month to month generally requires an accrual entry to be made to record wages and taxes payable.

When income is earned but not received and when expenses are incurred not but paid, the accrual method will require additional bookkeeping entries to account for the income and expenses than the cash method.

Having to record journal entries to recognize income and expenses from period to period without regard to whether cash has changed hands and then having to record the actual receipt of such income and the actual cash outlay for such expenses at a subsequent date adds to the complexity of the accrual method.

2) Paying taxes on income earned but not received:

Since income must be reported in the year it is earned under the accrual method rather than in the year the income is received, you can end up paying taxes on income for which payment has not been received.

EXAMPLE:

Result:

In contrast, under the cash method, you would include the $5,000 in your 2012 gross receipts, the year the payment was actually received. The $5,000 would be subject to income taxes for tax year 2012, which are due during April 2013 (plus extensions).

Using Both the Cash and Accrual Methods

You're allowed to use both the cash method and the accrual method.

For example, you could use the cash method for tax reporting purposes and the accrual method for your own internal financial reporting.

This way, you get the flexibility of reporting income and expenses under the cash method and more accurate financial reporting under the accrual method.

Audit Proofing Your Tax Return

If you use the accrual method for financial reporting and the cash method for tax reporting, should you ever be audited, the IRS will expect you to be able to support the information you reported on your tax return.

Make sure your books back up your tax return.

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.

  1. Cash method
  2. Accrual method and
  3. 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

Next:

Hybrid Method: Hybrid Method

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