What Is An Accounting Method
An accounting method is a set of rules used to determine how and when income and expenses are reported.
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
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. Expenses are recorded in the books and reported on your tax return in the year paid.
You're a sole proprietor. You operate a pool cleaning service in Phoenix, Arizona - Crystal Clear Pools. During December 2017 you perform pool cleaning services for two clients and bill them $250 each. Both clients pay you during January 2018. You must include the $500 ($250 x 2) in your 2018 gross receipts on Schedule C.
Constructive receipt takes place when income is made available to you without restriction. Physical possession is not required. For example, interest credited to your bank account December 31, 2017 and withdrawn January 2018 must be reported as income on your 2018 tax return.
Accrual basis accounting achieves a more accurate measurement of a business's periodic net income because it attempts to match revenues and expenses related to the same accounting period.
Accrual-basis accounting is based on two accounting principles:
- The Revenue Realization Principle
- The Matching Principle
Revenue Realization Principle
The revenue realization 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 received, rather than when it was earned.
You're a web designer. You use the accrual method of accounting. You design a website for a client in December 2017. You bill the client $1,000 for your work in December 2017. You get paid January 2018. You must report the $1,000 on your 2017 income tax return, .the year the $10,000 was earned.
Under the accrual method, expenses are reported in the year incurred, rather than when you actually paid it.
You're a web designer and use the accrual method. You rent office space for $700 a month. You pay your December 2017 rent on January 2, 2018. You must report the $700 rent expense in tax year 2017, even though you actually paid it in January 2018.
The matching 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, income and related expenses are reported in the correct year, which provides a more accurate picture of financial results.
This example will demonstrate how the financial results can dramatically differ from one period to another. In this example I'm using two tax years. However, the same periodic results would occur if financial statements were prepared on a monthly basis.
You started a web design business in November 2017. You obtained one client during December 2017 and completed designing a website for the client in December 2017. You billed the client $1,000 in December 2017. You received the $1,000 during January 2018. In addition, you paid your December 2017 rent of $700 on December 30, 2017.
Accrual Method: 2017 Tax Year Net income of $300 -
Gross receipts: $1,000 minus $700 rent expense. Since you earned the $1,000 in 2017 tax year and incurred $700 rent in tax year 2017. That you actually paid it in 2017 is irrelevant under the accrual method. Rent expense gets reported in 2017 even if you paid it in 2018. As you can see, the accrual method produces the correct results by matching the income and related expense in the correct period: net income of $300. This is what would be reported for tax purposes.
Cash Method: 2017 Tax Year Net Loss of $700:
Gross receipts: $0. Rent expense $700. Although you earned the $1,000 in tax year 2017, your actually received payment in tax year 2018. Therefore, you do not report the $1,000 in tax year 2017. You report it in tax year 2018. The rent expense was paid in 2017. so its reported in tax year 2017. Since no income was reported from this business in 2017, and only rent expense was reported for $700, the business ends up with a $700 loss.
Accrual basis accounting is more complex than cash basis accounting. It requires a greater knowledge of accounting principles and procedures. However, it provides more accurate financial information, which is useful for more effective management of the business.
The hybrid method combines the accrual and cash methods of accounting. For example, the accrual method could be used to account for inventory held for sale and the cash method to account for business expenses.
Whichever method of accounting you use, 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 when you file 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.
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
You select an accounting method by placing a check mark in the box that applies to you when you file Schedule C.
If You Own More Than One Business
If you have 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.
Changing Your Accounting Method
To change your accounting method, you must get IRS approval. File Form 3115, Application for Change in Accounting Method.
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.
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.
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. Check 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. 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
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. The cash method makes this possible because under the cash method you only report income when it is actually (or constructively) received.
For example, if you bill customers during December 2014 for services you performed during December 2014 and get paid during December 2014, you must report that income on your 2014 tax return.
However, you could defer the taxes for at least one year on the December 2014 income if you bill your customers during 2015 for December 2014 services and get paid during 2015.
Disadvantages of the Cash Method
Mismatching of Income and Related Expenses:
There is a principle in accounting called the matching principle. This principle states that income should be matched with the expenses that generated such income in order to reflect the correct net income or loss for the period.
The cash method does not adhere to the matching principle, since it only recognizes income when received and expenses when actually paid. As a result, wide swings (distortions) in financial results can occur over two or more accounting periods.
For example, suppose you started a business in December 2014. During December 2014, you paid $1,000 in expenses which generated $5,000 of income during December 2014. You receive the $5,000 of income during January 2015, the following tax year.
Under the accrual method, a net profit of $4,000 for 2014 would be correctly stated ($5,000 minus $1,000), since both income and related expenses would have been recognized in the books during December 2014.
However, under the cash method, December 2014 would show a loss of $1,000, since that's when the expense was paid ( the $5,000 was not recorded in the books since it was not received during 2014). Tax year 2015 would reflect an overstatement of $5,000, since thats the year the $5,000 was received even though it was actually earned during December 2014.
As you can see, since the cash method does not attempt to match income with related expenses, the financial results for two or more accounting periods can be distorted.
Does not comply with generally accepted accounting principles (GAAP):
While 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 difficult to secure financing.
GAAP is a body of principles and standards developed over many years by professional accountants for compiling, organizing, and reporting financial information.
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- Return to the Tax Basics for Startups Table of Contents to find related links.