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.
To determine when income has been earned and expenses have been incurred two tests must be met:
- The All Events Test
- The Economic Performance Test
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 amount 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.
The Economic Performance Test
This normally occurs when the property or service is provided.
Example: Reporting income under the accrual method:
- You bill a client $500 for services that you performed in December 2013
- You get paid the $500 in January 2014.
- Include the $500 in 2013 gross income, the year payment was earned.
Example: Reporting expenses under the accrual method:
- You order $300 worth of office supplies from a catalog in November 2013.
- You receive the items in December 2013.
- You pay the $300 invoice in January 2014.
- Report the expense in 2013, the year the expense was incurred.
Receiving Advance Payments Under the Accrual Method
Generally, if you're 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.)
- You are a dance instructor.
- You are prepaid $1,000 in 2013 to give 50 lessons.
- By the end of 2013 you only gave 20 lessons.
- You hope to complete the remaining 30 lessons in 2014.
- Include $400 in 2013 gross income and $600 in 2014 gross income.
- 2013: 20 lessons given in 2013 divided by 50 equals 40% x $1,000
- 2014: You must include the remaining $600 in 2014 whether you complete the remaining 30 lessons in 2014 or beyond.
If your contract was to extend into 2015 and you gave 50 lessons in 2013, 50 lessons in 2014, and 50 lessons in 2015, you would report one third of the income (50/150) in 2013 and the remaining two-thirds (100/150) in 2014.
Again, 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 the contract runs 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.
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
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.
- You use the accrual method of accounting
- In December 2013 you invoice clients $5,000 for services performed in December.
- You get paid in January 2014.
- You must report the $5,000 in your 2013 gross income, the year it was earned. The $5,000 is subject to income taxes.
In contrast, under the cash method, you would include the $5,000 in your 2014 gross receipts, the year the payment was actually received. The $5,000 would be reported on your 2014 tax return which would be filed by the April 15, 2015 deadline, 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.
The flexibility under the cash method allows you to defer the reporting of income. For example, if you perform services during December and send your invoices out on the last day of December, you will ensure that payment will not be received by you in the following tax year.
For example, if you send out invoices December 31, 2013 and get paid January 2014, you would include the payment in 2014 gross income. Your tax return for tax year 2014 would not be due until April 2015.
By holding off on your invoicing a few days, you have deferred (put off) having to pay taxes on income you earned in 2013 (assuming you had a profit) until the April 2015 deadline, one year after the 2014 April 15 deadline. That's cash in your pocket for an extra year that otherwise would have been paid to the U.S. Treasury had you used the accrual method.
The benefit of using the accrual method is that it matches income earned in an accounting period with the related expenses for the same period thereby producing a more accurate presentation of the businesses income or loss.
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. So, make sure your books support 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:
- Cash method
- Accrual method and
Place a check mark 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 3115, Application for Change in Accounting Method
- Return to the Tax Basics for Startups Table of Contents to find related links.