Per Diem Rates from the U.S. General Services Administration
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Rates are set by fiscal year, effective October 1 each year. Find current rates in the continental United States ("CONUS Rates").
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 during December 15, 2020. You get paid the $500 January 10, 2021. You include the $500 in 2020 gross income, the year the income was earned.
Example: Reporting expenses under the accrual method:
You order $300 worth of office supplies from a catalog during November 2020. You receive the items December 30, 2020. You pay the $300 invoice January 5, 2021. You report the expense in 2020, 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 the 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.)
Example:
You're a dance instructor. A student prepays you $1,000 in 2020 for 50 lessons. By the end of 2020 you only gave 20 lessons (20/50 = 40%). You intend to complete the remaining 30 lessons (60%) in 2021. Include $400 in 2020 (40% x $1,000) gross income and $600 (60% x $1,000) in 2021 gross income, whether you complete the remaining 30 lessons in 2021 or in a later year.
If your contract was to extend into 2021 and you gave 50 lessons in 2020, 50 lessons in 2021, and 50 lessons in 2022, you would report one third of the income (50/150) in 2020 and the remaining two-thirds (100/150) in 2021.
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
Matches income and related expenses:
The chief advantage of the accrual method is, it is designed to match 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.
In addition, the accrual method produces financial information that is comparable from period to period. This is important for identifying positive and negative trends, as well as deviations from budgeted amounts.
Complies with generally accepted accounting principles (GAAP):
Banks and other lending institutions give greater weight to financial statements that were prepared in compliance with GAAP because they tend to be more reliable than financial statements based on the cash method of accounting.
Disadvantages of the Accrual Method
Complexity:
The accrual method requires a greater knowledge accounting principles than does the cash method. For example, you must understand the principle of income and expense recognition. You also may must calculate monthly accrual amounts in order to prepare journal entries to be recorded in the general ledger.
Accrual entries
:For example, assume the weekly payroll period ends on a Wednesday, December 31, the last day of the accounting period, but the weekly paychecks are issued on Friday January 2. This is a situation where one weekly pay period overlaps two monthly accounting periods (M-W for December and Th-Fr for January).
This is where an accrual entry comes in. An accrual entry would allocate the payroll for the last week of December, M-W, to December even though the paychecks on January 2 include those days. In contrast, under the cash method, the entire week, M-F would be recorded in the books as payroll expense, which would include the last three days of December (M-W) and the first two days of January (TH-F) resulting in an overstatement of payroll expense in January and an understatement of payroll expense in December.
Accounts Receivable and Accounts Payable:
Under the accrual method, you must set up an accounts receivable account to record income earned but not received and an accounts payable account to record expenses incurred but not yet paid. When receivables are collected, you reduce the accounts receivable account. When the business pays its expenses, you reduce the accounts payable account. These entries are not required to be made in the books of account under the cash basis.
Having to record journal entries to recognize income and expenses from period to period without regard to whether cash has changed hands, 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.
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:
You use the accrual method of accounting. In December 2020 you invoice clients $5,000 for services performed in December 2020. You get paid the $5,000 in January 2021. You must report the $5,000 in your 2020 income, the year it was earned. The $5,000 is subject to income taxes in 2020.
In contrast, under the cash method, you would include the $5,000 in your 2021 income, the year the payment was received. The $5,000 would be reported on your 2021 tax return.
Using Both the Cash and Accrual Methods
Assuming you qualify to use the cash method, which most small businesses do, you may use the cash method for tax reporting purposes and the accrual method for your own internal financial reporting.
The cash method provides you with the flexibility of timing the reporting of income toward the end of the tax year. This allows you the opportunity to defer reporting income to the following tax year. You may also accelerate the reporting of expenses to the current year by paying expenses that are due in the following year.
For example, if you send out invoices December 31, 2020 and get paid January 2021, you would include the payment in 2021 income, the year you got paid. On the other hand, if you have an invoice that is not due until January 2021, you could pay it in 2020 and take the deduction in 2020.
Audit Proofing Your Tax Return
If you use the accrual method for financial reporting and the cash method for tax reporting, 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 election of an accounting method:
- Cash method
- Accrual method and
- Other
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
You need IRS approval to change your accounting method. File Form 3115, Application for Change in Accounting Method