Tax Accounting - Accounting Methods

Accounting Methods

Cash Receipts And Disbursements
Under the "cash" accounting method, firms will realize revenue from services provided in the year the payment is actually received, regardless of when the services were performed. Expenses are realized when they are paid, regardless of when the firm actually incurred the expense. If income is "constructively received" it must be reported.



Look out!
Cash Method:
Income – Reported when cash is received
Expenses – Reported when cash is paid
Advantages:
Reporting of income can be deferred by postponing the receipt of payment. Business owners can wait until January of the next year to mail out the previous year\'s fourth quarter invoices to delay receipt of payment.

"Constructive Receipt"- is assumed if income is subject to your control, set apart for you to draw at any time, or an amount is credited to your account.


Example:
You receive a check for services on Dec.1, but elect to wait to cash the check until January of the following year. The IRS views this as constructive receipt in December and reportable in that year, because you maintained possession (control).

The following entities may NOT use Cash Method:
  1. C Corporation
  2. Partnership with a C Corp as partner
  3. A tax shelter
  4. Tax-exempt trust with unrelated business income

The following entities CAN use Cash Method:

  1. Certain farming businesses
  2. Individuals
  3. Partnerships that do not have c corps as partners
  4. Accounting, law, engineering, health, consulting, architecture, actuarial science, and performing arts personal services corporations that qualify
  5. C corp or a partnership (with a c-corp partner) with average annual gross receipts over the prior three-year period of $5 million or less AND production, purchase or sale of merchandise is not an income-producing factor.

Accrual Method
Under the "accrual" accounting method, firms will match expenses against revenues in the year the firm incurs the liability for the expense, regardless of when the expense is actually paid. Revenues are realized when earned, regardless if payment has been made.


Look out!
Accrual Method:
Income – Reported as earned
Expenses Reported when incurred.
Limitations:
For businesses with inventories (goods are used as income producing), the accrual method must be used.

Safe Harbor Exception:
Business owners with average annual gross receipts of $10 million or less for the three prior tax year periods, may be able to use the cash method if they are not a retailer, wholesaler or manufacturer.

Hybrid Method
The hybrid method is a combination of the cash and accrual methods of accounting. It allows the taxpayer to account for some items of income under the cash method (i.e., interest income) and other under the accrual method (i.e., sales).

Change in Accounting Method
As a rule of thumb, you must obtain the consent of the IRS prior to any change in accounting method. The document used to request the change is Form 3115.

- If a change in accounting method is done, the taxpayer must make certain adjustments to income in the year of the change. This is done to disallow the taxpayer of an omission income or duplication of a tax deduction.

Acceptable Changes in accounting method:

  1. Change from the cash to accrual method,
  2. Change from FIFO to LIFO etc.
  3. Change from "completed contract method" to "percentage of completion" method (long-term contracts)
Long-term Contracts


Related Articles
  1. Investing

    What does Accrual Mean?

    In accrual-based accounting, transactions are recorded on the books as they occur, even if payment has not yet been received or made. Accruals represent liabilities and non-cash-based assets. ...
  2. Markets

    Earnings Quality: Measuring Accruals

    By Tim Keefe,CFA (Contact Author | Biography)As was noted earlier, earnings management is predominantly a function of manipulating accruals, so it is intuitive to use the magnitude of accruals ...
  3. Professionals

    What is Cash Basis Accounting?

    Cash basis accounting recognizes revenues and expenses at the time cash is paid or received.
  4. Personal Finance

    Alternate Methods Of Online Payment

    Paying by credit is one of the most common methods of payment for online shopping in the U.S. However, there are many other options worth testing out.
  5. Retirement

    Don't Lose Your Shirt On Mutual Fund Sales

    Mutual funds aren't guaranteed profit-makers, but with the right calculations and timing, you can avoid major losses.
  6. Fundamental Analysis

    Cash Flow From Investing

    Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it.
  7. Markets

    Earnings Quality: Investigating The Financing Of Accruals

    By Tim Keefe,CFA (Contact Author | Biography)Along with the time-series plots above, which illustrated scenarios where a firm experiences a large jump for two operating-assets accruals, investigation ...
  8. Active Trading Fundamentals

    Hedging

    Discover more about this method of reducing risk in your portfolio.
  9. Options & Futures

    Financial Statements: Revenue

    By David Harper (Contact David)Revenue recognition refers to a set of accounting rules that governs how a company accounts for its sales. Many corporate accounting scandals have started with ...
  10. Options & Futures

    Build Your Small Business During Downswings

    Here we offer some cost-saving measures to strengthen your business even when the market is weak.
RELATED TERMS
  1. IRS Publication 538

    A document published by the Internal Revenue Service (IRS) that ...
  2. Direct Method

    A method of creating a statement of cash flows during a given ...
  3. Cash Accounting

    An accounting method where receipts are recorded during the period ...
  4. Indirect Method

    A method for creating a statement of cash flows a company may ...
  5. Ratable Accrual Method

    A method for determining when and how much income was earned ...
  6. Percentage Of Completion Method

    An accounting method in which the revenues and expenses of long-term ...
RELATED FAQS
  1. How does accrual accounting differ from cash basis accounting?

    The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recognized. ... Read Answer >>
  2. What is the difference between accrual accounting and cash accounting?

    Understand the differences between the two basic methods of accounting commonly used by businesses: cash accounting and accrual ... Read Answer >>
  3. Why does the Internal Revenue Service (IRS) care about accounting practices?

    Learn why the Internal Revenue Service cares about accounting practices, as these ensure the accurate reporting of financial ... Read Answer >>
  4. When are businesses required to use accrual accounting?

    Determine when the accrual accounting method must be used instead of cash accounting. Most businesses use accrual accounting ... Read Answer >>
  5. What is accrual accounting used for in finance?

    Read about the accrual method of accounting, its uses and rules, and why it is considered so important for investors, lenders ... Read Answer >>
  6. Why does GAAP require accrual basis rather than cash accounting?

    Discover why GAAP requires the accrual basis for accounting rather than the cash basis, and learn why it is important for ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center