Tax Accounting - 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.
"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.
Income – Reported when cash is received
Expenses – Reported when cash is paid
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.Example:Accrual Method
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:
The following entities CAN use Cash Method:
- C Corporation
- Partnership with a C Corp as partner
- A tax shelter
- Tax-exempt trust with unrelated business income
- Certain farming businesses
- Partnerships that do not have c corps as partners
- Accounting, law, engineering, health, consulting, architecture, actuarial science, and performing arts personal services corporations that qualify
- 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.
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.
Income – Reported as earned
Expenses – Reported when incurred.
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.
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:
- Change from the cash to accrual method,
- Change from FIFO to LIFO etc.
- Change from "completed contract method" to "percentage of completion" method (long-term contracts)