Tax Accounting - Accounting Methods
Cash Receipts And DisbursementsLong-term Contracts
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.
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.
"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:
- C Corporation
- Partnership with a C Corp as partner
- A tax shelter
- Tax-exempt trust with unrelated business income
The following entities CAN use Cash Method:
- 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)
InvestingAccrual accounting is an important method of measuring the performance and position of a company. Learn more on how its used.
ProfessionalsCFA Level 1 - Cash Flow Computations - Direct Method. Learn the direct method to calculating a cash flow statement. Includes calculations for free cash flow, a useful valuation measurement.
MarketsBy Tim Keefe,CFA (Contact Author | Biography)Not all accrual accounts are subject to the same management manipulation, and some accruals are worth more attention than others. Recall Figure 6 ...
MarketsBy Tim Keefe,CFA (Contact Author | Biography)In order to understand a company's financial report, you need to understand the accounting concepts that are used to justify the accounting rules. ...
ProfessionalsCFA Level 1 - Cash Vs. Accrual Accounting. Examines the differences between cash and accrual accounting. Looks at the benefits of each and how to reconcile the two methods.
ProfessionalsCFA Level 1 - Section 6: Financial Statements. Introduction to financial statements. Briefly introduces the concept of financial statement analysis and two main accounting methods.
MarketsBy 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 ...
InvestingIn 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. ...
ProfessionalsCash basis accounting recognizes revenues and expenses at the time cash is paid or received.
The method by which income and expenses are reported for taxation ...
An accounting method that combines elements of the two major ...
A document published by the Internal Revenue Service (IRS) that ...
Accrual accounting is an accounting method that measures the ...
A method of creating a statement of cash flows during a given ...
A major accounting method that recognizes revenues and expenses ...
The main difference between accrual and cash basis accounting is the timing of when revenue and expenses are recognized. ... Read Answer >>
Understand the differences between the two basic methods of accounting commonly used by businesses: cash accounting and accrual ... Read Answer >>
Learn why the Internal Revenue Service cares about accounting practices, as these ensure the accurate reporting of financial ... Read Answer >>
Determine when the accrual accounting method must be used instead of cash accounting. Most businesses use accrual accounting ... Read Answer >>
Learn when accrual accounting is more useful than cash accounting when trying to determine a company's performance over a ... Read Answer >>
Take an in-depth look at the treatment of revenues and expenses within the accrual method of accounting and learn why many ... Read Answer >>