An accounting method is a set of rules used to determine when and how to report income and expenses in your books and on your income tax returns. You choose an accounting method when you file your first tax return. If you want to change your accounting method, you must get IRS approval.
No single accounting method is required of all taxpayers. You must use a system that clearly shows your income and expenses and you must maintain records that will enable you to file a correct return. In addition to your permanent books of account, you must keep any other records necessary to support the entries on your books and tax returns.
The two basic accounting methods are “Cash” and “Accrual“.
Cash Basis Accounting vs Accrual Basis Accounting
Cash Basis Accounting
With Cash Basis Accounting, income is recorded when cash (checks, money orders, or currency) is received, and expenses are recorded when paid. However, unpaid credit sales and purchases do not show on ledgers, which can present a misleading picture of income and expenses. With cash basis accounting you report income you receive during the year. You usually deduct expenses in the tax year you pay them. Most individuals and many sole proprietors use the cash method because they find it easier to keep cash method records.
Example: Interest is credited to your bank account in December 2001, but you do not withdraw it or enter it into your passbook until 2002. You must include the amount in gross income for 2001, not 2002.
Accrual Basis Accounting
Accrual Basis Accounting is where revenue and expenses are recorded in the period in which they are earned or incurred regardless of whether cash is received or disbursed in that period. This accounting basis is generally required in order to conform to GAAP in preparing financial statements for external users. You generally report income when you earn it, even though you may receive payment in a later year. You deduct expenses in the tax year during which they were incurred, whether or not you pay them that year. The purpose of an accrual method is to match income and expenses in the correct year.
Example: You are a calendar year, accrual basis taxpayer. You sold a computer on December 28, 2000. You billed the customer in the first week of January 2001, but did not receive the payment until February 2001. You include the amount received in February for the computer in your 2000 income.
Selecting an Accounting Method
Each tax payer must use a consistent accounting method, which is a set of rules for determining how and when to report income and expenses. The most commonly used accounting methods are the cash method and the accrual method. Under the cash method you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses in the tax year you incur them, regardless of when payment is made. For other methods, refer to Publication 538, Accounting Periods and Methods(PDF). Refer also to the Small Business Administration’s Recordkeeping in a Small Business(PDF).
Changing Your Accounting Method
If you want to change your accounting method, you must get IRS approval. A change in your accounting method includes a change not only in your overall system of accounting but also in the treatment of any material item. A material item is one that affects the proper time for inclusion of income or allowance of a deduction.
- Once you have chosen your accounting method, advance IRS approval is generally required if you want to change your accounting method. File Form 3115 to request a change in accounting method.
- If you are using an incorrect accounting method, it is to your advantage to change it before the IRS contacts you for an examination. For additional information, refer to Revenue Procedure 97-37. More stringent requirements apply for taxpayers wishing to change their accounting method during an examination.
- In many situations, advance IRS approval is not required to change your accounting method. However, Form 3115 is still required. You should file as early in the year as possible to give the IRS enough time to respond to the form before the original due date of the return for the year of change. If you do not file a Form 3115 during the year of change, an extension to file the form will be granted only in unusual and compelling circumstances.
The following revenue procedures apply to automatic accounting methods changes. Caution: It is important to read the entire revenue procedure after determining that a particular accounting method change applies to you.
Revenue Procedure 2001-10 allows taxpayers with annual gross receipts under $1,000,000, who were required to use the accrual method of accounting because they have inventory , to change to the cash method of accounting without advance permission from the IRS.
Revenue Procedure 99-49 describes several accounting method changes that no longer require advance permission from the IRS (note that Form 3115 is still required).
Changing your accounting method generally requires IRS approval. To get approval, you must file Form 3115, Application for Change in Accounting Method during the tax year for which the change is requested.
If your application is not properly completed according to the instructions for a current Form 3115, you will be notified and given 21 days from the date of the notification letter to furnish the necessary information. If you do not submit the required information within the reply period, the IRS will not process your Form 3115. The IRS can grant up to an additional 15 days to furnish the information.
Q: Does Total Office Manager use the Cash or Accrual Method?
A: Total Office Manager uses the Accrual Method of accounting for all transactions except sales tax. With regard to sales tax, you have the option of choosing which method you want; Cash or Accrual. We offer a Cash Basis option on sales tax so that you are not asked to pay sales tax for transitions which have not been collected (see the related topic, “Preferences – Sales Tax” for more information.
Q: How does a Cash Basis balance sheet and income statement differ from an Accrual Basis?
A: A Cash Basis Balance Sheet does not include accounts payable (A/P) or accounts receivable (A/R) of any type. There is no inventory. There is no Sales Tax Payable or any other similar liability.
On the income statement, A/R is treated as income and A/P is treated as an expense. Inventory is treated as a Cost of Goods Sold.
Q: We file our income tax return using the cash basis. Will this be OK with Total Office Manager?
A: Yes. Absolutely. Your accountant will know how to handle this situation.
Q: My accountant wants Cash Basis reports. How do I create them?
A: There is no need to. Print your balance sheet and income statement as you normally would. Your accountant will adjust these reports to a Cash Basis using the same technique described above. This is a very common practice.