IRS Publication 538 contains guidance on accounting periods and methods to be used by taxpayers:
An accounting method is a set of rules used to determine when income and expenses are reported. Your accounting method includes not only your overall method of accounting, but also the accounting treatment you use for any material item.
No single accounting method is required of all taxpayers. You must use a system that clearly reflects 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.
An accounting method clearly reflects income only if all items of gross income and expenses are treated the same from year to year.
If you do not regularly use an accounting method that clearly reflects your income, your income will be refigured under the method that, in the opinion of the IRS, does clearly reflect your income.
A taxpayer chooses his accounting method when he files his first income tax return.
The Tax Code requires that taxpayers use a consistent method of accounting from year to year. Thus, if a taxpayer wishes to change its accounting method it must get permission to do so from the IRS.
To request a change in accounting method you must file IRS Form 3115. This is a highly complex form and should not be completed without the assistance of a qualified CPA or tax attorney.
Most Commonly Used Methods
The two most commonly used methods of accounting are the Accrual and the Cash methods. Each of these methods are discussed briefly under separate heading below:
The Cash Method of accounting allows taxpayers to report their revenues when received and expenses when paid.
More than 95% of individual taxpayers use the Cash Method of accounting to report their taxable income and deductible expenses on their Forms 1040.
Under the Accrual Method of accounting a taxpayer records his income when a sale occurs, not when payment is received. Likewise, he records a deductible expense when it’s incurred, not when it’s paid.
A sale occurs when the following conditions are met:
- All the events that establish a taxpayer’s right to receive the income have happened; and
- The amount of income a taxpayer is to receive can be reasonably ascertained.
An expense is incurred when the following conditions are met:
- All the events that establish a taxpayer’s obligation to pay it have occurred; and
- The amount of the expense to be paid can be reasonably ascertained.
- In November 2009, you complete a late tax return for your largest corporate tax client.
- The return is signed and sent to the IRS.
- You send your client a bill for $1,000
- Your client pays the bill in January 2010.
Under the cash method the $1,000 is part of 2010’s revenue even though all of the events giving rise to the revenue were completed in 2009.
Under the accrual method the $1,000 is part of 2009’s revenue even though payment was not received until 2010.
Some Taxpayers Must Use Accrual Method
The following taxpayers are required to use the accrual method of accounting:
- Businesses with sales of more than $5 million per year; or
- Businesses that stock an inventory of items that it will sell to the public and whose gross receipts are over $1 million per year. (Inventory includes any merchandise a taxpayer holds for sale as well as supplies that will physically become part of an item held for sale.)
The cash method of accounting lends itself to more planning opportunities because the taxpayer himself has control over when he pays his expenses and how fast he gets paid for his work.
Planning is more difficult under the accrual method because it’s more difficult to change the objective fact of when a transaction is or is not complete.
In a previous post titled 7 All Time Tax Concepts I wrote the following about the importance of deferral of income and acceleration of deductions in structuring a sound tax plan:
When the layman thinks of tax planning he usually thinks of tax savings. However, by far the great majority of tax planning strategies involve not the saving of tax dollars but the deferral of tax liabilities to a future date.
The good tax pro understands two things about tax deferrals:
1) Because of effect of inflation, the payment of one dollar in taxes a year from now costs a taxpayer less than the payment of one dollar in taxes now; and
2) The deferral of income from a year in which the taxpayer has high marginal tax rate to a year in which the taxpayer has a lower marginal tax rate results in actual tax savings (deferring a tax deduction from a low rate tax year to a high rate tax year will likewise generate real tax savings).
Regardless of whether you use the accrual or cash method of accounting, in November or December of every year you should consult with your tax planner to discuss options for deferring taxable income to a subsequent tax year and accelerating deductions to the current year.
For example, if you use the cash basis method of accounting your tax planner might suggest that you prepay certain expenses that you anticipate will come due early in the following tax year. Likewise, your tax advisor might suggest that you delay the issuance of invoices in order to defer income to the following tax year.