We all know the rules. With a company’s first tax return, you select a method of accounting. Most professional tax programs default to the cash method of accounting, so it is the method that is usually selected by most tax professionals. However, I want you to think about this election the next time you just mark off cash and continue on. First, let’s discuss the various accounting methods that we can use for taxation.
Cash Method
This is the most commonly selected accounting method by most small businesses. Under the cash method, you recognize income when it is paid, and expenses (less those put on a credit card) when they are paid as well.
For instance, let’s say that you have a company in its first year, and they present you with accrual-based financial statements. Why are their books on the accrual method of accounting? Because a business owner needs to know how much money they are owed and how much they owe other people. However, according to the financial statements, in the first year, the business has $75,000 in accounts receivable and no accounts payable. Their net taxable income under the accrual method statements is $25,000. When you convert the statements to the cash method of accounting, the net income would be ($50,000) — which seems appealing. However, you have to think about tomorrow.
Determining a company’s method of accounting on their first tax return seems very simple, but the fact of the matter is that it will stick with the company, unless you ask for permission to change it.
Let’s discuss the different methods of accounting:
Accrual Method
Under the accrual method of accounting, you recognize income and expense as they incur. The accrual method of accounting is closely related to Generally Accepted Accounting Principles (GAAP), but not exactly.
In the tax realm, accounts receivable are considered income, and accounts payable are considered expenses. However, you can match income with expenses. For example, if you invoiced a customer for a job on December 24, and didn’t receive the income until January 4 of the following year, you have to claim the income in the year the income was incurred, which was the previous year. However, you can match the expenses associated with that income in the year the income was incurred, even if not paid until the following year.
Now if you are a CPA, you have different rules for income and expense matching under the new Income Tax Method of Accounting financial statements that you produce.
Further, for income tax purposes only, you can accrue expenses that you are contractually obligated to pay for the next three months, such as rents, wages, and other expenses.
The accrual accounting method is more useful than the cash accounting method when a person or company is trying to understand the performance of a business over a specified time period. Under the accrual accounting method, all revenue and expenses are matched together. All revenues are recorded in the period when goods and services are performed, and all expenses are recorded in the period when goods and services are purchased. This method provides a good snapshot of a company's performance over the determined timeframe.
Hybrid Method
The hybrid method of accounting is a combination of the cash and accrual methods. The IRS says you can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly reflects your income and you use it consistently.
With the Hybrid Method there are restrictions that apply:
If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales, and you can use the cash method for all other items of income and expenses.
Incidental and non-incidental materials and supplies:
For tax purposes, the cost of supplies may be deducted upon purchase as an ordinary and necessary business expense, in the case of incidental materials and supplies, or be capitalized under § 1.162-3 and expensed as consumed, in the case of nonincidental materials and supplies.
More specifically, incidental materials and supplies on hand at the end of the year may be deducted in the year of purchase as long as no record of consumption is kept, or no physical inventories are taken, provided the taxpayer's taxable income is clearly reflected by this method.
If you use the cash method for reporting your income, you must use the cash method for reporting your expenses.
If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
Any combination that includes the cash method is treated as the cash method for purposes of IRC §448.
The most basic concept of all accounting methods is that you must select the method of accounting that clearly reflects your income and your expenses.
Special Rules
Once your accounting method is selected, it cannot be changed without approval of the IRS (see below).
You must select the method of accounting that most clearly reflects your income and expenses.
CHANGING YOUR METHOD OF ACCOUNTING
In order to change your method of accounting, you have to file Form 3115. I like to refer to this form as “please...oh please…audit me now.” Stop and think about this, when you file this form, you are basically telling the IRS that you have never clearly reflected your income and expense on any prior tax return, and the Service may want to examine the past returns.
AUTOMATIC CHANGE OF ACCOUNTING
In Rev. Proc. 2008-52, 2008-2 C.B. 587, the IRS published procedures for obtaining automatic consent to change methods of accounting.
Changes in method of accounting to which Rev. Proc. 2008-52 applies include:
The use of the cash and disbursements method of accounting by certain small taxpayers;
Trade or business expenses (IRC § 162);
Depreciation or amortization (Code Section IRC §§§ 167, 168, or 197);
Capital expenditures (IRC § 263);
Uniform capitalization including UNICAP changes by producers of real or tangible personal
property (Rev. Proc. 2002-19, 2002-1 C.B. 696);
Methods of accounting (IRC § 446);
Obligations issued at discount (IRC § 454);
Prepaid subscription income (IRC § 455);
Taxable year of deduction (IRC § 461);
Inventories (IRC § 471);
Last-in, first-out (LIFO) inventories (IRC § 472);
Bank reserves for bad debts (IRC § 585);
Original issue discount (IRC § 1273); and
Short-term obligations (IRC § 1281).
One more caveat — a related owner of more than one business MUST use the same method of accounting for all of their businesses.
The selection of an accounting method should not be taken lightly. You must determine which method is a clear reflection of income and expense, not to mention which method of accounting will be the most beneficial for the client.