Cash Vs Accrual Accounting Methods

Under IRS definition, an accounting method is a set of rules used to determine when and how income and expenses are reported. Normally for IRS purposes, the accounting method–cash vs accrual–is chosen before you file the first business income tax return. It must then be used on a consistent basis for the life of the business, unless changes in the business occur that statutorily necessitate a change in the accounting method. If you wish to change methods for particular reasons of your own, you must get written permission from the IRS. Normally, you calculate your income and expenses by using three major methods: 1) Cash Method; 2) Accrual Method; or, 3) Hybrid Method in which select elements of cash and accrual are combined.

Cash Method
This is used by most sole proprietorships, and many businesses where inventory is not a major factor. In this method, income is reported when actually(or constructively) received, and expenses are deducted when paid or legally charged(like with a credit card). Constructive receipt means the money is made available to you without restriction. It doesn't always mean you have to have it in your possession. If it is credited to you, or given to your agent, it is still considered constructively received by you. Expenses that you pay for are generally deducted in that particular year, unless you have substantially prepaid expenses that actually were for another year. As an example, if you prepay a three year service contract you cannot deduct the full three years of expense in one year. You would have to allocate the cost instead. Note that there are restrictions on which type of business can and cannot use the cash method. Generally, this method can be used by sole proprietors, corporations with less than $5 million dollars in gross
receipts (current 2000 year rules), most general partnerships (unless a C Corporation is one of the partners), and farm businesses with less than $25 million dollars in gross receipts.
Tax planning opportunities exist with the cash method if you can time your constructive receipt of the income in such a way as to push it into another tax year. When you bill the client, when you actually receive the money and bank it, and when the job and its guarantees reach completion can each define when you have to report the income. As to taking expense deductions, buying and placing into use such things as business equipment and supplies can be equally timed. Advertising, marketing, and employee bonuses can also be timed to best suit you for tax planning purposes.

Accrual Method
Using an accrual method, income is reported in the year it is earned, not necessarily received, and expenses are deducted in the year they are incurred, not necessarily when paid. From the gross receipts perspective, an accrual method generally means you report the income when the client is billed and/or has received your service or product. So if you finish a job and bill the client this December 2000, but don't get paid until January 2001, the income is reported in 2000 under the accrual method. Note that there are certain exceptions to this if the business transactions involve "related persons, entities, and controlled groups" but this is relatively rare for the scope of this discourse. Unlike the cash method of accounting, accrual methodology can also involve making adjustments to reported income for bad debt allowances. If you report income when billed, but do not end up collecting all that is due you, you then may be able to write off the uncollectible portion as a business bad debt. In regard to business expenses, you deduct or capitalize these when you become liable for them. This liability issue involves meeting the "events and economic performance" rules. Before taking the deduction, all necessary events that create the liability must have happened, and the economic performance of the action must have occurred. Thus, if the expense is for materials, property, or services you incur in the production of income for your trade or business, economic performance occurs as you
provide your service or product. Tax planning avenues that may be open to accrual type operations involve the attempt to defer income into a future year, and accelerate expense deductions into the current year. In this way, the net income from the business may be lowered for the current year at the expense of the next year. This may be possible by arranging it so the job you are doing is not fully completed before the close of the year, in which case the receipts collected don't necessarily have to be posted as taxable income at that point. You get the cash, but defer paying taxes on it until a later date. Similarly on the expense side, you would attempt to accelerate expenses into the current year so the bill you receive can be written off even though you haven't paid for it yet. This type of tax deferring can be beneficial in two ways. First, from a "use of funds" perspective it may make sense since you will have an extra year's use of the tax money you have delayed. Second, if your business experiences relatively large swings in taxable income from year to year, this is a way of "levelling off" the taxable income, thus possibly lowering the marginal tax bracket and actually saving taxes overall. So if you are billed for office equipment placed into use in December 2000, but don't pay for it until January 2001, the deduction is taken in 2000 under an accrual method. While the use of an accrual method may be elective for most, a business that maintains inventory as a significant part of the production of income(stores, manufacturers, wholesalers) must use some form of accrual based accounting for the purchases and sales of the particular products in question. The full cash method is generally not allowed in this case.

Hybrid Method
This combination of cash and accrual may be allowable if you can clearly show income and expenses in a consistent methodology. If you have two distinctly different businesses, you may use a cash method for one, and an accrual method for the other. If inventory is a significant part of your business, you could use accrual for purchases of inventory and sales of these items, but you may use cash methods for all other income and expense items. However, there are limitations. If you elect the cash method for income, you must generally use the cash method for expenses. Conversely, if you elect accrual for expenses, you must use accrual for income. Within this hybrid method there may be different elections as to how income will be reported. As an example, a completed contracts method may be elected for income. This may apply to a construction type business where the projects take more than one year to complete.

Although, these are standard methods but these methods can be tweaked as per our requirement. However, if we go by standard methods of accounting and stick with its policies, we find ourself in a better position.