Accounting Methods: Cash, Accrual, and Hybrid

Accounting methods are used to record when income is received and expenses are paid so that the profit can be determined for a specific time period, called the accounting period. Accounting allows businesses to measure their success and tax authorities to determine taxable income. Accounting methods vary, but tax law restricts the choice of accounting methods and accounting periods for specific business entities.

One requirement of any accounting method is that it accurately reflects income. IRC §446(b) gives the IRS broad authority to determine whether the accounting method used clearly reflects income; otherwise, the IRS may calculate tax liability under an accounting method the IRS deems more accurate.

Once an accounting method is chosen, a business can only change it by requesting the change using Form 3115, Application for Change in Accounting Method during the tax year for which the change will apply. However, the IRS will consent automatically for many common accounting changes and extend the deadline for requesting the change to the taxpayer's filing date, including extensions, if the Instructions for Form 3115, Application for Change in Accounting Method are followed. But the IRS will not normally consent to a change in accounting method if it is for the final tax year of the business entity.

The Tax Cuts and Jobs Act has expanded the definition of a small business, which has the option of using the cash method of accounting, as one with average gross receipts not exceeding an inflation-adjusted statutory limit, which in 2022 was $27 million, in any 1 of the 3 previous years. Businesses satisfying the small business exception are no longer required to keep inventories, use the percentage of completion method, or need to use the uniform capitalization rules.

The 2 primary methods of accounting differ in when income and expenses are recognized:

  1. cash receipts and disbursements method
  2. accrual method

Cash Method of Accounting

Under the cash-receipts method (aka cash-basis method), cash, property, or services are included in the taxpayer's gross income in the year of actual or constructive receipt either by the taxpayer or by the taxpayer's agent. Hence, the cash method of accounting is the easiest to implement and is commonly used by sole proprietorships and small businesses. However, to prevent the acceleration of deductions to the current year, such as prepaying for a lease or for supplies, expenses with a benefit extending more than 12 months beyond the current tax year must be capitalized to an asset account, where the amount must be recovered through amortization, depreciation, or depletion.

Restrictions on Using the Cash Method

Because cash accounting makes it easier to understate taxable income, IRC §448 prohibits both C corporations and partnerships with C corporate partners with gross receipts exceeding $26 million, and tax shelters from using the cash method of accounting. Most businesses that maintain an inventory are prohibited from using the cash method. However, the prohibition against using the cash method has some exceptions:

Accrual Accounting

Although cash accounting is easier to implement, a business eventually reaches a size where it must provide financial reports to stakeholders, such as lenders or stockholders, that more accurately reflects the financial health of the business. Accrual accounting more accurately represents the financial status of the business because income is recorded when it is earned rather than when it is received; likewise, expenses are recognized when they are incurred rather than when they are paid. So that the status of one business can be accurately compared to other businesses, the methods of accounting have been standardized by the Financial Accounting Standards Board (FASB) through their publication of Generally Accepted Accounting Principles (GAAP).

The main purpose of GAAP is to present accurate financial information to the stakeholders of the business, including management, shareholders, creditors, and others. Therefore, GAAP accounting, often called financial accounting, tends to be conservative in its assessment of a business, by tending to understate income and overstate expenses that requires some judgment. However, tax authorities have a different objective since understating income or overstating expenses lowers taxable income. Hence, tax law modifies procedures used in financial accounting to prevent understating income or overstating expenses. This modification of financial accounting is called tax accounting.

So although IRC §446(a) stipulates that businesses should use the same method of accounting for taxes as they use in keeping their books, tax accounting differs in some ways from financial accounting to conform to the requirements of tax law, which may lead to a difference between book income and taxable income. For instance, prepayments received by a business are not treated as income until they are earned according to financial accounting principles, but, with certain exceptions, the income is taxable in the tax year in which it is received. If a business entity does not have to provide financial reports, it can just keep its books according to tax rules.

Under the accrual method, gross income must be reported when it is earned, regardless of when the income is actually collected, because the taxpayer has a right to receive it. There are 2 tests to determine if income has been received or an expense incurred: all-events test and economic performance test.

  1. The all-events test is satisfied when the amount of the income or expense is ascertainable with reasonable certainty and the business has the legal right to receive the income or the legal obligation to pay the expense.
  2. The economic performance test determines whether everything has occurred to earn the income or to be liable for the expense.

So, for instance, the income is earned when the amount is known with reasonable certainty and when everything occurred that was promised in exchange for the income. This includes completing services for the customer or transferring the property title to the buyer. However, if the payment is disputed, the income need not be reported until it is received since the amount cannot be determined with reasonable accuracy. Likewise, expenses are reported when they are incurred, not when they are paid. However, there is an exception for recurring items, expenses regularly paid for some items, which allows the business to deduct the expenses when accrued, even though economic performance has not been completed.

Special accounting methods apply for long-term contracts, installment sales, and mark-to-market accounting for securities:

Businesses that sell gift cards need not report the income until the cards are redeemed. If a gift card is exchanged for a return of merchandise, the business can treat the transaction as a payment of a cash refund and a sale of a gift card.

Revenue Procedure 71-21 allows the accrual basis taxpayer to defer recognition of income for advance payments for services if the services have been completed by the next tax year after the prepayment. For instance, if a service corporation sells a 12-month service contract and receives the full amount at the end of June, the corporation must recognize only 1/2 of that income for the current tax year and 1/2 of the income for the next tax year. However, if the customer prepaid a 24-month contract in June Year 1, the corporation must recognize the entire amount when received since, by the end of Year 2, there will still be unearned income from services provided in Year 3.

2½-Month Rule

The payment of wages or other expenses to unrelated parties can be accrued to the current tax year if the expenses are paid within 2½ months after the end of the tax year.

Expenses Paid to Related Parties

Expenses paid to related parties cannot be deducted until actually paid. Related parties include family members, business entities where the taxpayer owns a significant interest, or, if the taxpayer is a corporation, a related party would include other members of a corporate control group. So if a calendar-year business owner pays a commission to an unrelated salesperson on March 1, the expense can be accrued and deducted in the previous tax year, but a commission paid to her son would only be deductible when paid.

Special Rule for Real Estate Taxes

Real estate taxes incurred by a business can be deducted when paid, but there is a special exception that allows the business owner to ratably accrue the taxes over the time period to which they apply. So if a real estate property tax bill of $10,000 is paid for July 1 to June 30, the taxpayer can elect to deduct 1/2 of that, or $5000, in the payment year and the remaining $5000 next year. Different elections can be made for multiple businesses. The election must be made in the 1st tax year when real estate taxes are incurred by attaching a statement to the tax return stating which businesses that the election applies to and their methods of accounting, the time period covered by the real estate taxes, and the method used to calculate the apportionment. The election continues until it is revoked, which can be done by attaching a statement revoking the election.

Hybrid Method

Though most businesses use either the cash or accrual method of accounting, the hybrid method is sometimes used by businesses with inventory. Unless the business qualifies for the small-inventory-business exception, tax law requires businesses to use the accrual method of accounting to account for inventory and its sale, but many businesses with inventory also use a cash basis for all other income and expenses because of its simplicity. However, the same accounting method must be used to report both income and expenses.

Different methods of accounting can be used by a taxpayer for personal items and a business, or for 2 or more businesses, if the businesses are distinct, where separate books are maintained and there is no shifting of profit or losses among businesses.

Uniform Capitalization Rules

If a business, such as a retailer or wholesaler, produces real or tangible personal property, either to use in the business or to resell to customers, or if the property is acquired for resale, the selected accounting method may have to be modified by the uniform capitalization (aka UNICAP) rules (IRC § 263A). In essence, the direct cost of materials, labor, and production, and indirect costs of production must be added to the tax basis of the property instead of being expensed. Additionally, an allocable portion of mixed service costs — including accounting, warehousing, legal, and security costs — must be added to the basis of the affected property. The costs allocated by the UNICAP rules are eventually recovered through depreciation, amortization, or from the disposition of the property, usually through sales. However, some costs are specifically excluded from the UNICAP rules, so the business must 1st determine which costs are subject to the UNICAP rules, then take the steps necessary to add the allocable portion of those costs to the basis of the relevant property. For many affected businesses, this will involve adding the costs to the cost of inventory.

Fortunately, most small businesses will not have to worry about the complex UNICAP rules, primarily because of these exceptions:

Additional exceptions exist for some types of farming and other businesses.

A business subject to the uniform capitalization rules will incur temporary differences between book and taxable income, because under regular financial accounting, indirect costs are expensed rather than capitalized, so temporary differences due to the UNICAP rules will only reverse when the property is disposed of.

Under the 2017 Tax Cuts and Jobs Act, the gross receipts test to use the cash method of accounting also applies to farm C corporations and farm partnerships with a C corporation as a partner.

Businesses satisfying the small business exemption exception are no longer required to keep inventories, to use the percentage of completion method, or to use the uniform capitalization rules.