Accounting Methods: Cash, Accrual, and Hybrid
Accounting methods are the means of recording when income is received and expenses are paid so that profit can be determined for a specific time period, called the accounting period. It is the means by which a business can measure its own success and by which the tax authorities can determine taxable income. Tax law restricts the choice of accounting methods and accounting periods for specific business entities.
One requirement of any accounting method is that it must accurately reflect income. IRC §446(b) gives the IRS broad authority to determine whether the accounting method used clearly reflects income. If not, then the IRS may calculate tax liability for a taxpayer under an accounting method the IRS deems more accurate.
Once an accounting method is chosen, a business can only change it with the consent of the IRS. The taxpayer must request 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. However, 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 $26 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:
- cash receipts and disbursements method
- 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 also prohibited from using the cash method. However, the prohibition against using the cash method has some exceptions:
- Personal service corporations are permitted to use the cash method of accounting.
- There is also a small business exception for businesses that meet the gross receipts test, having an average annual gross receipt not exceeding $26,000,000 in at least 1 of the 3 previous tax years.
- A small inventory-based business exception allows businesses with inventories that meet the gross receipts test to use the cash method. The small business may treat inventories as non-incidental materials and supplies in the year they are used, consumed, or sold as part of the finished product.
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 its tendency to understate income and overstate expenses, when assessing income or expenses that involves some judgment. However, tax authorities have a different objective, since understating income or overstating expenses lowers taxable income. Hence, tax law modifies the procedures that must be used in financial accounting to prevent the understatement of income or overstatement of expenses. This modification of financial accounting is known as 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, then 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. 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. 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 title of the property to the buyer. However, if there is a dispute as to the payment, then the income does not have to be reported until it is actually received, since the amount of the receipts cannot be determined with reasonable accuracy. Likewise, expenses are reported when they are incurred rather than when they are paid. However, there is an exception for recurring items, which are expenses paid for specific types of items regularly, which allows the business to deduct the expenses when accrued, even though economic performance has not been completed.
Businesses that sell gift cards do not have to report the income until the cards are redeemed. If a gift card is given in exchange for a return of merchandise, then 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 following tax year of 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 ½ of that income for the current tax year and ½ of the income for the next tax year. However, if the customer prepaid a 24-month contract in June 2019, then the corporation must recognize the entire amount in the year received, since, by the end of 2020, there will still be unearned income from services provided in 2021.
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 cannot be deducted until they are actually paid. Related parties include family members, business entities where the taxpayer owns a significant interest, or, if the taxpayer is a corporation, then 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, then 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, then the taxpayer can elect to deduct ½ of that, or $5000, in the year of the payment and the remaining $5000 in the following 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.
Although 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 also be used by a taxpayer for personal items and a business, or for 2 or more businesses, as long as 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, then 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 — which includes accounting, warehousing, legal, and security costs — must also 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:
- if personal property is acquired for resale, then the business is exempt if its annual gross receipts — averaged over the shorter of the previous 3 years or the business's existence — do not exceed $26,000,000;
- if the indirect costs of producing the property do not exceed $200,000; or
- the business does not have an inventory and uses the cash method of accounting.
There are additional exceptions for some types of farming and other businesses.
If a business is subject to the uniform capitalization rules, then it 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. For more information, see Capitalization Period of Direct and Indirect Costs.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the gross receipts test has been increased to $26 million to use the cash method of accounting, and this 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, use the percentage of completion method, or need to use the uniform capitalization rules.