Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. The term "accounting method" includes not only the overall method of accounting you use, but also the accounting treatment you use for any material item.

You choose your method of accounting when you file your first tax return. If you want to change your accounting method after that, you must get IRS approval. See Change in Accounting Method, later.

No single accounting method is required of all taxpayers. You must use a system that clearly shows 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.

You must use the same accounting method from year to year. An accounting method clearly shows income only if all items of gross income and all expenses are treated the same from year to year.

If you do not regularly use an accounting method that clearly shows your income, your income will be figured under the method that, in the opinion of the IRS, clearly shows your income.

Methods you can use. Subject to the preceding rules, you can compute your taxable income under any of the following accounting methods.

1. Cash method.
2. Accrual method.
3. Special methods of accounting for certain items of income and expenses.
4. Combination (hybrid) method using elements of two or more of the above.

The cash and accrual methods of accounting are explained later.

Special methods. This publication does not discuss special methods of accounting for certain items of income or expenses. For information on reporting income using one of the long-term contract methods, see section 460 and its regulations, and section 1.451-3 of the regulations. Publication 535, Business Expenses, discusses methods for deducting amortization and depletion. The following publications also discuss special methods of reporting income or expenses.

1. Publication 225, Farmer's Tax Guide.
2. Publication 537, Installment Sales.
3. Publication 946, How To Depreciate Property.

Combination (hybrid) method. Generally, you can use any combination of cash, accrual, and special methods of accounting if the combination clearly shows income and you use it consistently. However, the following restrictions apply.

1. If an inventory is necessary to account for your income, you must use an accrual method for purchases and sales. You can use the cash method for all other items of income and expenses. See Inventories, later.
2. If you use the cash method for figuring your income, you must use the cash method for reporting your expenses.
3. If you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income.
4. Any combination that includes the cash method is treated as the cash method.

Business and personal items. You can account for business and personal items under different accounting methods. For example, you can figure your business income under an accrual method, even if you use the cash method to figure personal items.

Two or more businesses. If you operate two or more separate and distinct businesses, you can use a different accounting method for each if the method clearly reflects the income of each business. They are separate and distinct if books and records are maintained for each business.

If you use the accounting methods to create or shift profits or losses between businesses (for example, through inventory adjustments, sales, purchases, or expenses) so that income is not clearly reflected, the businesses will not be considered separate and distinct.

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