Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. Your 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 an accounting method for your business when you file your first income tax return that includes a Schedule C for the business. After that, if you want to change your accounting method, you must generally get IRS approval. See Change in Accounting Method, later.

Kinds of methods. Generally, you can use any of the following accounting methods.

• Cash method.
• An accrual method.
• Special methods of accounting for certain items of income and expenses.
• Combination method using elements of two or more of the above.

You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income.

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 have 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 only if you maintain complete and separate books and records for each business.

Cash Method

Most individuals and many sole proprietors with no inventory use the cash method because they find it easier to keep cash method records. However, if an inventory is necessary to account for your income, you must generally use an accrual method of accounting for sales and purchases. See Inventories, later.

Income

Under the cash method, include in your gross income all items of income you actually or constructively receive during your tax year. If you receive property or services, you must include their fair market value in income.

Example. On December 30, 2000, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2001. You must include the amount of the check in income for 2001.

Constructive receipt. You have constructive receipt of income when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are treated as having received it when your agent received it.

Example. Interest is credited to your bank account in December 2001. You do not withdraw it or enter it into your passbook until 2002. You must include it in your gross income for 2001.

Delaying receipt of income. You cannot hold checks or postpone taking possession of similar property from one tax year to another to avoid paying tax on the income. You must report the income in the year the property is received or made available to you without restriction.

Example. Frances Jones, a service contractor, was entitled to receive a $10,000 payment on a contract in December 2001. She was told in December that her payment was available. At her request, she was not paid until January 2002. She must include this payment in her 2001 income because it was constructively received in 2001.

Checks. Receipt of a valid check by the end of the tax year is constructive receipt of income in that year, even if you cannot cash or deposit the check until the following year.

Example. Dr. Redd received a check for $500 on December 31, 2001, from a patient. She could not deposit the check in her business account until January 2, 2002. She must include this fee in her income for 2001.

Debts paid by another person or canceled. If your debts are paid by another person or are canceled by your creditors, you may have to report part or all of this debt relief as income. If you receive income in this way, you constructively receive the income when the debt is canceled or paid. See Canceled Debt under Kinds of Income in chapter 5.

Repayment of income. If you include an amount in income and in a later year you have to repay all or part of it, you can usually deduct the repayment in the year in which you make it. If the amount you repay is over $3,000, a special rule applies. For details about the special rule, see Repayments in chapter 13 of Publication 535, Business Expenses.

Expenses

Under the cash method, you generally deduct expenses in the tax year in which you actually pay them. This includes business expenses for which you contest liability. However, you may not be able to deduct an expense paid in advance or you may be required to capitalize certain costs, as explained later under Uniform Capitalization Rules.

Expenses paid in advance. You can deduct an expense you pay in advance only in the year to which it applies.

Example. You are a calendar year taxpayer and you pay $1,000 in 2001 for a business insurance policy effective for one year, beginning July 1. You can deduct $500 in 2001 and $500 in 2002.

Accrual Method

Under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year.

Income--General Rule

Under an accrual method, you generally include an amount in your gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy.

Example. You are a calendar year, accrual method taxpayer. You sold a computer on December 28, 2001. You billed the customer in the first week of January 2002, but you did not receive payment until February 2002. You must include the amount received for the computer in your 2001 income.

Income--Special Rules

The following are special rules that apply to advance payments, estimating income, and changing a payment schedule for services.

Estimated income. If you include a reasonably estimated amount in gross income, and later determine the exact amount is different, take the difference into account in the tax year in which you make the determination.

Change in payment schedule for services. If you perform services for a basic rate specified in a contract, you must accrue the income at the basic rate, even if you agree to receive payments at a lower rate until you complete the services and then receive the difference.

Advance payments for services. Generally, you report an advance payment for services to be performed in a later tax year as income in the year you receive the payment. However, if you receive an advance payment for services you agree to perform by the end of the next tax year, you can choose to postpone including the advance payment in income until the next tax year. However, you cannot postpone including any payment beyond that tax year.

For more information about reporting advance payments for services, see Publication 538. That publication also explains special rules for reporting the following types of income.

• Advance payments for service agreements.
• Advance payments under guarantee or warranty contracts.
• Prepaid interest.
• Prepaid rent.

Advance payments for sales. Special rules apply to including income from advance payments on agreements for future sales or other dispositions of goods you hold primarily for sale to your customers in the ordinary course of your business. If the advance payments are for contracts involving both the sale and service of goods, it may be necessary to treat them as two agreements. An agreement includes a gift certificate that can be redeemed for goods. Treat amounts that are due and payable as amounts you received.

You generally include an advance payment in income for the tax year in which you receive it. However, you can use an alternative method. For information about the alternative method, see Publication 538.

Expenses

Under an accrual method of accounting, you generally deduct or capitalize a business expense when both the following apply.

1. The all-events test has been met. The test has been met when:
1. All events have occurred that fix the fact of liability, and
2. The liability can be determined with reasonable accuracy.
2. Economic performance has occurred.

Economic performance. You generally cannot deduct or capitalize a business expense until economic performance occurs. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided or as the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services. An exception allows certain recurring items to be treated as incurred during a tax year even though economic performance has not occurred. For more information on economic performance, see Publication 538.

Example. You are a calendar year taxpayer and use an accrual method of accounting. You buy office supplies in December 2001. You receive the supplies and the bill in December, but you pay the bill in January 2002. You can deduct the expense in 2001 because all events that fix the fact of liability have occurred, the amount of the liability could be reasonably determined, and economic performance occurred in that year.

Your office supplies may qualify as a recurring expense. In that case, you can deduct them in 2001, even if the supplies are not delivered until 2002 (when economic performance occurs).

Keeping inventories. When the production, purchase, or sale of merchandise is an income-producing factor in your business, you must generally take inventories into account at the beginning and the end of your tax year. If you must account for an inventory, you must generally use an accrual method of accounting for your purchases and sales. For more information, see Inventories, later.

Special rule for related persons. You cannot deduct business expenses and interest owed to a related person who uses the cash method of accounting until you make the payment and the corresponding amount is includible in the related person's gross income. Determine the relationship, for this rule, as of the end of the tax year for which the expense or interest would otherwise be deductible. If a deduction is not allowed under this rule, the rule will continue to apply even if your relationship with the person ends before the expense or interest is includible in the gross income of that person.

Related persons include members of your immediate family, including only brothers and sisters (either whole or half), your spouse, ancestors, and lineal descendants. For a list of other related persons, see Publication 538.

Combination Method

You can generally use any combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. However, the following restrictions apply.

• If an inventory is necessary to account for your income, you must generally use an accrual method for purchases and sales. (See, however, Inventories, later.) You can use the cash method for all other items of income and expenses.
• If you use the cash method for figuring 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.
• If you use a combination method that includes the cash method, treat that combination method as the cash method.

Inventories

Generally, if you produce, purchase, or sell merchandise in your business, you must keep an inventory and use the accrual method for purchases and sales of merchandise. However, if you are a qualifying taxpayer, you can choose to do the following, even if you produce, purchase, or sell merchandise in your business.

• Use the cash method of accounting.
• Not keep an inventory, even if they do not change to the cash method.

You are a qualifying taxpayer only if you meet the gross receipts test for each tax year ending after December 16, 1998. Your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. You must test 1998, 1999, and 2000 to see if you qualify to use the cash method and to not keep an inventory for 2001. You qualify if your average annual gross receipts for 1996, 1997, and 1998 are $1,000,000 or less (1998 test), your average annual gross receipts for 1997, 1998, and 1999 are $1,000,000 or less (1999 test), and your average annual gross receipts for 1998, 1999, and 2000 are $1,000,000 or less (2000 test). A tax shelter cannot be a qualifying taxpayer.

For more information, see Cash Method of Accounting for Qualifying Taxpayers under Cash Method in Publication 538.

Items included in inventory. If you are required to account for inventories, include the following items when accounting for your inventory.

• Merchandise or stock in trade.
• Raw materials.
• Work in process.
• Finished products.
• Supplies that physically become a part of the item intended for sale.

Valuing inventory. You must value your inventory at the beginning and end of each tax year to determine your cost of goods sold (Schedule C, line 42). To determine the value of your inventory, you need a method for identifying the items in your inventory and a method for valuing these items.

Inventory valuation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for similar businesses and must clearly reflect income. Your inventory practices must be consistent from year to year.

More information. For more information about inventories, see Publication 538.

Uniform Capitalization Rules

Under the uniform capitalization rules, you must capitalize the direct costs and part of the indirect costs for production or resale activities. Include these costs in the basis of property you produce or acquire for resale, rather than claiming them as a current deduction. You recover the costs through depreciation, amortization, or cost of goods sold when you use, sell, or otherwise dispose of the property.

Activities subject to the rules. You are subject to the uniform capitalization rules if you do any of the following, unless the property is produced for your use other than in a business or an activity carried on for profit.

• Produce real or tangible personal property. For this purpose, tangible personal property includes a film, sound recording, video tape, book, or similar property.
• Acquire property for resale.

Exceptions. These rules do not apply to the following property.

1. Personal property you acquire for resale if your average annual gross receipts are $10 million or less.
2. Property you produce if you meet either of the following conditions.
1. Your indirect costs of producing the property are $200,000 or less.
2. You use the cash method of accounting and do not account for inventories. For more information, see Inventories, earlier.

Special Methods

There are special methods of accounting for certain items of income or expense. These include the following.

• Amortization, discussed in chapter 9 of Publication 535, Business Expenses.
• Bad debts, discussed in chapter 11 of Publication 535.
• Depletion, discussed in chapter 10 of Publication 535.
• Depreciation, discussed in Publication 946, How To Depreciate Property.
• Installment sales, discussed in Publication 537, Installment Sales.

Change in Accounting Method

Once you have set up your accounting method, you must generally get IRS approval before you can change to another method. A change in your accounting method includes a change in:

1. Your overall method, such as from cash to an accrual method, and
2. Your treatment of any material item.

To get approval, you must file Form 3115, Application for Change in Accounting Method. You may have to pay a fee. For more information, see the form instructions.

Previous| First | Next

Publication Index | IRS-Forms Main | Home