2. Accounting Periods and Methods

Introduction

You must figure your taxable income and file an income tax return for an annual accounting period called a tax year. Also, you must consistently use an accounting method that clearly shows your income and expenses for the tax year.

Useful Items You may want to see:

Publication

• 538   Accounting Periods and Methods

See chapter 12 for information about getting publications and forms.

Accounting Periods

When preparing a statement of income and expenses (generally your income tax return), you must use your books and records for a specific interval of time called an accounting period. The annual accounting period for your income tax return is called a tax year. You can use one of the following tax years.

• A calendar tax year.
• A fiscal tax year.

Unless you have a required tax year, you adopt a tax year by filing your first income tax return using that tax year. A required tax year is a tax year required under the Internal Revenue Code and the Income tax Regulations.

Calendar tax year.   A calendar tax year is 12 consecutive months beginning January 1 and ending December 31.

You must adopt the calendar tax year if any of the following apply.

• You do not keep adequate records.
• You have no annual accounting period.
• Your present tax year does not qualify as a fiscal year.
• You must use the tax year required under the Internal Revenue Code and Income Tax Regulations.

If you filed your first income tax return using the calendar tax year and you later begin business as a sole proprietor, you must continue to use the calendar tax year unless you get IRS approval to change it. See Change in tax year, later.

If you adopt the calendar tax year, you must maintain your books and records and report your income and expenses for the period from January 1 through December 31 of each year.

Fiscal tax year.   A fiscal tax year is 12 consecutive months ending on the last day of any month except December. A 52-53 week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not have to end on the last day of a month.

If you adopt a fiscal tax year, you must maintain your books and records and report your income and expenses using the same type of tax year.

For more information on a fiscal tax year, including a 52-53 week tax year, see Publication 538.

Change in tax year.   Once you have chosen your tax year, you must, with certain exceptions, get IRS approval to change it. To get approval, you must file Form 1128, Application To Adopt, Change, or Retain a Tax Year. You may have to pay a fee. For more information, see the form instructions.

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, 2001, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 2002. You must include the amount of the check in income for 2002.

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 2002. You do not withdraw it or enter it into your passbook until 2003. You must include it in your gross income for 2002.

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 2002. She was told in December that her payment was available. At her request, she was not paid until January 2003. She must include this payment in her 2002 income because it was constructively received in 2002.

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, 2002, from a patient. She could not deposit the check in her business account until January 2, 2003. She must include this fee in her income for 2002.

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 2002 for a business insurance policy effective for one year, beginning July 1. You can deduct $500 in 2002 and $500 in 2003.

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, 2002. You billed the customer in the first week of January 2003, but you did not receive payment until February 2003. You must include the amount received for the computer in your 2002 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 2002. You receive the supplies and the bill in December, but you pay the bill in January 2003. You can deduct the expense in 2002 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 2002, even if the supplies are not delivered until 2003 (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. The following taxpayers can use the cash method of accounting even if they produce, purchase, or sell merchandise. These taxpayers can also choose to not keep an inventory, even if they do not change to the cash method.

1. A qualifying taxpayer.
2. A qualifying small business taxpayer.

For a qualifying small business taxpayer, these rules apply to an eligible business (defined later).

Qualifying taxpayer.   You are a qualifying taxpayer only if you meet the gross receipts test for each prior tax year ending after December 16, 1998. To meet the test for a prior tax year, your average annual gross receipts must be $1,000,000 or less for the 3 tax years ending with the prior tax year. For example, you must test 1998, 1999, 2000, and 2001 to see if you are a qualifying taxpayer that can use the cash method and choose to not keep an inventory for 2002. Use Table 2-1 to determine if you are a qualifying taxpayer for 2002.

Table 2-1. Are You a Qualifying Taxpayer for 2002?

a) Are your average annual gross receipts $1,000,000 or less for each 3-year period below?			b) Do you meet the test in a) for each tax year below?
(1)	(2)	(3)	Test Year
1999	2000	2001	2001
1998	1999	2000	2000
1997	1998	1999	1999
1996	1997	1998	1998
c) If your answer is Yes to a) and b), you are a qualifying taxpayer for 2002.

Qualifying small business taxpayer.   You are a qualifying small business taxpayer for your eligible business only if you meet the gross receipts test for each prior tax year ending on or after December 31, 2000. To meet the test for a prior tax year, your average annual gross receipts must be $10,000,000 or less for the 3 tax years ending with the prior tax year. For example, you must test 2000 and 2001 to see if you are a qualifying small business taxpayer that can use the cash method for your eligible business and choose to not keep an inventory for 2002. Use Table 2-2 to determine if you are a qualifying small business taxpayer for your eligible business for 2002.

Table 2-2. Are You a Qualifying Small Business Taxpayer for Your Eligible Business for 2002?

a) Are your average annual gross receipts $10,000,000 or less for each 3-year period below?			b) Do you meet the test in a) for each tax year below?
(1)	(2)	(3)	Test Year
1999	2000	2001	2001
1998	1999	2000	2000
c) If your answer is Yes to a) and b), you are a qualifying small business taxpayer for your eligible business for 2002.

Eligible business.   An eligible business is any business for which a qualified small business taxpayer can use the cash method and choose to not keep an inventory. You have an eligible business if you meet any of the following requirements and did not previously change (and were not required to change) from the cash method to an accrual method for any business as a result of becoming ineligible to use the cash method.

1. Your principal business activity is described in a North American Industry Classification System (NAICS) code other than any of the following.
   1. NAICS codes 211 and 212 (mining activities).
   2. NAICS codes 31-33 (manufacturing).
   3. NAICS code 42 (wholesale trade).
   4. NAICS codes 44-45 (retail trade).
   5. NAICS codes 5111 and 5122 (information industries).
2. Your principal business activity is the provision of services, including the provision of property incident to those services.
3. Your principal business activity is the fabrication or modification of tangible personal property upon demand in accordance with customer design or specifications.

Information about the NAICS codes can be found at www.census.gov.

Business not owned or not in existence for 3 years.   If you did not own your business for all of the 3-tax-year period used in figuring your average annual gross receipts, include the period of any predecessor. If your business has not been in existence for the 3-tax-year period, base your average on the period it has existed including any short tax years, annualizing the short tax year's gross receipts.

Not keeping an inventory.   If you choose to not keep an inventory, you will deduct the cost of the items you would otherwise include in inventory in the year you sell the items, or the year you pay for them, whichever is later. If you are a producer, you can use any reasonable method to estimate the raw material in your work in process and finished goods on hand at the end of the year to determine the raw material used to produce finished goods that were sold during the year.

Changing methods.   If you are a qualifying taxpayer or small business taxpayer and want to change to the cash method, you must file Form 3115, Application for Change in Accounting Method. For an automatic change in accounting method, you must follow the provisions in Revenue Procedure 2002-9 in Internal Revenue Bulletin 2002-3, as modified by Revenue Procedure 2002-28, in Internal Revenue Bulletin 2002-18, and Revenue Procedure 2002-19, in Internal Revenue Bulletin 2002-13. For additional guidance, see the provisions in Revenue Procedure 2001-10 if you are a qualifying taxpayer and Revenue Procedure 2002-28 if you are a qualifying small business taxpayer. Those provisions also apply if you no longer want to keep inventories. You may file one Form 3115 if you choose to make both changes.

More information.   For more information about the qualifying taxpayer exception, see Revenue Procedure 2001-10 in Internal Revenue Bulletin 2001-2. For more information about the qualifying small business taxpayer exception, see Revenue Procedure 2002-28 in Internal Revenue Bulletin 2002-18.

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.

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