Accounting Periods
and Methods

All income tax returns are prepared using an accounting period (tax year) and an accounting method.

Accounting Periods

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

• A calendar year, which begins on January 1 and ends on December 31.
• A fiscal year (including a period of 52 or 53 weeks). A regular fiscal year is 12 consecutive months ending on the last day of any month except December.

You generally adopt a tax year by filing your first income tax return using that tax year. If you filed your first return as a wage earner using the calendar year and you later start your own business, you must continue to use the calendar year as your business tax year. You generally cannot change your tax year without IRS approval. For more information, see Publication 538.

Accounting Methods

An accounting method is a set of rules used to determine when and how income and expenses are reported. You must use the same accounting method from year to year. The two most common accounting methods are the cash method and an accrual method. A third method, called a hybrid method, is generally a combination of cash and accrual.

The text and examples in this publication generally assume you use the calendar year as your tax year and either the cash or hybrid method as your accounting method. Generally, if inventories are needed to account for your income, you must use an accrual method, discussed later, for your sales and purchases. However, if you are a qualifying taxpayer or a qualifying small business taxpayer, you can use the cash method of accounting, even if you purchase or sell merchandise. You also can choose to not keep an inventory, even if you do not change to the cash method. For more information, including definitions of a qualifying taxpayer and a qualifying small business taxpayer, see Publication 538.

Cash method.   Under the cash method, you report income in the year it is received, credited to your account, or made available to you on demand. You need not have physical possession of it. You deduct expenses in the year you pay them, even if they were incurred in an earlier year.

Check received.   If you receive a check before the end of the tax year, you must include it in income for the year you receive it even though you do not cash or deposit it until the next year.

Accrual method.   Under an accrual method, you generally report income in the tax year when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy. Generally, you deduct or capitalize business expenses when you become liable for them, whether or not you pay them in the same year.

Prepaid expenses.   Expenses paid in advance generally can only be deducted in the year to which they apply under either the cash or an accrual method. (However, see Exception for recurring items under Accrual Method in Publication 538.) For example, suppose you have a subscription to a direct-selling journal that runs out at the end of 2002. It will cost you $30 to renew the subscription for one year or $54 for 2 years. You decide to renew for 2 years and mail your check at the end of November 2002. You cannot deduct the $54 on your 2002 return. However, you can deduct half of the $54 in 2003 and the other half in 2004.

Business Income

You must report all income you receive as a direct seller. This includes any of the following.

• Income from sales - payments you receive from customers for products they buy from you.
• Commissions, bonuses, or percentages you receive for sales and the sales of others who work under you.
• Prizes, awards, and gifts you receive from your selling business.

You must report this income regardless of whether it is reported to you on an information return.

Income From Sales

You have income from sales if your customers buy directly from you and you buy the products you sell from a company (or another direct seller).

If some of your customers buy their products directly from the company, you, as the sales agent, do not have any sales income from these transactions. You will generally receive a commission or bonus for making the sale, but you will have no direct income from the sale itself. If all of your sales are handled this way, the rules in this section do not apply to you. Report your commissions as other business income. For more information, see Other Income, later.

Depending on the company with which you are affiliated and the nature of its marketing and compensation plan, you may have income from sales, commissions, bonuses, or all three.

Example 1.   Your customers pay you the retail price for goods they order. You forward the orders and payments to the company. The company sends the merchandise to fill the orders. The company also sends you a commission.

You are acting as a sales agent for the company. You did not purchase the products to sell to your customers. Your payment from the company is commission income, not income from sales. Include the commission in your gross receipts. The amount your customers pay for the goods they order is not included in income.

Example 2.   Your customers pay you a deposit when you take their orders. You send the orders to the company, but keep the deposits for yourself. The company fills the orders by shipping the merchandise to your customers. Your customers pay the company the remainder of the retail price (usually cash on delivery).

You are acting as a sales agent for the company. The deposit is your commission income. You have no income from sales.

Example 3.   Your customers pay you for the goods you sell them, either when you take their orders or when you make deliveries. After your customers place orders, you order the goods from the company (or from a direct seller you work under). You either send the money directly to the company with your orders, or you are billed later. In either case, you are able to charge your customers more than you pay for the goods.

You are buying products wholesale and selling them retail. The full amount received from your customers is income from sales.

Example 4.   You keep a supply of goods that your customers regularly buy from you. This allows you to fill their orders without delay. You order and pay for the goods before your customers request them.

You have purchased goods to resell to customers. The full amount received from your customers is income from sales.

Example 5.   You have recruited several other direct sellers who order their products through you. Commissions or bonuses paid to you by the company are shared with the direct sellers in your group based on sales, purchases, or some other formula established by the company whose products you sell. You keep the portion of the commissions you are not required to distribute to the direct sellers in your group.

The bonuses you receive from the company are included in income as commissions, not as income from sales.

Gross Profit

Gross receipts minus cost of goods sold equals gross profit.

If you have income from sales and you are filing Schedule C, Form 1040, figure your gross profit and the income to report by following these steps.

1. Figure the total your customers paid you during the year for goods you sold them. Include this in the gross receipts you report on line 1 of Schedule C.
2. Subtract the amount (if any) your customers paid that you had to return in the form of refunds, rebates, or other allowances. Show this on line 2 of Schedule C.
3. Finally, subtract the cost of the goods sold (line 4 of Schedule C). To figure the cost of goods sold, you must know the value of the inventory at the beginning and end of the year, and your purchases during the year. See Cost of Goods Sold, next, and Inventory, later.

Cost of Goods Sold

To figure your cost of goods sold, follow these steps.

1. Start with the value of your inventory at the beginning of the tax year. This is usually the same as the value of your inventory at the end of the previous year. Valuing inventory is discussed later under Inventory.
2. Add to your beginning inventory the cost of merchandise you bought during the year to sell to customers. This does not include the cost of merchandise you bought for your own use.
3. Subtract from this total the inventory on hand at the end of the year. The difference is your cost of goods sold during the year.

Example 1.   Janet sells cookware on the sales-party plan. On December 31, 2001, she did not have any cookware on hand to sell to customers. She does not have a beginning inventory for 2002.

During the year, Janet spent $5,270 on goods in her product line. Of this amount, $130 was for cookware sets she gave for personal gifts and $40 was for a set for her own use. She purchased $5,100 [$5,270 - ($130 + $40)] worth of goods to sell to customers.

On December 31, 2002, Janet had several sets of cookware in boxes for delivery to customers. The cost of these sets was $220. Her ending inventory for the year is $220, and her cost of goods sold for 2002 is $4,880 ($0 beginning inventory + $5,100 purchases - $220 ending inventory).

Example 2.   Lisa is a direct seller of cosmetics. She has an established clientele and knows what items are steady sellers. When the company has a special sale on these items, she buys extra quantities for future sales. She had merchandise costing $200 on hand at the end of 2001 (which would be her beginning inventory for 2002) and merchandise costing $175 at the end of 2002. During the year she purchased $3,250 of merchandise. Purchase returns and allowances were $50. She withdrew $200 of cosmetics for personal use. Lisa figures her cost of goods sold for 2002 as follows:

Beginning inventory			$200
Add:	Merchandise purchased during the year	$3,250
Subtract:	Purchase returns and allowances	50
Subtract:	Goods withdrawn for personal use	200	3,000
Goods available for sale			$3,200
Subtract:	Ending inventory		175
Cost of goods sold			$3,025

Lisa figures her gross profit by subtracting the cost of goods sold from her gross receipts ($5,375) for the year as follows:

Gross receipts	$5,375
Minus: Cost of goods sold	3,025
Gross profit	$2,350

Purchases.   When figuring cost of goods sold, include the full cost of all merchandise you buy to sell to customers. This cost includes all postage and freight charges incurred.

Figure your purchases at the actual price you pay. Deduct a cash discount or a trade discount in figuring the cost of your purchases. A cash discount or a trade discount is the difference between the invoice price and the actual price you have to pay.

Purchase returns and allowances.   Subtract purchase returns and allowances from your total purchases for the year when figuring cost of goods sold. This includes any rebates or refunds you received off the purchase price. It also includes any credit you received for returned merchandise.

Personal withdrawals.   Subtract from your purchases for the year the cost of goods in your product line that you bought for personal use and the cost of goods you withdrew from inventory. Merchandise is considered withdrawn from inventory when it is no longer available for sale to customers. For example, if you sell a particular kind of soap and give some as a gift or use some yourself, you must withdraw the soap from inventory because it is no longer available for sale. Follow this procedure for all products withdrawn for personal use, even if you are using the product only to familiarize yourself with its characteristics or to demonstrate loyalty to the company whose products you sell.

Inventory

Many direct sellers have little or no inventory. Others keep a considerable inventory on hand. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. However, see Qualifying taxpayer and Qualifying small business taxpayer in the discussion on exceptions under Inventories in Publication 538.

If you have income from sales, you need to know how to figure your inventory at the end of each tax year. Your inventory practices must be consistent from year to year.

Figuring inventory involves:

1. Taking inventory,
2. Identifying the cost, and
3. Valuing the inventory.

You need to know your inventory at the beginning and end of each tax year to figure your cost of goods sold. Beginning inventory will usually be the same as the prior year's ending inventory. Any differences must be explained in a schedule attached to your return. Taking inventory.   The first step is to identify and count all merchandise in your inventory. Include all goods to which you have title at the end of the year. This generally will be any goods you have on hand and have not yet sold to customers.

Include merchandise you have purchased, even if you have not yet physically received the goods. You may also have title to goods that were shipped to you but not yet received. If the risk of loss during shipment is yours, you will probably have title to the goods during shipment. If you buy merchandise that is sent C.O.D., title passes when payment and delivery occur.

Goods not yet paid for.   You may have title to goods purchased but not yet paid for. If you are billed for merchandise, you must usually pay the bill within a certain time. In this case, you have title to the goods and must include them in inventory, provided they are not sold by the end of the year.

Consignments.   Merchandise you receive on consignment is not purchased by you and is never included in your inventory. You have merchandise on consignment if you do not have to pay for what you have in stock until the time you sell it and collect the retail price from the customer.

Identifying the cost.   The second step in figuring your inventory is to identify the cost of inventory items. Use the specific identification method when you can identify and match the actual cost to the items in inventory. Most direct sellers will be able to use this method.

If you cannot identify specific items with their invoices, you must make an assumption about which items were sold during the year and which remain. Make this assumption using either the first-in first-out (FIFO) method or the last-in first-out (LIFO) method.

The FIFO method assumes that the first items you purchased or produced are the first items you sold, consumed, or otherwise disposed of.

The LIFO method assumes that the last items that you purchased are sold, consumed, or otherwise disposed of first.

Valuing the inventory.   The third step in figuring your inventory is to value the items you have in inventory. The value of your inventory is a major factor in figuring your taxable income. The method you use is very important.

The two most common methods to value non-LIFO inventory are the cost method and the lower of cost or market method. LIFO inventory may only be valued at cost.

Cost method.   If you use the cost method to value your inventory items, the value of each item is usually its invoice price. Add transportation, shipping, and other necessary costs to acquire the items. Subtract any discounts you received.

Lower of cost or market method.   See Publication 538 for a discussion of the lower of cost or market method.

New business.   For a new business not using LIFO, you may choose either method to value your inventory. You must use the same method to value your entire inventory, and you cannot change the method without first obtaining IRS approval.

Other Income

You must report on your tax return all income you receive from your business unless it is excluded by law. In most cases, your business income will be in the form of cash, checks, and credit card charges. But business income can be in other forms, such as property or services. These and other types of income are explained next.

Commissions, bonuses, and percentages.   Many direct sellers receive a commission on their sales or purchases. Your commission might be called a bonus or percentage, and it might be based on both your own sales and the sales of other direct sellers working under you, or on purchases from the company with which you are affiliated.

Report the full amount of any commissions you receive as business income, even if you pay part of it to other direct sellers working under you. You can usually deduct the part you pay to others as a business expense. For more information, see Commissions under Other Expenses, later.

Prizes, awards, and gifts.   If you receive prizes, awards, or gifts in your role as a direct seller, report their full value as business income. The following are examples of items that must be included in income.

• Cash.
• Free merchandise.
• Expense-paid trips.
• Use of a car.
• Jewelry signifying your level of achievement as a direct seller.
• Membership in organizations or clubs.
• Tickets to sporting events, shows, or concerts.

Value of goods or services received.   Report income received in the form of goods or services at their fair market value. Fair market value is the price agreed on between a willing buyer and a willing seller when both have reasonable knowledge of the facts and neither is forced to buy or sell.

Value of use of property.   If you receive the free use of property through your direct-sales performance, you must include the fair market value of the use of the property in your business income. There are special rules for the free use of an automobile and certain other property. For more information, see Publication 525.

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