A business can operate under one of three methods of accounting: cash, accrual, or hybrid. Each method differs in the way income and expenses are recognized. The majority of businesses can choose the method that they prefer; however, there are some restrictions. For example, Corporations (other than S-Corporations) with annual gross income over $5 million are not allowed to use the cash method of accounting.
The Internal Revenue Service (IRS) automatically will be informed of the choice when the business files their first business tax return. Once the accounting method has been determined, the IRS must grant approval before changing the method. Form 3115, Application for Change in Accounting Method can be submitted to the IRS with the request.
Note: There is a significant user fee charged for Advanced Consent Request Procedures (up to $7,000, depending upon the gross income of the business and scope of change). No user fees are charged for changes that qualify under the Automatic Change Request Procedures. Details on these two procedures are included with the instructions for Form 3115. Rates are explained in the Internal Revenue Bulletin 2012-1 dated January 3, 2012.
When utilizing the cash method of accounting, businesses report the income when it is actually received and expenses when they are actually paid. The cash basis is the most common and easiest method of accounting for business transactions. A check from a customer that was received or that was made available before the end of the tax year is considered income constructively received in that year, even if the check is not cashed or deposited into a bank account until the following year. Payments follow a similar format. When issuing a check to pay for a business item, it becomes an expense for the year in which the check was written, not when it clears the bank.
When operating under the accrual method, income must be reported as earned, even when it has not been physically received. Expenses may be used to offset income when the actual payment has not been made. Under this method, accounts receivable and accounts payable must be maintained in order to determine these balances. When the business sends an invoice to a customer, the business must report the income as being earned at that point in time even though no money traded hands. Likewise, business owners incur expenses when the transaction happens, not necessarily when the expense is paid for.
The hybrid method offers a combination of cash and accrual systems. Most businesses will operate under cash or accrual, but this is another option to be considered as long as it accurately reflects income and expenses.
Let’s look at a hypothetical transaction:
Abby operates an advertising agency. She just completed a project for a client, and is ready to be paid for her services. At what point would she consider this income?
Under the cash method, Abby would record the income when the client pays her invoice.
Under the accrual method, Abby would record the income as soon as she performs the service and invoices her client.
When Abby needs office supplies, she orders them through a local company. When should she record this expense?
Under the cash method, she would not record the supplies as an expense until she pays for them.
Under the accrual method, she would record the supplies as an expense when they are delivered to her.
Considerations when selecting an accounting method:
|Income Recognized||Upon receipt||When earned|
|Expenses Recognized||When paid||When incurred|
|Ease of Use||Simple||Complex|
|Recordkeeping time||Minimal||More time involved|
|Use with inventory||No (although some exceptions)||Yes|
|Use with accounts payable & receivable||No||Yes|