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 your accounting method when you file your first tax return. After that, if you want to change your accounting method, you must first get IRS approval. See Rimini hotel roomsChange in Accounting Method, later.

Kinds of methods. Generally, you can figure your taxable income under any of the following accounting methods.

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

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.

Cash Method

Most individuals and many sole proprietors with no inventory use the cash method of accounting. However, if an inventory is necessary to account for your income, you must use an accrual method of accounting for sales and purchases.

Income

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

Example. On December 30, 1998, Mrs. Sycamore sent you a check for interior decorating services you provided to her. You received the check on January 2, 1999. You must include the amount of the check in income for 1999.

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. You have interest credited to your bank account in December 1999. You must include it in your gross income for 1999 and not for 2000 when you withdraw it or it is entered in your passbook.

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 1999. She was told in December that her payment was available. At her request, she was not paid until January 2000. She must include this payment in her 1999 income because it was constructively received in 1999.

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, 1999, from a patient. She could not deposit the check in her business account until January 3, 2000. She must include this fee in her income for 1999.

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 (claim of right) in chapter 16 of Publication 535, Business Expenses.

Expenses

Under the cash method, you must 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 1999 for a business insurance policy that is effective for one year, beginning July 1. You can deduct $500 in 1999 and $500 in 2000.

Accrual Method

Under an accrual method of accounting, income is generally reported in the year earned and expenses are deducted or capitalized in the year incurred. The purpose of an accrual method 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, 1999. You billed the customer in the first week of January 2000, but you did not receive payment until February 2000. You must include the amount received for the computer in your 1999 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 an amount in gross income on the basis of a reasonable estimate, and you later determine the exact amount, take the difference, if any, 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, Accounting Periods and Methods. That publication also explains special rules for reporting the following types of income.

• Advance payments you get for service agreements.
• Advance payments you get 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 the following apply.

1. The all-events test has been met:
   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 use of property by you, 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 who uses an accrual method of accounting. You buy office supplies in December 1999. You received the supplies and the bill in December, but you pay the bill in January 2000. You can deduct the expense in 1999 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 1999, even if the supplies are not delivered until 2000 (when economic performance occurs).

Inventories. An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales. Inventories are discussed in chapter 6.

Special Rules 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, Accounting Periods and Methods.

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.

Caution:

Special uniform capitalization rules apply to a farming business. See chapter 7 in Publication 225, Farmer's Tax Guide.

Activities subject to the rules. You are subject to the uniform capitalization rules if you do any of the following in the course of a business or an activity carried on for profit.

1. Produce real or tangible personal property for use in the business or activity.
2. Produce real or tangible personal property for sale to customers.
3. Acquire property for resale. However, this rule does not apply to personal property if your average annual gross receipts are $10 million or less for the 3 prior tax years.

Special Methods

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

• Depreciation, discussed in Publication 946, How To Depreciate Property.
• Deduction for bad debts, discussed in chapter 14 of Publication 535, Business Expenses.
• Installment sales, discussed in Publication 537, Installment Sales.

Combination 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.

• 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 in the discussion of expenses under Accrual Method, earlier.
• 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.
• Any combination that includes the cash method is treated as the cash method.

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 not only includes a change in your overall system of accounting, but also a change in the treatment of any material item. For examples of changes that require approval and information on how to get approval for the change, see Publication 538, Accounting Periods and Methods.