The IRS requires you to maintain consistent accounting throughout your fiscal year. You must use a method that clearly reflects your income.
When you file your first tax return, you’ll decide on an accounting method. No one method is mandatory but your method must accurately mirror your income and expenses and thus the upkeep of your records and books is crucial. Not only books, but you must maintain any documents that support the data in your books—receipts, invoices, manifests, etc.
Your accounting method must be the same every year. A change will need to be approved by the IRS. If the IRS deems your method to not clearly reflect your income, the IRS will re-figure your income based on what they say constitutes an accurate portrayal of your income, which usually means, “audit.”
There are 4 accounting methods acceptable by the IRS and the first 2 are discussed below:
- Special Methods
The cash method is the most simple of the methods and the one that is used most by small businesses—businesses with under 5$ million in yearly sales or $1 million in inventory on hand to sell within the tax year. The Cash Method is essentially, your records documented with when and how much cash is received in revenue and when and how much you pay out in expenses.
Under the Cash Method, you combine your total gross income, which includes not only cash received for goods and services sold, but also for property and services you received in exchange for goods and services using the the received property and services Fair Market Value to determine it’s monetary contribution to your total gross income.
You must also include in your gross income, income that you received “constructively.” A Constructive Receipt is when income is made available to you without any restriction but you’ve yet to take possession of it. A simple example of this is a local client says they have a check ready for you and all you have to do is pick it up. You then, hold off on picking up the check until your next tax year begins and thus, reducing your taxable income for the prior year. The IRS considers this to be part of your gross income for the year in which the client made the check available to you. You’d have to prove that you were unable to pick up the check until the next tax year in order to claim that it was income that went towards the next tax year.
Expenses are usually deducted from taxable income when they are actually paid. However, expenses paid in advance only count towards the applicable tax year. For example, if you were to buy the license to use a photo for marketing purposes and the license was good for 2 years, the expense must be capitalized—spread out over the 2 years the license is valid.
The Accrual Method is when you can assume that income will be received based on a transaction and that projected income is considered in the tax year that it was assumed (or earned). For example, you send an invoice for a delivered service that requires the payer to fulfill the invoice terms within 30 days and they pay on the 30th day and that day falls in the following tax year. This income counts towards the tax year the service was rendered regardless of whether or not the recipient has yet to pay it.
Another way of understanding the Accrual Method, the tax year the service is performed or the goods are delivered is the year the income is considered to fall under.
If you wound up receiving less from your customer than you’d estimated on this year’s return, you can take the difference out in the following year’s return. And if you agreed on a rate, you must accrue and claim that rate even if you ended up giving the client a reduced rate. Again, the difference in the rate would be deducted from the following year’s taxable income.
If you receive payment in advance, you may be able to defer that until the following year if that’s when you’re delivering the service. For example, in December, a wedding photographer that books a wedding scheduled for June the following year and takes a deposit to hold the date. The deposit can be counted towards the following tax year. However, if the photographer is so in demand she books out over a year in advance, i.e., if the service is not going to be rendered before the end of the following tax year, the wedding photographer will have to report the deposit for the year it was received.
Pros & Cons of Cash and Accrual Methods
Simply, the Cash Method of Accounting is good for showing you an accurate cash-flow but it can be misleading for the bigger picture as well as sales history. For example, by looking at the books a retailer would see January as the best month of the year and December quite dismal when actually, it’s the other way around as the business happened in December but paid for via credit card payments in January.
Conversely, the Accrual Method can show you just how much revenue is coming in “in real-time” but the actual cash in the bank is quite low because customers haven’t paid yet. If your business quickly reacts to sales trends, it’s best to have sales reporting based on the Accrual Method so you can react to the business as it happens.
Obviously, you’d want to have a handle on both methods to be a prudent manager of your business, but to the IRS, you need to pick a method that is a clear reflection of your income. So the Cash Method may be good for a business like a wedding photographer who, for the most part, has a predictable turnaround of cash. The Accrual Method may be best for businesses that have long pending times between delivered goods and services and payments received.