Choosing an Accounting Method
You choose an accounting method for your business when you file your first income tax return.
An accounting method is a set of rules used to determine when and how income and expenses are reported. There are two basic accounting methods.
Cash method - Under the cash method, you report income in the tax year you receive it. You usually deduct or capitalize expenses in the tax year you pay them.
Accrual method - Under an accrual method, you generally report income in the tax year you earn it, even though you may receive payment in a later year. You deduct or capitalize expenses in the tax year you incur them, whether or not you pay them that year.
Method Most Advantageous for You
If you need inventories to show income correctly, you must generally use an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale.
Certain small business taxpayers may be eligible to adopt or change to the cash method of accounting and may not be required to account for inventories.
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. In general, any accounting method that consistently uses accounting principles suitable for your trade or business clearly shows income. An accounting method clearly shows income only if it treats all items of gross income and expense the same from year to year.
If You Own More Than One Business
When you own more than one business, you can use a different accounting method for each business if the method you use for each clearly shows your income. You must keep a complete and separate set of books and records for each business.
Changing Your Method of Accounting
Once you have set up your accounting method, you must get IRS approval before you can change to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the treatment of any material item.
Historically, a taxpayer has been required to use an accrual accounting method with regard to purchases and sales of merchandise whenever the taxpayer was required to account for inventories. In Revenue Procedure 2001-10, 2001-1 C.B. 272 and Revenue Procedure 2002-28, 2002-1 C.B. 815, the Commissioner has exempted some qualifying taxpayers from having to use an accrual accounting method and from having to account for inventories.
Revenue Procedure 2001-10 is available for use by "qualifying taxpayers." A qualifying taxpayer is a taxpayer (1) who has average annual gross receipts of $1,000,000 or less and (2) who is not a tax shelter within the meaning of Internal Revenue Code Section 448(a)(3).
Revenue Procedure 2002-28, exempts
"qualifying small business
taxpayers" from the requirements to
use the accrual accounting method
and permits treatment of inventorial
items as materials and supplies that
are not incidental. You are a
qualifying small business taxpayer
if your average annual gross
receipts are in excess of $1,000,000
but are not more than $10,000,000,
and your principle business activity
is an eligible business. Review
Sections 3 and 4 of Revenue
Procedure 2002-28 for the
qualification requirements or