"Cash method accounting" refers to recording an item of income or expense when it is paid. Cash method does not literally mean only receipt or use of actual dollars. It covers any kind of payment including:
- Credit cards
Most businesses selling services use cash method accounting for income and expenses. Under cash method accounting, one simply reports income in the year received and expense income in the year paid. Most small businesses and individuals use this method of accounting.
Are There Any Income Tax Issues with Cash Method Accounting?
There are a few special federal income tax rules to watch out for. One is the legal doctrine of "constructive receipt," which requires counting some items as income before they are actually received. This means an individual has income, for tax purposes, as soon as it is available or credited to their account, even if they don’t immediately accept it.
On the other hand, under cash method accounting, and individual is not allowed to take a deduction in the current year for items paid for but not yet received. Thus, taxpayers should be particularly aware of end of the year income and expenses.
What Is Accrual Method Accounting?
With accrual accounting, income is treated as received when it is earned, regardless of when it is actually received. On the other hand, an expense is recorded at the time the obligation to pay arose, and not necessarily when it is actually paid. Corporations, manufacturers, and businesses with inventories of goods prefer to use this method
Are There Any Income Tax Issues with Accrual Method Accounting?
Accrued income and expenses must meet what the IRS calls the "all events test" to become fixed. This means that all events required to secure a right to receive payment or to cause a liability for the expense, must have happened. At that point in time the income or expense becomes "fixed," as if it actually happened, whether or not any cash has changed hands.
Do I Need a Lawyer?
Accounting and tax issues can quickly become very complicated, particularly for businesses that frequently deal in large amounts of goods. If you are an inventory business, you should consider hiring the services of an accountant and a tax attorney. The accountant can help you set up and maintain streamlined accounting and inventory systems, and a tax lawyer can help you choose the right accounting method, and help you make sure you are reporting your income properly. Additionally, should you fall into trouble with the tax authority, an attorney is best suited to help you get out of trouble.