Accounting Methods

An accounting method is set of rules to determine when income and expenses are reported. A taxpayer chooses an accounting method upon filing of the intial tax return for an entity. The cash method is the most common, however if a business keeps an inventory it must use the accrual method for sales and purchases. With the cash method, income is reported when the taxpayer actually or constructively receives income.

The accrual method of accounting reports income in the year earned and deducts or capitalizes expenses in the year incurred. The purpose of the accrual method is to match income and related expenses in the same year. With the accrual method, income is recognized when the payment is received, income amount is due to the taxpayer, taxpayer earns the income, or the property title has passed. For instance a taxpayer can record income on the accrual method months before the cash is received (especially is nice to smooth earnings) with accounts receivable. Accounts receivable are a current asset, the debit on the balance sheet for amounts credited to revenue. However, transactions amount paid to related parties on the cash method must handled on the cash basis. For tax purposes an company will make an M-1 adjustment for this if the transaction laps the tax year.