Choosing a Tax Accounting Method

Do you know that accounting method actually used on the initial return is an election of that method, so tax payers should carefully analyze financial data to ensure that the method is applied properly.

A business must use the same accounting method to figure its taxable income and to keep its books, and the method must clearly reflect its income. Understanding Accounting Methods

An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. In general, there are four types of accounting methods, which dictate how business transactions are recorded in the business financial books:

  • Cash Method – income is recognized in the year received, and expenses in the year paid.
  • Accrual Method – Income reported in year it is earned and deduct or capitalize expense in the year incurred.
  • Special Method – This method of accounting is for certain item of income or expenses and it's include for Amortization, Bad Debts, Depletion, Depreciation, Installment Sales.
  • Hybrid Method – Any combination of two or more above methods of accounting methods, if the combination clearly reflects business income and use it consistently.

Why Method Matters

The accounting method a business uses can have a major impact on total revenue the business reports as well as on expenses that it subtracts from revenue to get the bottom line. The core underlying difference between these two methods is the timing of transaction recordation. The timing difference between the two methods occurs because revenue recognition is delayed under the cash method until payments arrives in the business.

Similarly, the recognition of expenses under the cash basis can be delayed until such time as invoice paid.

BASIS FOR COMPARISON CASH ACCOUNTING ACCRUAL ACCOUNTING
Meaning The accounting method in which the income or expense is recognized only when there is actual inflow or outflow of cash. The accounting method in which the income or expense is recognized on mercantile basis.
Nature Simple Complex
Applicability of matching concept No Yes
Recognition of revenue Cash is received Revenue is earned
Recognition of expense Cash is paid Expense is incurred
Degree of Accuracy Low Comparatively high

Changing your accounting method

Generally, you can use any permitted accounting method when you file your first tax return and you don't need any IRS approval for the first time. However, you have to use the selected method consistently from year to year and it must clearly reflect your income.

Any business that wants to change its accounting method, need to take permission from IRS for change in accounting method by using Form 3115 to request a change.

A change in your accounting method includes a change not only in your overall system of accounting by also in the treatment of any material item. A material item is one that affects your income or your ability to take a deduction.

Timing and application process: Applications can be made at any time during the tax year, but the earlier the better. You may also get a six month of extension to file the application so long as your tax return for the year in which the change is requested is filed on time.

The IRS looks at two things when deciding whether or not to approve a request for a change in accounting methods:
  • Whether the new method will accurately reflect income
  • Whether the new method will create or shift profits and losses between businesses.

For any further assistance regarding Bookkeeping feel free to contact us at bopmanagers@aotax.com or Phone: 703-584-5533 Ext: 334 we will be very happy to assist you.