Accrual Method Accounting

Under the accrual method, you record business income when a sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later.

To be more precise, under the accrual method you recognize an item of income when all the events that establish your right to receive the income have happened, and when the amount of income you are to receive is known with reasonable accuracy. If you estimate an amount due to you with reasonable accuracy and record it as income, and the amount you eventually receive differs from your estimate, you should make an adjustment to your income in the year you actually receive the payment.

Example You sold a big-screen television for $3,000 in December of 2008. You sent out a bill in January of 2009 and the customer paid you later that year. However, when he got the bill, your customer pointed out that your competitor, Store X, was selling the same model for $50 less, so you adjusted your price by $50 to avoid losing the sale. Under the accrual method, you would recognize $3,000 of income in 2008, because that is when all events establishing your right to the income took place. You would reduce your 2009 income by $50 to reflect the lower payment you actually received.

The accrual method also says that you recognize an item of expense when you become liable for it, whether or not you pay for it in the same year. Becoming liable means that all events have occurred that establish your obligation, you can determine the dollar amount with reasonable accuracy, and "economic performance" has occurred. Economic performance means that the property or services have been provided or the property has been used.

Work Smart The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.

Who must use accrual? Most types of business that have inventory must use the accrual method, at least for sales and for purchases. Inventories are necessary in most marketing, manufacturing, retail, or wholesale businesses.

Certain small service businesses that also sell related products and have average annual gross receipts under $10 million for the previous three-year period may use the cash method of accounting for their income and expenses. The cash method, instead of the accrual method, can be used under the following four safe harbors:

• The taxpayer may use the cash method if its principal business activity is not retailing, wholesaling, manufacturing, mining, publishing or sound recording. The taxpayer determines its principal business activity by reference to the codes in the North American Industry Classification System, published by the Department of Commerce (www.census.gov/epcd/www/naics.html).
• The taxpayer may use the cash method if its principal business activity is the provision of services, even if the taxpayer is providing property incident to the services.
• The taxpayer may use the cash method if its principal business activity is custom manufacturing as defined in the guidance.
• Regardless of the taxpayer's primary business activity, the taxpayer may use the cash method with respect to any separate and distinct trade or business that satisfies one of the first three safe harbors.

There is also another exception for artists, authors, and photographers who sell works that they have created by their own efforts. They are not required to assign their qualified creative expenses to the particular works they have created as "cost of goods sold," which generally means they don't need to keep track of inventory costs. "Qualified creative expenses" do not include expenses related to printing, photographic plates, film, videotape, etc., so if you are involved in mass reproduction or publishing of your own creative work, you'll have to use inventory accounting for that part of your business.

C corporations with average annual cash receipts over $5 million that are not personal service corporations generally must use the accrual method. Other types of entities that must use accrual accounting are partnerships that have one or more C corporations as partners, tax shelters, and charitable trusts having unrelated business taxable income.

Hybrid methods. Since using two different accounting methods can be cumbersome, it's more practical for most businesses that carry inventory to simply use the accrual method for everything.

However, if you wish, you can use a hybrid method that uses accrual to the extent required by law, and uses cash for the remainder of your income and expenses. Consult your accountant for more details on how this would work.

Pros and cons of accrual. Even if your business does not have inventory, if you have a lot of complex transactions during the year you may find the accrual method more desirable, because expenses are deducted in the year in which the income to which they relate is reported. By using the accrual method, your net income tends to be leveled out, avoiding income "peaks" that are subject to higher tax rates.

For some business owners, the accrual method does not necessarily reduce taxes, and may create many unnecessary accounting headaches when compared with the cash method. On the other hand, most accountants feel that the accrual method is the only one that accurately reflects the true financial state of your business.

In selecting the most appropriate accounting method, there's one disadvantage of the accrual method that tax planners like to emphasize — it is more difficult to minimize taxes by shifting items of income and expense from one year to another under the accrual method. The cash-method business owner may be able to collect fees, rents, interest, and other obligations in advance or hold off collection until a later year. The cash-method owner can also usually control expenses to some extent by accelerating or deferring payment for items such as advertising, supplies, repairs, interest and taxes.

Controlling income and expenses is not nearly as easy for the accrual-method business owner. He or she can defer some income into the next tax year by shipping and invoicing as little as possible during the closing days of the year, but this may not be worth the cash-flow problem that it may cause. Or the owner can try to accelerate expenses by requesting the delivery and billing of supplies, etc., before the end of the year.