The Internal Revenue Service advises that each taxpayer (business or individual) must figure taxable income on an annual accounting period called a tax year. The calendar year is the most common tax year. Other tax years include fiscal, 52-53-week, and short tax years.
For information on how to choose your tax year, refer to Accounting Periods in IRS Publication 538.
Each taxpayer must use a consistent accounting method, which is a set of rules for determining how and when to report income and expenses. The most commonly used accounting methods are the cash method and the accrual method. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses in the tax year you incur them, regardless of when payment is made.
Cash Method Example
Frances Jones, a consultant, received a $10,000 payment on a contract in December. Although she wanted to hold the check until January to defer paying taxes on the payment to the following tax year, she must include it in the current year’s income because it was paid in the current year.
Accrual Method Example
James owns a local gym. He uses a calendar tax year and the accrual method of accounting. He sells a $600 contract for six consecutive months of personal training starting in November and is paid the full $600 in November. He includes $200 of the payment in his current-year taxes and defers the remaining $400 to the following year, when he will complete the contract. Refer to Accounting Methods, in IRS Publication 538, for information on how to choose your accounting method.
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales.
Changing Your Accounting Method
Once you have set up your accounting method and filed your first return, you must generally get IRS approval to change the method. If your current method clearly shows your income, the IRS will weigh the need for consistency in reporting against the need for change.
For additional information on accounting methods, refer to IRS Publication 538, Accounting Periods and Methods.
Read the following articles from the IRS website on cash vs. accrual accounting: