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.
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You sold a big-screen television for $800 in
December of 2001. You sent out bill in January
of 2002 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
$800 of income in 2001, because that is when all
events establishing your right to the income
took place. You would reduce your 2002 income by
$50 to reflect the lower payment you actually
received.
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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.
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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.
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Who must use accrual? Most types of businesses 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.
At the end of 2001, the IRS issued new rules allowing certain
small service businesses that also sell related products and
have average annual gross receipts under $10 million for the
previous three year period to 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 principal business activity is not retailing,
wholesaling, manufacturing, mining, publishing or sound
recording, determined by reference to the codes in the North
American Industry Classification System published by the
Department of Commerce
- the principal business activity is the provision of
services, even if the taxpayer is providing property
incident to the services
- the principal business activity is custom manufacturing
- 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 put off payment 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.
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