The cash method of accounting is very simple to use, because it's usually obvious when you receive money from a customer or other payer, or when you pay an expense with cash, credit card or a check. When money comes in or goes out, it's recorded and recognized for tax purposes. By contrast, the accrual method requires you to recognize transactions when they occur, not necessarily when the cash changes hands.

 

Work Smart Although the accrual method gives you a more accurate picture of your financial situation than the cash method, the accrual method can also be very complicated. Small service-oriented businesses have especially complained for some time that they have been burdened with using the accrual method to account for materials and other goods provided to customers in conjunction with their services (e.g., plumbing fixtures installed by plumbers; shingles put on by roofers). Fortunately, beginning in 2001, the IRS will allow small service businesses that also sell related products and have average annual gross receipts under $10 million to use the cash method of accounting for their income and expenses. The major requirement to qualify for this relief is that the principal business activity (i.e., over half of the gross receipts) must be the provision of services.

However, as you would expect, there are a few complicating factors to remember. For one thing, even if you are paid in the form of property or services instead of money, or if you pay some of your own debts through some type of barter arrangement, you must recognize these payments at the fair market value of what you give or receive.

You can't delay recognition of income by not taking control of money that you're entitled to receive. Under the cash method, income is recognized when it is actually or constructively received. "Constructive receipt" occurs when money is made available to you without restriction, is posted to your account, or is received by your agent.

 

If a customer pays you with a check on December 30, 2001, you have constructively received the money and must count it as income in 2001, even if you don't cash the check or deposit it into your bank account until sometime in January of 2002.

Similarly, if you receive interest on a money market account, you have constructive receipt of the money when it is credited to your account, not when it is withdrawn.

With most business expenses, the cash method allows you to deduct the costs in the year that you paid them. However, some expenditures are not entirely deductible in the year you pay for them; for example, the purchase price of capital assets must be depreciated or amortized over a number of years. Generally, if you make advance payments for an expense that apply substantially beyond the end of the current year, the payments must be prorated and deducted proportionately over the period in which the payments apply.

 

If you purchase a one-year business owner's insurance policy and coverage begins on July 1, 2001, you can only deduct six months' worth of premiums in 2001. The remainder would be deductible in 2002.

Some of the more common items that fall under this rule are amounts paid to obtain a loan, such as prepaid interest, points, and loan origination fees, which must ordinarily be deducted over the course of the loan.

Advance lease payments must be deducted in the year to which they apply, and amounts paid to acquire a lease from another lessee must be deducted evenly over the course of the entire lease.