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.
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
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to your account, not when it is withdrawn.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