IRS Cash Vs. Accrual
In determining the accounting method best for your business, consistency is the key. The Internal Revenue Service does not suggest a preference between the most common counting methods, cash and accrual. But once you start with one method, you need to get approval from the IRS before changing.
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Cash Accounting
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The IRS notes that most individual taxpayers and many small businesses depend on the cash method for their accounting. Under this method, all income you receive during the tax years is added to your gross income. You need to count, however, all income you actually receive and "constructively receive." The IRS defines constructive receipt as income credited to you or made available to you "without restriction," even if you don't possess it. .
The same is mostly true for expenses. However, this doesn't apply to expenses paid in advance. The IRS holds that the expense is deductible only in the year it applies unless it qualifies for a 12-month rule. If you buy a one-year business insurance policy mid-year and pay the premium up front, the whole amount is deductible in the tax year you paid it. If the expense covers a right or benefit that extends longer, you only capitalize the percentage of the expense applicable to each tax year.
Accrual Method
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Under the accrual method, income is counted as gross income in the year earned, regardless of when payment is received. The date of earning income is the earliest of when the income is due; when you complete the work, service or sale of merchandise; when title of property has passed; or when you actually receive payment.
You deduct or capitalize expenses in the tax year they're incurred, not necessarily when they're paid. Specifically, an expense is reportable when you can determine the expense or liability with reasonable accuracy and an "economic performance has occurred." If you order office supplies in December and you receive the bill and the supplies in the same month, an economic performance has occurred and liability, the cost, is fixed and can be determined, even if actual payment doesn't occur until after the new tax year begins.
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Inventory May Need Accrual Method
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If your business needs you to account for inventory, then the IRS may demand you use an accrual method for accounting. If your average annual gross receipts over each of a series of test years do not exceed $10 million, than you can use the cash method. You determine the average annual gross receipts by adding receipts for the current year and the previous two years, then dividing by three. Test years depend on the year you're filing.
Request Permission to Change
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Once you file your first tax return covering your business income, you cannot change your accounting method without first getting approval from the IRS. You get approval by filing Form 3115, Application for Change in Accounting Method.
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