Cash Method v. Accrual Method

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A comparison of the two primary accounting methods (Cash method and Accrual method) used to calculate taxable income for US Federal income taxes. According to the Internal Revenue Code, a taxpayer may compute taxable income under the following methods of accounting:

  1. the cash receipts and disbursements method;
  2. an accrual method;
  3. any other method permitted by the chapter; or
  4. any combination of the foregoing methods permitted under regulations prescribed by the Secretary.[1]

As a general rule, a taxpayer must compute taxable income using the same accounting method he uses to compute income in keeping his books.[2] Also, the taxpayer must maintain a consistent method of accounting from year to year. Should he change from the cash method to the accrual method (or vice versa), he must notify and secure the consent of the Secretary.[3]

Contents

[edit] Cash method

Cash method taxpayers include income when it is received, and claim deductions when expenses are paid.[4] A cash method taxpayer can look to the doctrine of constructive receipt and the doctrine of cash equivalence to help determine when income is received. Most individuals start as cash method taxpayers. There are three types of taxpayers that cannot use the cash method: (1) C corporations; (2) partnerships with at least one C corporation partner; and (3) tax shelters.[5]

[edit] Accrual method

Accrual method taxpayers include items when they are earned and claim deductions when expenses are owed.[6] An accrual method taxpayer looks to the “all-events test” and “earlier-of test” to determine when income is earned.[7] Under the all-events test, an accrual method taxpayer generally must include income "for the taxable year when all the events have occurred that fix the right to receive income and the amount of the income can be determined with reasonable accuracy.[8] Under the "earlier-of test, an accrual method taxpayer receives income when (1) the required performance occurs, (2) payment therefore is due, or (3) payment therefore is made, whichever happens earliest.[9] Under the earlier of test outlined in Revenue Ruling 74-607, an accrual method taxpayer may be treated as a cash method taxpayer when payment is received before the required performance and before the payment is actually due. An accrual method taxpayer generally can claim a deduction “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.”[10]

[edit] History

Originally, federal law required all taxpayers to use the cash method of accounting.[11] However, many businesses used the accrual method, as most generally accepted accounting principles ("GAAP") were based thereon, and objected to the new law.[12] Less than a year after the 1913 Revenue Act, the IRS allowed use of the accrual method for deductions, then for income, and in 1916, Congress formally adopted the accrual method into U.S. tax law.[13]

[edit] See also

[edit] References

  1. ^ IRC § 446(c)
  2. ^ IRC § 446(a).
  3. ^ IRC § 446(e).
  4. ^ Treas. Reg. § 1.446-1(c)(i)
  5. ^ IRC § 448(a)
  6. ^ Treas. Reg. § 1.446-1(c)(ii)
  7. ^ Treas. Reg. § 1.446-1(c)(1)(ii)(A); Revenue Ruling 74-607
  8. ^ Id.
  9. ^ Revenue Ruling 74-607
  10. ^ Treas. Reg. § 1.461-1(a)(2)(i)
  11. ^ Revenue Act of 1913.
  12. ^ Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 380 (Thompson-West, 2nd ed. 2007).
  13. ^ Id.