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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.
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.
Who must use accrual? Any type of business that has an inventory must use the accrual method, at least for sales and for purchases. Inventories are necessary in most marketing, manufacturing, retail, or wholesale businesses, or service businesses in which customers are charged for parts, materials, or components.
Cash method and inventories. As mentioned earlier, not every business is eligible to use the cash method. The most significant exception applies to businesses that have inventory. However, most small businesses qualify for an exception to this prohibition.
Gross receipts of $1 million or less. You are not required to use the accrual method of accounting for inventories if you have average gross receipts (income from your business) of $1 million or less for the three most recent tax years. To determine if you qualify for this exception in 2011, add your gross receipts for 2008, 2009 and 2010 and then divide by three. You qualify for the exception if the resulting amount is $1 million or less.
Gross receipts of $10 million or less. If your average annual receipts are greater than $1 million, you may still be able to qualify for an exception to the requirement that you use inventory accounting. To qualify under this second exception, you must have average gross receipts of $10 million or less for the three most recent tax years and your business must be considered a "qualifying business." A business is a "qualifying business" if it meets any one of the following definitions:
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.
Qualified creative expenses. There is an 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' 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 hold off collection 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.