CASH VS. ACCRUAL
Every business taxpayer is required to have an accounting method to report income and expenses. The two most commonly used methods are cash and accrual. Once you choose your accounting method, you must follow it consistently. Generally, you may not change your method of accounting unless you obtain permission from the IRS.
Due to its simplicity, the cash method is a popular choice for small businesses. To determine gross income, add up the cash, checks, and fair market value of property and services you receive during the year.
If you receive a check on December 28, 2011, but decide not to cash or deposit it until after December 31, 2011, you must still count the check as income in the year you received it.
Business expenses are usually deducted in the year they are paid. For example, you order office supplies in October 2011 and they arrive in December 2011. You send a check to pay for them in January 2012. Under the cash method, you should claim that business expense deduction on your 2012 tax return because that is the year you paid for the supplies. Certain businesses cannot use the cash method. In addition, special rules apply for the accounting of inventory.
With the accrual method, income is reported in the year in which all events that fix the right to receive it have occurred, and the amount can be determined with reasonable accuracy, even if income was received in a different year. For example, the accrual method calls for income to be reported when a service is performed. It doesn’t matter that the customer doesn’t pay until the following year.
Similarly, you deduct business expenses in the year the liability arises, regardless of when they are actually paid. Using the office supply example, under the accrual method, you may deduct the business expenses for supplies on your 2011 tax return, the year you ordered the supplies and they were delivered, even though you sent a check to pay for them in January 2012. You may deduct the expenses in 2011 because that is when you became liable for the expense. See Publication 538, Accounting Periods and Methods .