Accounting Periods
Each taxpayer (business or individual) must figure taxable income on an annual accounting period called a tax year. The calendar year is the most common tax year. Other tax years include fiscal, 52-53-week, and short tax years. For information on how to choose your tax year, refer to Accounting Periods in Publication 538.
Accounting Methods
Each taxpayer must also use a consistent accounting method, which is a set of rules for determining how and when to report income and expenses. The most commonly used accounting methods are the cash method and the accrual method. Under the cash method, you generally report income in the tax year you receive it and deduct expenses in the tax year you pay them. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received, and deduct expenses in the tax year you incur them, regardless of when payment is made.
Cash Method Example
Frances Jones, a farmer, was entitled to receive a $10,000 payment on a contract in December 2001. The contract was not a production flexibility contract. She was told in December that her payment was available. At her request, she was not paid until January 2002. She must include this payment in her 2001 income because it was constructively received in 2001.
Accrual Method Example
James is a farmer who uses a calendar tax year and an accrual method of accounting. He enters into a turnkey contract with Waterworks in 2001. The contract states that James must pay Waterworks $200,000 in December 2001 and that they will install a complete irrigation system, including a new well, by the close of the year 2003. He pays Waterworks $200,000 in December 2001, they start the installation in May 2003, and they complete the irrigation system in December 2003. Economic performance for James' liability in the contract occurs as the property and services are provided. James incurs the $200,000 cost in the year 2003.
Refer to Accounting Methods, in Publication 538, for information on how to choose your accounting method.
Inventories
An inventory is necessary to clearly show income when the production, purchase, or sale of merchandise is an income-producing factor. If you must account for an inventory in your business, you must use an accrual method of accounting for your purchases and sales.
Changing Your Accounting Method
Once you have set up your accounting method and filed your first return, you must generally get IRS approval to change the method. If your current method clearly shows your income, the IRS will weigh the need for consistency in reporting against the need for change.
Additional Resources
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