An accounting method is a set of rules used to determine when and how income and expenses are reported. You choose an accounting method for your business when you file your first income tax return.
There are two basic accounting methods.
- Cash Method. Under the cash method, you report income in the tax year you receive it. You usually deduct or capitalize expenses in the tax year you pay them.
- Accrual Method. Under an accrual method, you report income in the tax year you earn it, even though you may receive payment in a later year. You deduct or capitalize expenses in the tax year you incur them, whether or not you pay them that year.
- Hybrid Method. Under the hybrid method, you use the accrual method for inventories purchases and sales, and use cash method for operating expenses.
If you need inventories to show income correctly, you must generally us an accrual method of accounting for purchases and sales. Inventories include goods held for sale in the normal course of business. They also include raw materials and supplies that will physically become a part of merchandise intended for sale.
You must use the same accounting method to figure your taxable income and to keep your books. Also, you must use an accounting method that clearly shows your income. In general, any accounting method that consistently uses accounting principles suitable for your trade or business clearly shows income.
More than one business. When you own more than one business, you can use a different accounting method for each business as long as the method clearly shows your income. Each business must be reported using its own EIN number.
Changing your method of accounting. Once you have set up your accounting method, you must get IRS approval before you can change it to another method. A change in accounting method not only includes a change in your overall system of accounting, but also a change in the treatment of your inventory. This can result in restating inventories and other costs, so should probably not be done without the help of an accountant specializing in small business tax accounting.