Accounting Methods Overview
A comprehensive guide to various accounting methods that business owners can use to keep track of their finances. There are
A taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for such year (Reg. Sec. 1.4461(e)(1)). Permissible methods generally include Cash and Accrual, but the accounting system used must clearly reflect income (Reg. Sec. 1.446-1(2))
-
But you generally can’t use the cash method if there is inventory unless an exception discussed in the following dialog applies.
-
Generally, C corporations and partnerships with a C corporate partner cannot use the cash method if their gross receipts exceed $25 million after 2017 ($26 million for tax years beginning in 2019 through 2021 and $27 million for 2022) (TCJA).
Thus, where inventory is not a material factor a taxpayer can generally use the cash method regardless of the amount of gross receipts (except for C corporations and partnerships with a C corporate partner as discussed above).
However, the accrual method of accounting is mandatory where the production, purchase or sale of merchandise is a significant income producing factor (Reg. Sec. 1.446-1(a)(4)(i)). Thus where there is inventory, the accrual method of accounting would be mandatory unless a gross income exception applies.
Exceptions
There are exceptions to the above rules for mandatory use of the accrual method of accounting. TCJA (effective beginning in 2018) allows businesses (termed “small business taxpayers”) to use the cash method of accounting if they have average annual gross receipts of $25 million (indexed for inflation after 2018) or less during the preceding three years. The amount is $26 million for tax years beginning in 2019 through 2021 and $27 million for 2022. (Code Sec. 448) In addition, the taxpayer’s method of accounting for inventory won't be treated as failing to clearly reflect income if the method: (Code Sec. 471(c)(1)(B))
-
Treats inventory as non-incidental materials and supplies (Code Sec. 471(c)(1)(B)(i)), or
-
Conforms to the taxpayer's method of accounting reflected in an "applicable financial statement" (i.e., an AFS, defined below) of the taxpayer for that tax year or, if the taxpayer doesn't have any AFSs for the tax year, the taxpayer's books and records prepared in accordance with the taxpayer's accounting procedures (Code Sec. 471(c)(1)(B)(ii)).,
Sole Proprietorship
In the case of a sole proprietorship, the $25 million ($26 million for 2019 through 2021; $27 million for 2022) gross receipts test is applied as if the sole proprietorship is a corporation or partnership. (Code Sec 471(c)(3)).
The provision retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities are allowed to use the cash method without regard to whether they meet the gross receipts test described above, so long as the use of such method clearly reflects income (Committee report).
Consistent with present law, the cash method generally may not be used by taxpayers, other than those small business taxpayers, i.e., those that meet gross receipts test explained above, if the purchase, production, or sale of merchandise is an income-producing factor. In addition, the cash method may not be used by a tax shelter (Committee report).
Change In Accounting Method
The cash basis accounting exceptions to accrual accounting are permissive and a taxpayer wishing to switch to cash accounting under these TCJA provisions can change accounting methods by using Form 3115 – Application for Change in Accounting Method. Per Rev Proc 2018-40, the IRS will provide automatic consent to a small business taxpayer’s application to change to the cash method of accounting.
Applicable Financial Statement (AFS)
For purposes of this exception, an AFS is defined by reference to Code Sec 451(b)(3), and is a financial statement which is certified as being prepared in accordance with generally accepted accounting principles and which is:
-
A 10–K (or successor form), or annual statement to shareholders, required to be filed by the taxpayer with the U.S. Securities and Exchange Commission (SEC) (Code Sec 451(b)(3)(A)(i))
-
An audited financial statement of the taxpayer which is used for credit purposes, reporting to shareholders, partners or other proprietors, or to beneficiaries (Code Sec 451(b)(3)(A)(ii)), or any other substantial nontax purpose (but only if the taxpayer doesn’t have a statement described in the bullet just above), or
-
Filed by the taxpayer with any other Federal agency for nontax purposes, but only if there’s no statement as described in the two bullets above (Code Sec 451(b)(3)(A)(iii)).
-
A financial statement which is made on the basis of international financial reporting standards and is filed by the taxpayer with an agency of a foreign government which is equivalent to the U.S. SEC and which has reporting standards not less stringent than the standards required by the SEC, but only if there is no statement of the taxpayer described in the three bullets above (Code Sec 451(b)(3)(B)), or
-
A financial statement filed by the taxpayer with any other regulatory or governmental body specified by the Treasury Secretary, but only if there is no statement of the taxpayer described in the bullets above (Code Sec 451(b)(3)(C)).
Pre-2018 Exceptions
There are two exceptions to the accrual method for years prior to 2018:
-
$1 Million or Less Average Gross Receipts - Taxpayers (other than tax shelters) with 3-year average annual gross receipts of $1 million or less do not have to account for inventories or use an accrual method of accounting. Businesses permitted to use the cash method under this exception that do not want to account for inventories (Rev. Proc. 2001-10) must treat all inventoriable items (e.g., items purchased for resale and raw materials purchased for use in producing finished goods) in the same manner as non-incidental materials and supplies, deductible in the year in which they are first used or consumed in the taxpayer's operations (Reg. § 1.162-3(a)(1)).,
Taxpayers qualifying for the exception and that do not want to use inventories must treat merchandise inventory in the same way that cash method taxpayers are required to treat materials or supplies (other than incidental costs) under Reg. 1.162-3. Thus, taxpayers using the cash method under Rev. Proc. 2001-10 may not deduct merchandise costs until the year in which the merchandise is consumed, used, or sold. The procedure says that taxpayers may use any reasonable method of estimating the amount of raw materials and finished goods inventory to determine the amount of raw materials used to produce finished goods during the year, provided that method is used consistently.
Apart from the simplified bookkeeping this procedure allows, the main advantage of IRS’s liberalized allowance of the cash method is deferral of income until payment is received, rather than accounting for the income when billed.
-
Over $1 Million and Up To $10 Million Average Gross Receipts – Another pre-2018 exception applies to taxpayers (other than tax shelters) with 3-year average annual gross receipts of over $1 million and up to $10 Million (Rev. Proc. 2002-28) that also do not wish to account for inventories or use an accrual method of accounting, provided they are NOT any one of the following North American Industry Classification System (NAICS) businesses:
-
Retailing (NAICS codes 44 – 45);
-
Wholesaling (NAICS code 42);
-
Manufacturing (NAICS codes 31 – 33);
-
Mining (NAICS codes 211, 212);
-
Publishing (NAICS code 5111); or
-
Sound recording (NAICS code 5112).
Rev. Proc. 2002-28 does not apply to a farming business of a qualifying small business taxpayer. However, farmers generally are allowed to use the cash method for their farming business anyway.