Tax Accounting Methods and Periods
Every taxpayer whether they be individuals or business entities, must calculate taxable income for an annual accounting period, which is called a tax year in common nomenclature. The calendar year is the most common and convenient tax year. Others include a fiscal year and a short tax year.
It is necessary for each taxpayer to use a consistent accounting method. An accounting method is a set of rules for determining when to report income and expenses. Commonly used tax accounting methods are the cash method and the accrual method.
Under the cash method, you have to report income in the tax year you receive it, and deduct expenses in the tax year in which you pay the expenses.
Under the accrual method, you report income in the tax year you actually earn it, regardless of receiving date. You deduct expenses in the tax year you incur them, regardless of when payment is actually made.
You can use a tax year to figure your taxable income. A tax year is a yearly tax accounting period for keeping records, reporting income and expenses. You can use the following standards as tax years:
I) A Calendar Year
II) A Fiscal Year
Unless you already have a necessary tax year, you must adopt a tax year by filing your first income tax return using that particular tax year. A required tax year is a tax year made mandatory under the Internal Revenue Code or the Income Tax Regulations. You cannot merely adopt a tax year by;
I) Filing an application for an extension of time to file an income tax return
II) Filing an application for an employer identification number
III) Paying estimated taxes
A calendar year is quite simple to calculate as it consists of 12 consecutive months, beginning on January 1st and ending on December 31st.
If you adopt the calendar year, you must maintain your books and records and report your income and expenses with the dates accordingly.
If you file your first tax return using the calendar tax year and later begin business as a sole proprietor or become a partner or become a shareholder in a corporation; you must continue to use the calendar year unless you obtain approval from the IRS to change it.
Generally, anyone is allowed to freely adopt the calendar year. However, you must adopt the calendar year if;
I) You keep no books or records
II) You have no annual accounting period
III) Your present tax year does not qualify as a fiscal year
IV) You are required to use a calendar year by a provision in the regulations
A fiscal year is 12 successive months ending on the last day of any regular month except December 31st. If you are allowed to adopt a fiscal year, you must consistently maintain your books and records and report your income and expenses using that time period.
An accounting method is a set of rules used to determine when and how income and expenses are reported on your tax return. Your accounting method includes not only your overall method of accounting, but it also includes the accounting treatment you use for any material item.
No single accounting method is required to be used by all taxpayers. You must use a system that clearly reflects your income and expenses. You must maintain records that will enable you to file a correct return. In addition to your permanent accounting books, you must keep any other records necessary to support the entries on your books and tax returns.
You must use the same accounting method from year to year. An accounting method clearly reflects income only if all items of gross income and expenses are treated the same.
If you do not use an accounting method that clearly reflects your income, your income will be refigured under the method that does clearly reflect income, at least in the opinion of IRS.
Methods you can use
You can figure your taxable income under following accounting methods;
I) Cash method
II) Accrual method
Most individuals and many small businesses use the cash method of accounting. Generally, if you produce, purchase or sell merchandise, you must keep an inventory and use a cash method for sales and purchases of merchandise.
Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. If you receive property and services, you must include their fair market value in income.
Under an accrual method of accounting you report income in the year it is earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual accounting method is to matchincome and expenses in the correct year.
Generally, you include an amount in gross income for the tax year in which all events that fix your right to receive the income have occurred and you can determine the amount with a reasonable accuracy.