Accounting Methods: Cash Basis vs. Accrual vs. Hybrid

Topics: Internal Revenue Service, Taxation in the United States, Tax Pages: 9 (3317 words) Published: February 24, 2013
Accounting Methods: Cash Basis vs. Accrual vs. Hybrid
Which Method is Most Advantageous for Small Business?

Many tax preparers fail to communicate to their small business owner clients about the types of accounting methods allowed by the Internal Revenue Service (IRS) and the advantages and disadvantages of each. The average small business owner simply trusts that the tax preparer is utilizing the method most advantageous to them. This paper explores cash basis, accrual, and hybrid accounting methods approved for tax purposes by the IRS. By comparing and contrasting the advantages and disadvantages of all of the methods, this paper will attempt to will seek to identify the method most advantageous to the small business owner. By using multiple authoritative and non-authoritative sources to compare and contrast the methods, this paper will attempt to simplify the choice of accounting method to be used.

Keywords: accounting method, cash basis, accrual basis, hybrid method,

When opening a new business, a small business owner is faced with an enormous amount of decisions to make. One of the most important of those decisions is determining which accounting method they will choose to keep their books. This paper will analyze the accounting methods of cash basis, accrual, hybrid and special accounting methods. It is important to have a thorough understanding of the different methods allowable under the law and how each method differs from the others. The fact is, there is no accounting method that is perfect. Both accounting methods have pros and cons. After carefully evaluating the various accounting methods and the goals of the business, the small business will have to choose which method is the best option. To do this, the business owner must consider the current size of the business, the business plans for future growth, and if third parties such as lenders or shareholders will be involved in the future. According to Internal Revenue Service (IRS) Publication 538, “An accounting method is a set of rules used to determine when income and expenses are reported on your tax return” (pg. 8). An accounting method includes the overall method of accounting and how the business accounts for its material and equipment. A business is required to use an accounting method that clearly reflects all income and expenses and accurate records must be maintained to enable the business to file accurate tax returns. In addition the business is required to keep proof of purchases and deposits to support the records used in filing of tax returns. If the business fails to use an accounting method that clearly reflects their income, the IRS will refigure the income under the method it sees fit (IRS, 2012). The business owner chooses an accounting method when filing his first business tax return. If a business wants to change accounting methods, it must receive formal approval from the IRS. It is required that a business use the same accounting method from year to year. An accounting method only reflects income and expenses properly if the accounting method used is the same one year as it is the next. The cash basis method of accounting is the most popular method of reporting income and expenses in small business. Much like a checkbook ledger, income and expenses are recorded when funds are actually or constructively received or actually disbursed from the account. Income is constructively received when it is deposited into the business account or made available to you. If the business receives property and services for payment, the fair market value of the property or services must be recognized in income for the business. The IRS does not allow a cash basis business to hold checks or other payments from one year to another to postpone paying taxes on such income in the year it was actually received. If the business authorizes an agent to receive revenue for them, it will be considered received when such...
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