Comparison of cash and accrual methods of accounting

Accountancy
Key concepts
Accountant · Accounting period · Bookkeeping · Cash and accrual basis · Cash flow management · Chart of accounts · Journal  · Special journals · Constant Item Purchasing Power Accounting · Cost of goods sold · Credit terms · Debits and credits · Double-entry system · Mark-to-market accounting · FIFO & LIFO · GAAP / IFRS · General ledger · Goodwill · Historical cost · Matching principle · Revenue recognition · Trial balance
Fields of accounting
Cost · Financial · Forensic · Fund · Management · Tax
Financial statements
Statement of financial position · Statement of cash flows · Statement of changes in equity · Statement of comprehensive income · Notes · MD&A · XBRL
Auditing
Auditor's report · Financial audit · GAAS / ISA · Internal audit · Sarbanes–Oxley Act
Accounting qualifications
CA · CPA · CCA · CGA · CMA · CAT · CFA  · CIIA  · ACCA  · CIA  · CTP · ICAEW · CIMA  · IPA  · ICAN
This box: view · talk · edit

The two primary accounting methods of the cash and the accruals basis (the difference being primarily one of timing) are used to calculate US public debt,^[1] as well as taxable income for U.S. federal income taxes and other income taxes. According to the Internal Revenue Code, a taxpayer may compute taxable income by:

1. the cash receipts and disbursements method;
2. an accrual method;
3. any other method permitted by the chapter; or
4. any combination of the foregoing methods permitted under regulations prescribed by the Secretary [of the Treasury].^[2]

As a general rule, a taxpayer must compute taxable income using the same accounting method he / she uses to compute income in keeping his / her books.^[3] Also, the taxpayer must maintain a consistent method of accounting from year to year. Should he / she change from the cash basis to the accrual basis (or vice versa), he / she must notify and secure the consent of the Secretary.^[4]

Cash basis

Cash basis tax payers include income when it is received, and claim deductions when expenses are paid.^[5] A cash basis taxpayer can look to the doctrine of constructive receipt and the doctrine of cash equivalence to help determine when income is received. Most individuals start as cash basis taxpayers. There are four types of taxpayers that cannot use the cash basis: (1) corporations with over $5,000,000 in gross receipts; (2) partnerships with at least one C corporation partner; (3) tax shelters;^[6] and (4) taxpayers required to keep inventory (retail, wholesale, manufacturer etc...)^[7] Exceptions (1) Farming Businesses (2) Qualified PSC's (3) Entities with gross receipts of not more than $7,000,000 ^[8]

Similar definition of cash basis accounting is true for financial accounting purposes.^[9]

Accrual basis

Accrual basis taxpayers include items when they are earned and claim deductions when expenses are incurred.^[10] An accrual basis taxpayer looks to the “all-events test” and “earlier-of test” to determine when income is earned.^[11] Under the all-events test, an accrual basis taxpayer generally must include income "for the taxable year when all the events have occurred that fix the right to receive income and the amount of the income can be determined with reasonable accuracy."^[12] Under the "earlier-of test", an accrual basis taxpayer receives income when (1) the required performance occurs, (2) payment therefore is due, or (3) payment therefore is made, whichever happens earliest.^[13] Under the earlier of test outlined in Revenue Ruling 74-607, an accrual basis taxpayer may be treated, as a cash basis taxpayer, when payment is received before the required performance and before the payment is actually due. An accrual basis taxpayer generally can claim a deduction “in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.”^[14]

Similar definition of accrual basis accounting is true for financial accounting purposes, except that revenue can't be recognized until it's earned even if a cash payment has already been received.^[9]

History

Originally, federal law required all taxpayers to use the cash basis accounting.^[15] However, many businesses used the accrual basis, as most generally accepted accounting principles ("GAAP") were based thereon, and objected to the new law.^[16] Less than a year after the 1913 Revenue Act, the Internal Revenue Service allowed use of the accrual basis for deductions, then for income, and in 1916, Congress formally adopted the accrual basis accounting into United States tax law.^[17]

See also

Revenue recognition Matching principle Accruals Deferrals in accounting

Accrual basis accounting Adjusting entries Tax accounting Claim of right doctrine

References

1. ^ "Measuring the Deficit: Cash vs. Accrual". Government Accountability Office. http://www.gao.gov/special.pubs/longterm/deficit/. Retrieved 19 January 2011. 
2. ^ IRC § 446(c)
3. ^ IRC § 446(a).
4. ^ IRC § 446(e).
5. ^ Treas. Reg., 26 C.F.R. § 1.446-1(c)(1)(i)
6. ^ IRC § 448(a)
7. ^ Pinson, Linda. Keeping the Books. Kaplan Publishing, 2007 pp 10 - 11.
8. ^ IRC § 448(b)
9. ^ ^{a b} "What are Accruals and the Meaning of Accrued in Accounting?". Simplestudies LLC. 2010-02-25. http://simplestudies.com/accruals-meaning-of-accrued-in-accounting.html. Retrieved 2010-02-25. 
10. ^ Treas. Reg., 26 C.F.R. § 1.446-1(c)(1)(ii)
11. ^ Treas. Reg., 26 C.F.R. § 1.446-1(c)(1)(ii)(A); Revenue Ruling 74-607
12. ^ Id.
13. ^ Revenue Ruling 74-607
14. ^ Treas. Reg., 26 C.F.R. § 1.461-1(a)(2)(i)
15. ^ Revenue Act of 1913.
16. ^ Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials, 380 (Thompson-West, 2nd ed. 2007).
17. ^ Id.