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Accounting Methods

It is important to understand the rules for when income is recognized, that is, in which accounting period it should be taxed. The accounting method that you use will help to resolve this question. The "realization concept" states that no income is recognized for tax purposes until it has been realized by the taxpayer. A realization occurs whenever an amount is received without any restriction as to its disposition. In most cases, realization occurs when an arm's-length transaction takes place.

Cash basis taxpayers - Gains from the disposal of assets, profits from a trade or business, and earned income such as wages and salaries are included in gross income for the taxable year in which the amounts are actually or constructively received.

Although not actually reduced to a taxpayer's possession, income is constructively received in the taxable year during which it is credited to your account, set apart for you, or otherwise made available so that you may draw upon it at anytime, or so that you could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

All that is required is that something with a fair market value (property, services, etc.) be received. In addition this method gives taxpayers a somewhat limited ability to determine the year of taxation by accelerating or deferring cash receipts. Because of this ability to determine the year of taxation using the cash method, restrictions are placed on the use of the method by certain types of taxpayers. The most basic restriction on the use of the cash method is that taxpayers who sell inventories must account for sales, purchases, and inventories using the accrual basis.

Accrual basis taxpayers - Gains from the disposal of assets, profits from a trade or business, and earned income such as wages and salaries are included in gross income when it is earned, regardless of the actual period of receipt. Income is considered earned when (1) all the events have occurred which fix the right to receive such income, and (2) the amount of income earned can be determined with reasonable accuracy.

Two important aspects of the accrual method should be noted. First, the checkbook approach commonly used by cash basis taxpayers is not sufficient to account for the many accruals and deferrals of income required by the accrual method. Second, accrual basis taxpayers have little control over the timing of their income, because the earning of the income, not the receipt of payment, is the critical factor.

The receipt of prepaid income by accrual basis taxpayers is generally taxable in the tax year in which payment is received. Thus, advance receipts of rent, royalties, payments for goods, and payments for services are taxable when the cash payment is received, even for accrual basis taxpayers.