Comparison of Cash Method and Accrual Method of accounting
Encyclopedia
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
, 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:
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. 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.
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) corporation
s with over $5,000,000 in gross receipts; (2) partnership
s with at least one C corporation partner; (3) tax shelter
s; and (4) taxpayers required to keep inventory (retail, wholesale, manufacturer etc...) Exceptions (1) Farming Businesses (2) Qualified PSC's
(3) Entities with gross receipts of not more than $7,000,000
Similar definition of cash basis accounting is true for financial accounting purposes.
” and “earlier-of test” to determine when income is earned. 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." 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. 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.”
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.
("GAAP") were based thereon, and objected to the new law. 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.
Matching principle
The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...
) are used to calculate US public debt
United States public debt
The United States public debt is the money borrowed by the federal government of the United States at any one time through the issue of securities by the Treasury and other federal government agencies...
, as well as taxable income
Taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
for U.S. federal income taxes
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
and other income taxes. According to the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
, a taxpayer may compute taxable income by:
- the cash receipts and disbursements method;
- an accrual method;
- any other method permitted by the chapter; or
- any combination of the foregoing methods permitted under regulations prescribed by the Secretary [of the TreasuryUnited States Department of the TreasuryThe Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...
].
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. 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.
Cash basis
Cash basis tax payers include income when it is received, and claim deductions when expenses are paid. A cash basis taxpayer can look to the doctrine of constructive receiptConstructive receipt
For federal income tax purposes, the doctrine of constructive receipt is used to determine when a cash-basis taxpayer has received gross income. A taxpayer is subject to tax in the current year if he or she has unfettered control in determining when items of income will or should be paid...
and the doctrine of cash equivalence
Doctrine of Cash Equivalence
The Doctrine of Cash Equivalence states that the U.S. Federal income tax law treats certain non-cash payment transactions like cash payment transactions for federal income tax purposes. The doctrine is used most often for deciding when cash method taxpayers are to include certain non-cash income...
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) corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s with over $5,000,000 in gross receipts; (2) partnership
Partnership
A partnership is an arrangement where parties agree to cooperate to advance their mutual interests.Since humans are social beings, partnerships between individuals, businesses, interest-based organizations, schools, governments, and varied combinations thereof, have always been and remain commonplace...
s with at least one C corporation partner; (3) tax shelter
Tax shelter
Tax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments...
s; and (4) taxpayers required to keep inventory (retail, wholesale, manufacturer etc...) Exceptions (1) Farming Businesses (2) Qualified PSC's
Personal service corporation
A corporation is a personal service corporation if it meets all of the following requirements:1. Its principal activity during the “testing period” is performing personal services . Generally, the testing period for any tax year is the prior tax year...
(3) Entities with gross receipts of not more than $7,000,000
Similar definition of cash basis accounting is true for financial accounting purposes.
Accrual basis
Accrual basis taxpayers include items when they are earned and claim deductions when expenses are incurred. An accrual basis taxpayer looks to the “all-events testAll-events test
The all-events test, under U.S. federal income tax law, is the requirement that all the events fixing an accrual-method taxpayer's right to receive income or incur expense must occur before the taxpayer can report an item of income or expense.-Application:...
” and “earlier-of test” to determine when income is earned. 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." 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. 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.”
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.
History
Originally, federal law required all taxpayers to use the cash basis accounting. However, many businesses used the accrual basis, as most generally accepted accounting principlesGenerally Accepted Accounting Principles
Generally Accepted Accounting Principles refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards...
("GAAP") were based thereon, and objected to the new law. Less than a year after the 1913 Revenue Act, the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
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.
See also
- Revenue recognitionRevenue recognitionThe revenue recognition principle is a cornerstone of accrual accounting together with matching principle. They both determine the accounting period, in which revenues and expenses are recognized...
- Matching principleMatching principleThe matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...
- Accruals
- DeferralDeferralDeferred, in accrual accounting, is any account where the asset or liability is not realized until a future date , e.g. annuities, charges, taxes, income, etc. The deferred item may be carried, dependent on type of deferral, as either an asset or liability...
s in accounting
- Accrual basis accounting
- Adjusting entriesAdjusting entriesIn accounting/accountancy, adjusting entries are journal entries usually made at the end of an accounting period to allocate income and expenditure to the period in which they actually occurred. The revenue recognition principle is the basis of making adjusting entries that pertain to unearned and...
- Tax accounting
- Claim of right doctrineClaim of right doctrineIn the tax law of the United States the claim of right doctrine causes a taxpayer to recognize income if they receive the income even though they do not have a fixed right to the income...