Cash Method Expenditures

• Most individual taxpayers must use the cash method for reporting their taxable income and claiming deductions unless they have a business reason for using the accrual method. The cash method of reporting is relatively simple since you report all earnings in the tax year you actually receive cash payment, regardless of when you actually earn the income. As a result, your expenditures are also not deductible until you make a payment for them. For example, if you incur a liability for medical bills in December 2011 but wait until January 2012 to pay the invoice, the expenditure isn't deductible until you file your 2012 tax return in early 2013.
  
  

Accrual Method Expenditures

• If you operate a business, you are eligible to use the accrual method of accounting. As the name implies, your expenses are deductible at the moment you accrue them, which is when you become legally liable for the payment. This generally occurs when a creditor fully performs its obligations of a contract or transaction. For example, if you operate an air conditioning business and you have an account with a local supply house that allows you to purchase equipment on credit; you are legally liable for its payment once the supply house delivers non-defective equipment to you. Therefore, even if you don't pay the equipment invoice until a future tax year, you can claim a deduction for the expenditure in the tax year delivery takes place.
  
  

Income Recognition Implications

• Accrual method taxpayers have the advantage of claiming deductions before having to part with the cash for its payment. However, there are drawbacks to recognizing income before you receive it. This is because the IRS will require a tax payment for the revenue you earn, no matter when you receive it. This can present cash flow issues to a business when it earns the revenue in one tax year and collects payment in the next.
  
  

Accounting Method Example

• To illustrate how both methods affect your annual tax liability, suppose that you earn income for your services of $5,000 in 2011, but don't receive the final $3,000 payment until 2012. Further assume that you have $1,000 of expenditures that you incur and pay in 2011. A cash method taxpayer will report $2,000 of gross income for the year and a $1,000 deduction for a taxable income of $1,000. In 2012, the same taxpayer reports $3,000 of taxable income. In contrast, an accrual taxpayer will report the $5,000 revenue and claim the $1,000 deduction in 2011, resulting in taxable income of $4,000 with no further tax implications in 2012.