Cash Method of Accounting

 

Many businesses that maintain small or nominal amounts of inventory prefer to use the cash method of accounting instead of the accrual method.
 
However, the Internal Revenue Service (IRS) challenges the use of the cash method in many instances, and the burden of proof then shifts to the taxpayer to establish that the cash method clearly reflects income. Meeting the burden of proof can be costly and time consuming to taxpayers being challenged, leaving little recourse except to accede to IRS determinations.

 

In December 2001, the Treasury Department and the IRS released a Proposed Revenue Procedure to liberalize and simplify accounting procedures for small businesses. 

 

The new rules delay payment of taxes until the revenue is received, alleviating a significant hardship for many small business owners. Under accrual accounting, revenue is taxed when "earned," but before actually received. This often causes cash flow problems for businesses, when taxes must be paid before funds become available.

 

The new rules also allow certain small businesses with gross receipts of $10 million or less to use the cash method of accounting for their income and expenses. This can greatly simplify accounting for these small businesses – service providers and custom manufacturers, in particular – and provide certainty about what the rules are. Formerly, because of uncertainty in interpretation of the rules, their scope and application were often left to the courts.

 

 

It is appropriate for certain businesses, in particular small businesses, to report their taxable incomes using the cash method of accounting, even if they maintain some inventory, and the Internal Revenue Service's (IRS) ability to challenge the use of the cash method should be restrained.