You must be hard core if you clicked to come to this page. So here we go …
Tax accounting is based on the concept of the tax year. The books are closed on Dec. 31 of each year (or a different month if you are on a fiscal year) and whatever happened during the year determines your taxes. You could have big swings in taxable income from
year to year, but that doesn’t matter. The IRS looks at one year at a time.
Now what’s this fiscal year business?
Fiscal years
Most small businesses use a calendar year just like individuals. Fiscal years can be used to manipulate tax, so the IRS sets up the calendar year as the default requirement. You need a good business reason to pick another tax year. But many businesses, particularly seasonal businesses, do use a fiscal year.
For example, a retailer who does his main business at Christmas may pick a tax year that ends on Jan. 31 of every year. For this retailer, it doesn’t make sense to do a closing inventory on Dec. 31. Waiting a month gives a better picture of his annual income.
Accrual versus cash method
Now that we’ve defined a tax year, how do you know whether a transaction falls within a given tax year?
Every transaction has three components: (1) a contract (which may be oral or even unspoken), (2) some delivery of goods or services under the contract, and (3) payment.
For many transactions, the three are basically simultaneous. You go into a store and buy something for cash. There’s no question what tax year the transaction falls into.
But what if you sell on credit (or buy on credit). The delivery of the goods or services may occur this year and payment next year. When do you report the transaction on your tax return?
The answer is, it depends. It depends on whether you use the cash or accrual method of accounting.
- Under the cash method, you report the transaction (income or expense) the year payment is made or received.
- Under the accrual method, you generally report the transaction when the goods or services are delivered. The IRS calls this economic performance and requires you to report income when you did everything that was required to earn the money regardless of when you get paid (and when you became obligated to pay, in the case of a deductible business expense).
Most sole proprietorships and some partnerships operate under the cash method. Corporations generally operate under the accrual method.
Exceptions to the tax year concept
Although most transactions are reported in the year they are paid or accrued, there are some exceptions. The most notable are depreciation and inventory.
HREF=”/business/smallbusiness/article/0,2669,ART-28826,FF.html#deprec”>Depreciation is a deduction that is allowed instead of deducting the cost of buildings or equipment that are used in your business. If the normal accounting conventions were followed, you would deduct the purchase price for these items in the year you paid for them or accrued the obligation to pay. This is not done. Instead, the purchase price is broken up and a portion is deducted each year during the deemed life of the property.
Inventory is a special accounting device for accumulating costs for goods you sell and deducting them only when you sell them.
Keep receipts, ledgers, invoices, tax returns, and other records for at least six years. Records of property should be kept as long as you own the property plus six years.
