Accounting Methods and Periods

There are two major methods of accounting: the cash methods and the accrual methods, both of which are described below. The vast majority of taxpayers use the cash method. Also, taxpayers may file their tax returns using the calendar year or a fiscal year. The vast majority use the calendar year. Thus, in this courses, you may assume all information is based on the cash method of accounting and the calendar year unless otherwise specified.

Cash Method of Accounting
When the cash method of accounting is used, income is reported in the tax year it is constructively or actually received, and deductions are claimed in the tax year paid. Constructively received means that the income is available to the taxpayer, regardless of whether it is actually in his possession. Constructively received income includes income credited to an account, income and reinvested by an agent of the taxpayer, a check or other payment received before the end of the year even if not deposited or converted to cash, and income for which the date of receipt is controlled by the taxpayer (for example, income due and payable from an activity owned or controlled by the tax payer who elects to defer receipt).

Example: Shehgarlynn had $150 interest credited to her savings account by her bank during 2007. Shehgarlynn left the $150 on deposit. Even though she did not use the money, Shehgarlynn constructively received the interest during 2007 and must report it on her 2007 tax return.

Calendar Year
The calendar year is January 1 through December 31.The normal due date for filing a calendar-year tax return (including the final return of a taxpayer who died during the tax year) is April 15 following the end of the tax year. Taxpayers may receive an automatic extension until August 15 filing Form 4868 by April 15. If April 15 falls on a Saturday, Sunday, or legal holiday, the due date is extended to the next business day.

Other Accounting Methods And Periods

Accrual Method of Accounting
When the accrual method of accounting is used, income is reported in the tax year earned, whether or not received. Deductions are claimed in the tax year incurred, whether or not paid.

Example:
Shehgarlynn, an accrual-basis taxpayer, earned $750 for services performed on December 28, 2007. She was not paid until January 10, 2008. Shehgarlynn must report the 750 on her 2007 return.

Hybrid Method of Accounting
A hybrid accounting method is a combination of methods, usually of the accrual and cash methods. Business often use a hybrid method because the accrual method is required on tax returns for inventory accounting, but the cash method is more convenient for operating expenses.

Fiscal Year
Instead of the calendar year, a few tax-payers report their income using a fiscal year. A fiscal year may end on the last day of any month except December.

Once a taxpayer chooses an accounting method and an accounting period, he cannot change either one without the consent of the IRS. Taxpayers may use a different accounting method for each separate and distinct business. A married couple may use different accounting methods and still file a joint return, but they must use the same accounting period.

What is Income?

Generally speaking, income is financial gain derived from labor (work), capital (money) or a combination of the two. Unless specifically exempt or excluded by law, all income is subject to income tax and is reported on the tax return.


Gross income is total worldwide income received in the form of money, property, or services that is subject to the tax. There are two types of gross income:

• Earned income is received for services performed. Some examples are wages, commissions, tips, and generally, farming and other business income.
• Unearned income is taxable income that does not meet the definition of earned income. It includes money received for the investment of money or other property, such as interest, dividends, and royalties. It also includes pension, alimony, unemployment compensation, and other income that is not from performing service.

Non taxable income is by law exempt from tax. Exempt income includes child support, municipal bond interest, welfare benefits, VA benefits, various military allowances, workers' compensation, gifts, and life insurance proceeds paid to the death of the insured.

Gross Income
There are two aspects to determining gross income:

1. Who owns the income, and
2. What income should be reported on a tax return.

Ownership of income is determined by state law. The laws regarding the ownership of income and property in most states are based on British common law. These states are called separate property states. In separate property states, income belongs to the person who earned it or who owns the property that produced the income.

Nine states are community property states. With the exception of Wisconsin, the laws of community property states are based on Spanish civil law. Generally, in community property states, income received by a married couple for services performed is considered to belong half to the husband and half to the wife regardless of which of them earned the income. The laws regarding the ownership of income from property vary among these states. The nine community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Generally, ownership of the income of a married couple needs to be determined only if they file separate returns.