Cash v. Accrual Accounting
There are two basic accounting methods – the cash method or accrual method. The “taxable year” for the cash method is always a calendar year. Corporations using the accrual method can choose to use a fiscal year, which can be any twelve month period. Fiscal years can be helpful for businesses that are seasonal in nature, or the corporation wants a full year in operation before filing its first tax return. Some accountants will also encourage corporations to select a fiscal year to allow the accountant to work on the company’s returns in a less-busy time of the year.
If you are on the cash method, you deduct expenses in the tax year you pay them and record income when it is received. One drawback to the cash method for services companies is that there are no bad debt losses. If you perform a service and bill a customer and then never get paid, there is no bad debt to deduct.
Generally, under the accrual method, you can deduct an expense as soon as it is incurred or becomes due, whether or not you actually pay the expense at that time (the debt is owed as soon as you receive the bill, not when you send the check). The exception is when the debt is to a person related to you. If that person uses the cash method of accounting, you must actually pay the bill before you can deduct it.
Income is booked when you perform the service if you are using accrual accounting. Then, when you didn’t get paid, you would record it as a loss. On the accrual method, you deduct expenses when both of the following apply: all events have occurred that fix the fact of liability; and the liability can be determined with reasonable accuracy; and economic performance has occurred. If your expense is for property or services provided to you, or for your use of property, economic performance occurs as the property or services are provided, or the property is used. If your expense is for property or services you provide to others, economic performance occurs as you provide the property or services.
If you are contesting an expense, like a tax dispute, under the cash method, you would take the expense deduction only when you actually pay the disputed amount. Under the accrual method, you can choose to deduct the expense in the year you actually pay the liability or the year that you resolve the contest.
More information can be found in IRS Publication 538.