Setting up the books for a small business
By Bankrate.com

Most business owners realize that they should base taxable income on the same tax year in each year they file a return. Following a consistent set of rules is also essential for reporting income and expenses.

This set of rules is called an accounting method. There are two methods most business owners use: the cash method and the accrual method. And there are guidelines on when a business owner must use a particular method and how to change from one accounting method to another.

Show me the money
An accounting method is a set of rules used to determine when and how to report income and expenses in a company's books and on its income tax returns. There are two basic accounting methods.

The cash method reports income in the tax year the business owner receives it and deducts expenses in the tax year in which they were made. The accrual method reports income in the tax year it is earned, regardless of when payment is received, and deducts expenses in the tax year they are incurred, regardless of when payment is made.

Does a correct report of income in a business include inventories on hand? These are goods a business owner ordinarily holds for sale in the business, as well as raw materials and supplies that will become part of the sales merchandise. Generally, if you produce, purchase or sell merchandise in your business, you must keep an inventory and use the accrual method.

However, Internal Revenue Service rule changes now allow some small operations (those with average annual gross receipts of more than $1 million and up to $10 million) to choose the cash method and not account for inventories. You should consult IRS Publication 538 if you have questions regarding inventories.

These changing times
It is important to use the same accounting method when calculating taxable income and keeping books. Also, any accounting method must clearly show the company's income. By that, the IRS means that the accounting method of choice must consistently use whatever accounting principles are suitable for the business owner's trade or business. The agency expects the owner to treat all categories of gross income and expenses in the same way on each year's return.

People with more than one business can use a different accounting method for each business. Again, it is essential that the accounting method used for each clearly show income. It will be especially important to keep complete and separate sets of books and records for each business.

Keep in mind that once you establish your accounting method you are expected to stick to it. Once the first return is filed, the IRS will have to approve any change to another accounting method.

Letting the IRS know
When is approval required? It isn't as obvious as it seems. An obvious change in an accounting method would be a change in the overall system of accounting. However, if treatment of any material item is changed, the business owner is technically changing the accounting method as well. For instance, if the method used to change the value of inventory or to figure depreciation is changed, an accounting change is being made that requires IRS approval.

A business owner who wants to change an overall accounting method or the accounting treatment of any item must file a current Form 3115. Attach any required user fee. The form should be filed during the tax year for which the change is requested.

It is a good idea to file Form 3115 as early in the year as possible so the IRS has enough time to respond to the form before the return for the year of change has to be filed. The IRS ordinarily acknowledges receipt of a completed Form 3115 within 30 days of receipt.

-- Updated: June 15, 2002