Accrual Accounting Methods for a Cash Basis Business

The cash method of accounting is most commonly used by sole proprietorships and small businesses. In cash accounting, you usually recognize the income when it is received and the expense when the bill is paid out. However, there are some expenses that need to be treated differently.

1. Inventory

If an inventory is necessary to account for your income, you must generally use the cost of goods sold to calculate your purchase cost.  You can use the cash method for all other items of income and expenses. For example if you bought $10,000 of inventory in January and had $5,000 left at the end of the year you can ONLY write off the COGS of $5,000 for the portion of goods that you sold, no matter what accounting method you are using.

2. Capitalization instead of expense

As a general rule cash method taxpayers may deduct expenses when paid. However, when the asset will have a useful life that is greater than one year and the cost of the asset is above a threshold, it must be capitalized. For example, a small business might set a threshold of $500. This means that when the cost of an asset is $500 or greater it will not be an expense but will instead be an asset on the balance sheet. you can deduct the depreciation expense of your company’s assets from its taxable net income over years.

The IRS considers an asset to be owned by a business when it is “put into service,” that is, when it starts being used. So even if you buy the asset in 2016, if you don’t start using it until 2017, you can’t take a depreciation expense 2016 and you have to claim depreciation for the asset in 2017 (bonus depreciation).

3. prepaid expenses

Under the general rule you may not deduct the full amount of an advance payment covering more than 12 months. Common prepaid expenses include rent, insurance, interest, and the cost of obtaining a lease or loan. Such an expense cannot be deducted in full in the tax year in which it is paid. You must deduct a portion of the payment in the year to which it applies. For example, you are a cash method taxpayer on a calendar year. On November 1, 2016 you pay $2,400 in advance for business insurance covering 2 years. The $2,400 paid in 2016 must be deducted ratably over the 2-year period, $200 in 2016, $1200 in 2017 and $1000 in 2018.


However, there’s an important exception called the 12-month rule. It lets you deduct a prepaid future expense in the current year if the expense is for a right or benefit that extends no longer than the earlier of:

  • 12 months, or
  • until the end of the tax year after the tax year in which you made the payment.

Same as the above example, but October 30, 2016 you paid $1,200 for business insurance covering from November 1, 2016 to October 2017. The benefit does not extend beyond 12 months after the right to receive the benefit begins. You can fully deduct $1,200 in 2016 based on 12-month rule.


4. Wages not accrued

If you use cash-basis accounting method, the salary expense is recorded when you actually make the payment. If you don’t pay wages for a portion of December 2016 until January 2017, you record the full expense in 2017. This applies to both your financial statements and your tax return.

Employee wages must be recorded as the date of the paycheck issued, regardless when the work was done and when the payment was earned. For example, you pay employees on January 5, 2017, for work done in the last week of December 2016. The gross pay is taxable in 2017, not 2016. You report the employee wages on form 941 and W-2 in 2017. If you pay write a paycheck and make it available on 12/31/2016, , it will be on the 2016 W-2 even if you don’t personally pick it up until after.

Cash basis employer may deduct the portion of wages attributable to employee income tax withholding and employee FICA taxes in the year in which the wage is paid to the employee since these are part of the wages paid. On the other hand employer payroll taxes are not deductible until actually paid.

5. Credit card purchase

The deduction for business expenses purchased with a credit card is taken in the year of the purchase, regardless of when the credit card bill is paid.  For example, if you buy computers for your business in December, 2016, using your business credit card, you can get the depreciation deduction in 2016 and pay off the credit card in 2017.