Bookkeeping Essentials

Many small business owners still track the income and expenses of their operation using the old checkbook and receipts method. This is perfectly legal, and often meets the requirements of the tax laws. Unfortunately, some retailers using this rudimentary cash accounting method have discovered that it's not easy to change accounting methods — even if you're required to do so by the IRS.

Fortunately, with permission, any business owner or manager can change their accounting method to reap the maximum benefit, increase profitability, and reduce their tax bills. Naturally, many changes in accounting methods require adjustments, often resulting in a one-time increased tax bill. In the long run, however, utilizing the most efficient accounting method can mean long-term savings — both financial and in (possible) jail time served.

Tax laws require every gift business to use a method of accounting that does not "distort" income. But, of course, the definition of "distortion" can vary, given the IRS's desire to maximize revenues from the definition used by the small business using an accounting system designed to keep the tax bill to its legal minimum.

Although no specific accounting method is required, every business must use a system that shows its income and expenses. Naturally, records must support the entries under that accounting method.

In addition, the same accounting method must be used from year to year. If a retailer does not use a method that clearly shows its income, that income will be figured by the IRS using a method that, in the opinion of the IRS, clearly reflects income.

The most commonly used methods are the cash method and an accrual method. Under the cash method, a retailer reports income the year it is received, and deducts expenses the year they're paid. Under an accrual method, a retailer reports income in the tax year it is earned, regardless of when payment is actually received. Expenses are deducted in the tax year they are incurred, regardless of when payment is made.

There are also special methods of accounting for certain items of in-come and expenses, as well as hybrid or combination methods that use elements of both the cash and accrual accounting methods. A gift and decorative accessories business can use any combination of cash, accrual, and special methods of accounting so long as the combination is consistent and transparent.

In fact, a business owner can use different accounting methods to account for business and personal items. For example, even if the owner uses the cash method to figure personal income, business income can be computed by the accrual method.

The IRS does not require approval to choose the initial accounting method for a business. However, once a method is in use and the operation's first tax returns have been filed, approval is usually necessary to make changes. A change in accounting method can mean a change in the overall system of accounting, as well as a change in treatment, for tax purposes of any material item. (A material item is one that affects the proper time of inclusion of income or allowance for a deduction.)

Both business owners who voluntarily change their method of accounting with IRS permission, and those that are compelled by the IRS to make a change, must make certain adjustments to income in the year of that change. Adjustments are necessary to prevent duplication or omission of items. In addition, there are rules that allow higher-than-average tax bills resulting from so-called "bunching of income" to be spread over several tax years.

Reconciling disparate views of how and when income and expenses should be accounted for is never easy. What's more, you must get permission from the IRS to change your accounting method — even if you're making the change to comply with IRS orders. Although the tax rules don't instruct which to use, they do require IRS permission to switch to another accounting method.

As an illustration, consider a possible situation involving a gift retailer using the accrual method of accounting to deduct vacation pay for her employees. In the accrual method, income is reported in the year earned and expenses are deducted when they are incurred. In 1995, our gift retailer claimed a tax deduction for accrued vacation pay, attributable to employment during the year. The gift retailer's accounting method for vacation pay limited payment to those employed on the first working day of the following year. After being called to task by the IRS, the incorporated retailer began claiming the vacation pay deduction in the proper year.

Unfortunately, as the U.S. Tax Court recently ruled, the gift retailer's method of accounting for vacation pay was changed. The retailer argues that the disallowed deduction resulted from a change in the underlying facts, or that the modified figure results from a computation error.

No deal, says the Tax Court. The S corporation's method of accounting for vacation pay was changed. That change requires an adjustment in order to avoid duplicate deductions under Section 481, "Changes In Accounting Method" rules.

Few small business owners always agree with the IRS about when income and expenses should be reported, or how income should be treated for tax purposes. But using any acceptable accounting method on a consistent basis will reduce chances of a confrontation with the IRS.