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Unit 3: Tax Planning: An Introduction

There are two main accounting methods used for record-keeping: the cash basis and the Notes
accrual basis. Small business owners must decide which method to use depending on the
legal form of the business, its sales volume, whether it extends credit to customers, and the
tax requirements set forth by the Internal Revenue Service (IRS). The choice of accounting
method is an issue in tax planning, as it can affect the amount of taxes owed by a small
business in a given year.
Accounting records prepared using the cash basis recognises income and expenses according
to real-time cash flow. Income is recorded upon receipt of funds, rather than based upon
when it is actually earned, and expenses are recorded as they are paid, rather than as they
are actually incurred. Under this accounting method, therefore, it is possible to defer
taxable income by delaying billing so that payment is not received in the current year.
Likewise, it is possible to accelerate expenses by paying them as soon as the bills are
received, in advance of the due date. The cash method is simpler than the accrual method,
it provides a more accurate picture of cash flow, and income is not subject to taxation until
the money is actually received.

In contrast, the accrual basis makes a greater effort to recognize income and expenses in
the period to which they apply, regardless of whether or not money has changed hands.
Under this system, revenue is recorded when it is earned, rather than when payment is
received, and expenses recorded when they are incurred, rather than when payment is
made. The main advantage of the accrual method is that it provides a more accurate
picture of how a business is performing over the long-term than the cash method. The
main disadvantages are that it is more complex than the cash basis, and that income taxes
may be owed on revenue before payment is actually received. However, the accrual basis
may yield favourable tax results for companies that have few receivables and large current
liabilities.
Some form of record-keeping is required by law and for tax purposes, but the resulting
information can also be useful to managers in assessing the company’s financial situation
and making decisions. It is possible to change accounting methods later, but the process
can be complicated. Therefore it is important for small business owners to decide which
method to use up front, based on what will be most suitable for their particular business.

2. Cash vs. Accrual Basis: A taxpayer chooses his accounting method when he files his first
income tax return. The Tax Code requires that taxpayers use a consistent method of
accounting from year to year. Thus, if a taxpayer wishes to change its accounting method
it must get permission to do so from the IRS. To request a change in accounting method
you must file IRS Form 3115. This is a highly complex form and should not be completed
without the assistance of a qualified CPA or tax attorney. The two most commonly used
methods of accounting are the Accrual and the Cash methods. Each of these methods is
discussed briefly under separate heading below:
(a) Cash Method: The Cash Method of accounting allows taxpayers to report
their revenues when received and expenses when paid. More than 95% of individual
taxpayers use the Cash Method of accounting to report their taxable income and
deductible expenses on their Forms 1040.
(b) Accrual Method: Under the Accrual Method of accounting a taxpayer
records his income when a sale occurs, not when payment is received. Likewise, he
records a deductible expense when it’s incurred, not when it’s paid.
A sale occurs when the following conditions are met:

All the events that establish a taxpayer’s right to receive the income have
happened; and

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