Tax Accounting Methods and Inventories
Permissible Methods and Changes
Taxpayers adopt an overall method: cash, accrual, or a hybrid, plus special methods for particular items. Accrual taxpayers follow the all-events test and economic performance rules, and certain related-party accruals are deferred until paid. A change in method generally requires consent on Form 3115 and a section 481(a) adjustment spread over the prescribed period. The trap is assuming a method can be changed unilaterally, or treating a change in accounting method as a change in accounting estimate.
Cash Versus Accrual
Cash-method taxpayers recognize income when actually or constructively received and deduct when paid, subject to economic performance for certain liabilities. Accrual taxpayers recognize income when all events fix the right to receive and the amount is determinable with reasonable accuracy. Constructive receipt and the claim-of-right doctrine are frequent test points.
Inventory Rules
Know the uniform capitalization rules, the choices among cost methods, and the small-business exceptions that permit cash-method treatment of inventory. Lower of cost or market, specific identification, and the retail method each carry distinct rules. The trap is applying the cash method to a business with inventory without confirming an exception applies.
Worked Example
An accrual taxpayer receives a $10,000 advance for services to be performed over two years. Under the deferral rules the taxpayer may defer the advance and recognize $5,000 per year, assuming the deferral test is met. A cash taxpayer receiving the same advance recognizes the full $10,000 on receipt absent a restriction.