An accounting method is a set of rules used to determine when income and expenses are reported on your tax return. Your accounting method is chosen when you file your first tax return. If you later choose to change your accounting method, you must file Form 3115 Application for Change in Accounting Method, and get approval from the IRS.
The two main accounting methods used to compute taxable income are the cash method and the accrual method. There are other special methods, as well as hybrid options, but those are rare, and do not apply to most taxpayers.
The cash method of accounting is the most commonly used method among individuals and small businesses. Under this method, you include income items in the year you actually receive them. If you receive property or services, you must include their Fair Market Value (FMV) in income as well. Expenses are included in the year you actually pay them, with certain exceptions for expenses paid in advance that will benefit you beyond the 12-month period after benefit begins.
Under the accrual method of accounting, you generally report income in the year it is earned, and deduct or capitalize expenses in the year they are incurred. This method is intended to better match income and expenses in the correct year.
For more information, see IRS Publication 538 Accounting Periods and Methods.
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