Cash Method Rules

• Accounting for your taxable income under the cash method rules is the simpler of the two accounting methods, which is why a majority of individual taxpayers calculate their income tax this way. Cash method accounting requires you to report only the income you actually receive a cash payment for during the tax year. For example, if you provide services in 2011 but don't receive payment from your client until 2012, you report the income in 2013 when you file your 2012 tax return. Similarly, the expenses you report on your tax return aren't deductible until the tax year you make payment for them.
  
  

Accrual Method Rules

• The accrual method of accounting is more appropriate for taxpayers who engage in business activities. Accrual accounting requires the reporting of income or revenue at the time you earn it rather than when you receive it. Using the example from above, an accrual taxpayer must report the income in 2011 when he finishes providing the services and has a legal entitlement to payment, regardless of which tax year payment finally arrives. In regards to expenses, you can generally claim the deduction at the moment there is a fixed and determinable liability to make the payment, regardless of which tax year you actually pay it in.
  
  

When is Liability Fixed

• To determine when a liability becomes fixed and determinable for purposes of claiming a deduction under the accrual method, the IRS uses the "all-events test." This test provides that your expense is deductible once the other party performs all services or delivers all goods that entitle it to a payment for a precise amount not subject to change. For example, if you place an order for paper with an office supplies store, your liability to pay for that paper becomes fixed and determinable when the company delivers the paper to you.
  
  

Pros and Cons

• Both methods of accounting have their pros and cons. The benefit to accrual method taxpayers is their ability to claim a deduction before cash payments are made, which in some cases allows them to claim deductions earlier than a cash method taxpayer can for the same expense. The drawback, however, is that accrual taxpayers make cash payments for income tax liabilities that relate to revenue they don't receive by the end of the tax year; whereas, cash method taxpayers can wait until they receive the cash and use those funds to pay the tax later.