How the Different Accounting Methods Can Affect a Taxpayers Income

Accounting Methods and Taxpayer Income

Depending on the type and size of company you own, the methods used to conduct your business accounting can vary greatly, and these differences may have significant impact on the eventual amount of income declared to the Internal Revenue Service when you file taxes. Sole proprietors and small business owners who have not fully incorporated typically rely on cash-basis accounting, which is the "major accounting method that recognizes revenues and expenses at the time physical cash is actually received or paid out" (Investopedia, 2011). Using this accounting technique is simpler for small businesses that operate on a local level, and allows the business owner to avoid the costs of hiring a professional bookkeeper. Cash-basis accounting also leads to a greater degree of manipulation, in the form of "under-the-table" payments, handshake agreements and deliberate fabrication of expenses. Large companies and corporations opt for the second major accounting method, accrual accounting, "a form of accounting whereby revenues are recognized when they are earned, not when they are received" in which "cash does not need to change hands before the revenue is recognized" (Forbes Financial Glossary, 2010). This more flexible form of accounting enables corporations, and other large entities such as local governments, to align their expenses with revenues while maintaining sufficient capital reserves. The choice between cash-basis accounting and accrual accounting can result in very serious ramifications for taxpayers during income tax season, and each method can produce entirely different income statements for the same set of financial circumstances.

Small business owners have already deduced that cash-basis accounting allows them the opportunity to manage their tax liability by exercising financial creativity. By requesting that each of his vendors holds off on sending payment for outstanding invoices until the beginning of a new year, a tradesman working as a carpenter or painter can easily reduce their net income for the past year, and thus reduce their tax hit. This practice is nearly universal among small businesspeople, and is used particularly often during prolonged stretches of difficult economic conditions. By artificially inflating or deflating income in order to reduce tax liability for a given year, cash-basis accounting allows small business owners to level the proverbial playing field, by giving them the chance to present income statements that more accurately reflect the day-to-day operations of their company.