Overview of the Cash Method
The cash method of accounting requires that sales be recognized when cash is received from a customer, and that expenses are recognized when payments are made to suppliers. This is a simple accounting method, and so is attractive to smaller businesses. It is possible under the cash method to alter reported earnings, which is why the IRS is suspicious of its use (though the IRS still allows it). Examples of cash method manipulation are:
Revenue. A business receives a check from a customer near the end of its fiscal year, but does not cash it until the next year, in order to delay the recognition of taxable income in the current year.
Expenses. A business pays its suppliers early in order to recognize more expense in the current fiscal year, thereby reducing its taxable income in the current year.
The behavior noted in both examples is prohibited by the IRS, but can be difficult to spot unless a detailed audit is conducted.
The IRS requires certain accounting actions in order to mitigate the possibility of income manipulation. In particular, it imposes the concept of constructive receipt, under which cash receipts must be recorded as soon as all restrictions related to the receipts have ended. For example, this would call for the recognition of interest income on a bond for which the coupon comes due prior to year-end, but for which the related payment has not yet been received.
There are valid circumstances where the cash method can be used to delay the recognition of taxable income. In particular, if a company's business is highly seasonal and sales peak just prior to year-end, cash receipts from customers will probably arrive in the following year, thereby delaying the recognition of taxable income. This approach works best when the fiscal year terminates immediately after the peak of the selling season.
Limitations on Use of the Cash Method
Given the tax advantages of the cash method, the IRS restricts its use with the following rules:
It is allowed when the reporting entity has average annual gross receipts of $25,000,000 or less for the past three tax years.
It is allowed for a personal service business for which at least 95% of all activities are related to services.
In essence, the cash method is allowed for smaller, non-manufacturing businesses. If a business expands, it can expect to switch away from the cash method and move to the accrual method.