An accounting method is the set of rules a taxpayer uses to decide which year an item of income or expense belongs to. It is not a filing choice made each spring. Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books (26 U.S. Code section 446(a)).
That single sentence does more work than the rest of the subject. The books lead and the return follows, so a client whose bookkeeping runs one way and whose return runs another has a problem no adjusting entry fixes.
The Four the Code Permits
Subject to subsections (a) and (b), a taxpayer may compute taxable income under the cash receipts and disbursements method, an accrual method, any other method permitted by this chapter, or any combination of those methods permitted under regulations (26 U.S. Code section 446(c)).
The first two are the ones everybody names. The third and fourth are where real client files live.
| Method | What it is |
|---|---|
| Cash receipts and disbursements | Income when actually or constructively received, expenditures when actually made. Who may use it, and the receipt test, are in cash accounting |
| An accrual method | Income when the right to receive it is fixed and the amount is determinable, costs when incurred. The two tests are in accrual accounting |
| Any other method permitted by the chapter | The special methods, named below |
| Any permitted combination | A hybrid, subject to a symmetry rule |
Source: 26 U.S. Code section 446(c).
The Special Methods Are Named
The regulation gives examples rather than leaving the third category open. Special methods of accounting are provided in the Code and regulations, including sections 61 and 162 relating to the crop method, section 453 relating to the installment method, and section 460 relating to the long-term contract methods. Special methods for particular items of income and expense are provided under other sections of chapter 1, for example section 174 on research and experimental expenditures and section 175 on soil and water conservation expenditures (26 CFR 1.446-1(c)(1)(iii)).
An installment sale is not a variation on the accrual method. It is a method in its own right, and it sits inside the same permission structure as everything else here.
A Combination Is Allowed, and It Is Not Free
Any combination of those methods is permitted in connection with a trade or business if the combination clearly reflects income and is consistently used, and where the combination includes a special method the taxpayer must comply with that method’s own requirements (26 CFR 1.446-1(c)(1)(iv)).
Then comes the rule that catches hybrid bookkeeping. A taxpayer using an accrual method for purchases and sales may use the cash method for all other items of income and expense. But a taxpayer using the cash method in computing gross income from a trade or business shall use the cash method in computing that business’s expenses, and a taxpayer using an accrual method in computing business expenses shall use an accrual method for the items affecting gross income (26 CFR 1.446-1(c)(1)(iv)).
Read plainly: you may not accrue your expenses while keeping your income on cash. The one-sided hybrid that flatters a return is the one the regulation names and forbids.
One Taxpayer Can Carry More Than One Method
The permission runs per trade or business rather than per taxpayer, so a taxpayer carrying on more than one may use a different method for each of them (26 U.S. Code section 446(d)).
Per business is not per entity and not per convenience, so the first question on a two-activity client is whether the second activity is genuinely a separate trade or business. The same permission read as a planning choice rather than a bookkeeping fact is in tax avoidance.
A Single Item Can Be a Method
This is the definition most preparers have never read, and it decides whether a correction is a fix or a filing.
A change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in that overall plan, and a material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction (26 CFR 1.446-1(e)(2)(ii)(a)).
The same paragraph lists what that sweeps in: a change from cash to an accrual method or the reverse, a change involving the method or basis used in valuing inventories, a change from the cash or accrual method to a long-term contract method or the reverse, and certain changes in computing depreciation or amortization (26 CFR 1.446-1(e)(2)(ii)(a)).
So switching how a client’s inventory is valued, or how an asset is depreciated, is a change of accounting method. It is not a correction of an error, and it does not belong on next year’s return as a quiet adjustment.
Who Can Override the Whole Thing
If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income (26 U.S. Code section 446(b)).
Clear reflection of income is the ceiling over every other rule on this page. A method can be permitted by subsection (c), applied consistently, and still be replaced.
Changing One Needs Consent First
A taxpayer who changes the method of accounting on the basis of which he regularly computes income in keeping his books shall, before computing taxable income under the new method, secure the consent of the Secretary (26 U.S. Code section 446(e)). The regulation adds that consent must be secured whether or not the new method is proper or is permitted under the Code (26 CFR 1.446-1(e)(2)(i)).
Filing without asking is not a shortcut with a fine attached, either. Where the taxpayer does not file a request to change, the absence of consent shall not be taken into account to prevent the imposition of any penalty or addition to tax, or to diminish it (26 U.S. Code section 446(f)).
Common Questions
The Code lists four rather than three: the cash receipts and disbursements method, an accrual method, any other method the chapter permits, and any permitted combination (26 U.S. Code section 446(c)). Lists of three usually mean cash, accrual and a hybrid, which collapses the third and fourth categories into one.
No. A standard such as US GAAP governs what the financial statements say, and an accounting method governs which taxable year an item falls into. A client can be on the accrual basis for its statements and still fail a tax method test, which is why the two are settled separately.
Yes on the accounting framework, and no on the starting point. Subsection (a) ties taxable income to the method the taxpayer uses in keeping his books, so a divergence has to be a specific difference the Code allows rather than a second set of books kept on a different plan.
Certain changes in computing depreciation or amortization are listed as changes in method of accounting (26 CFR 1.446-1(e)(2)(ii)(a)), so it is not automatically a free choice made on a fixed asset schedule.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can grade a real block of its own method and book-to-tax work through a trial task before anything client facing depends on it.
