What are the tax implications in the U.S. for doing ones accounting on the cash method versus the accrual method? As I understand it the main difference is in the timing (i.e. which period) of realizing income and expenses. So beyond potentially having more flexibility with an accrual basis, are there specific tax benefits/gotchas/rules for using that method?
Accrual accounting and cash accounting are two very different methods of accounting, and which one you use could have either an insignificant or major impact your annual tax return. The vast majority of individuals and some eligible small businesses use the cash method of accounting, because it is generally simpler and more intuitive than accrual basis.
In cash-based accounting, you record revenue (income) when you receive the cash, not when you earn it. For example, you would record your paycheck when the funds were in your bank account, even if the check was a month late and you had earned that money several weeks prior. In addition to recording income when received, you record expenses when you pay them, not when you owe them. For example, you would record your credit card payment when you send the funds to the credit card company, even if they sent you the bill two months prior.
On the other hand, in accrual-based accounting, you record revenue (income) when you earn it, regardless of whether or not you have actually been paid. For example, you would record your paycheck at the end of each workday, since you earned the income, even if you only got paid once or twice a month. In accrual accounting, it does not matter when you get paid; it only matters when you earn income. Likewise, you record expenses when you incur them, not when you actually pay them. For example, if you received a credit card bill on the first day of the month, you would record the bill as an expense as soon as you received it, even if you did not pay your bill until 30 days later.
Thus, because of these differences in how income and expenses are recorded, the tax implications come from the fact that in accrual, some of the income you record in one year might not actually be received until the next year, and some of the expenses you incurred might not be paid until the next year. In cash accounting, only the income you receive in a given year counts as income for that year, even if you earned more and didn't receive the funds until the next year. Likewise, if you owe a massive amount on a bill but only paid a small part during the year, you would only record the small part you paid as expense. This is why cash accounting tends to be the simpler of the two methods, but is also why it affects the annual tax return in a different way from accrual accounting.
If you have a major expense in a given year (like a costly medical bill), you could only deduct the amount you actually paid in that year from your taxes if you were on the cash system. If you were on accrual, you could deduct the entire invoice for the year you received it regardless of when you actually paid it. Likewise, on the accrual method, if you earned a massive amount of income in a given year, you would have to record all of the income you earned that year, even if you only received half of the funds that year. On the cash method, you would only need to record as income the amount you actually received.
Be aware that you while you can choose whether to use cash or accrual on your first tax return, the IRS requires you to use the same method in subsequent years. Individual taxpayers and eligible small businesses generally prefer the cash method, because it requires less tedious record-keeping and is generally easier to understand. If your first tax return was calculated using the cash-based method, you will be required by the IRS to use that method on all subsequent returns unless the IRS grants you permission to change methods.
In an accural basis, the date of invoice [or expected payment date, if giving a grace] is taken as the date when the payment was received. Similarly on the expense side, the date when the payment was due is taken as expense. So your profit and loss is on this basis.
On the other hand, on cash basis, if when you receive the funds. By this it means when it is available to you in the Bank account