When you file your first tax return for your business, you must indicate the accounting method you use to file your taxes. The accrual method requires you to report income at the time when it was earned and expenses at the time they were incurred, even if you haven't actually received the income or paid the expenses yet, while the cash method requires you to report income when it is received and expenses when they are paid. After you file your initial tax return, you can't change your accounting method without getting permission from the IRS.
If you want to change your accounting method after the first year you file taxes, file Form 3115. You must report your business income and expenses on this form and explain why you want to change accounting methods. Discovering that the method you are using has tax disadvantages is usually sufficient reason to change. The IRS must respond to the form and give you permission to change methods before you switch from accrual to cash method of accounting.
Most businesses are free to use either method of accounting. However, if your business makes more than $5 million dollars in gross receipts, the IRS requires you to use the accrual method of accounting. Thus, for a business of this nature, you won't be able to switch methods unless your revenue drops below $5 million, regardless of your reason for wanting to change.
Reasons to Change
The accrual method of accounting may make it more difficult to know what money your business actually is taking in, according to Nolo.com. Using this method, you list income when it is earned and expenses when they are incurred rather than reporting income when you get it and expenses when they are paid. Thus, you may not have money in your business accounts, even though it's on your books. In addition, you may have to pay taxes on money you haven't yet earned if you record income in December that you don't receive until January.
You should consider which accounting method to use before filing your first tax return so that you don't have to apply for a change of accounting method. Decide which method best suits your business' needs based on how much cash you expect to flow through the business. Most small businesses use the cash method; however, you may wish to use the accrual method if you expect to have a high cash flow or want a better picture of your business' long term profitability.