The main type of accounting methods that the IRS allows a taxpayer to take advantage of are the cash method and accrual method of accounting. It is a general misconception that a taxpayer must utilize one method or the other method, but this is not true. A taxpayer has the option to use a combination of permissible accounting methods.
Hybrid Method Restrictions
For example, the accrual method, which must be used for purchases and sales of inventory, may be combined with the cash method for other items of income and expenses. It is important to understand that there are restrictions that must be followed if a taxpayer wishes to use a hybrid method.
If the cash method is used for income, it must also be used for expense. And if the accrual method is used for expenses, it must also be used for income.
Income Producing Factor
Another important fact to remember is the fact that the accrual method is required to be used by the IRS if inventories are an income producing factor. If this were not mandatory, a cash basis taxpayer could easily reduce reported net income by increasing stock of inventory and then increase reported net income by depleting normal inventory.
The effect of this required adjustment is to change only the computation of the tax deduction for the cost of inventory sold from a strict cash basis to an accrual basis of accounting.
When Inventory is Minimal
The fact that inventories are essential does not always mean that the accrual method of accounting is needed on an overall basis. This is especially true if the business is one in which inventories are minimal, with little change from year to year, and little of business is done on a credit basis.
In this situation, a taxpayer may find it better to keep their books and prepare returns almost entirely on a cash basis, making adjustments only for the variations in opening and closing inventories.