For tax purposes, a taxpayer must report income and expenses using the cash or accrual method. Under the cash method, a taxpayer reports income when it is actually received, and deducts expenses when they are paid by cash or check. The accrual method specifies that amounts are included in income when earned, and expenses are deductible when incurred, and the amounts can be accurately determined. This is regardless of when the actual cash changes hand. For example, if you perform a service and invoice the customer, you would include the income when it is received under the cash method and include it when invoiced under the accrual method.
Many service businesses use the cash method of reporting.
Not only is the bookkeeping less complex than the accrual method, but it enables the taxpayer to pay taxes only when they actually have the cash. The focus of this IRS attention has been on the question of inventory. The materials for a particular contract are ordered and used as needed for each job. But, in recent court cases the IRS has contended that these materials are necessary for the production of income, making the business ineligible to use the cash method of accounting. The IRS has won some of these cases, but in others the court contended that the IRS was abusing its authority.