Saturday, May 21, 2022

M-2: ACCRUAL vs CASH basis in ACCOUNTING and TAX – practice and RESEARCH [THE A-GAME V1]

Hello and welcome again uh today's module two uh we will look into accrual and cash basis of accounting with more detailed and we also look into irs publications related to accrual and cash accounting and to see if we can save something on a business taxes .

By going from one basis to another here is a link to irs publications that's a very useful link in that in these publications you will need you will need to look into two uh first uh let's do first things first .

Uh accounting periods and methods i have given you the link here that's that's the shorter one uh 538 recently revised uh we will we will look into some uh useful information here first of all it discussed this discusses .

Accounting periods uh most of the time you will deal with accounting periods which correspond to calendar year but they also all of you to move that period depending on your circumstances and they also provide a bit of a coverage for cash method and accrual .

Method of accounting as well as they give you some insights about inventories inventories is a complicated profit in taxation so first of all all of that is about taxation accounting standards are managed by us gap in previous lecture we discussed a bit about our .

Transactions and i introduced several different columns for transactions two for accounting methods accrual accounting and cash method and two for tax based on cash basis accounting and tax based on accrual method of accounting .

And these four they correspond from time to time and they disagree from time to time that's that's why accountants accountants always have some business to do so let's move on um accounting periods so basically it's a .

Calendar year or a fiscal year which can be different from calendar year if if you happen to deal with an entity with a calendar year different from with a fiscal year different from a calendar year you now know where to go to look for details but that's probably .

Enough to know by now uh about that topic because most of the time small businesses and other businesses have calendar year um only in rare circumstances they change the year but that also some big uh companies also have different years .

I believe apple apple has a different year from calendar change in a tax year so now we come to accounting methods and in accounting methods they say that what methods can you use generally you can figure out a taxable income under any of the following accounting methods .

Cash method accrual method special methods of accounting for certain items a hybrid method which combines element of two or more of the above and that's that's interesting so what we already know what cache method is and what what's an accrual method is .

Uh but what what about special methods so they say that okay we have a farmer's tax guide here so if you're a farmer your accounting might be different from accrual and cash method for tax for tax purposes if you do an installment sales uh that might also be like a leases if you .

Involved with the leases or other types of installment sales you might have a different accounting you might have a different methods if you depreciate property for example uh from time to time irs allows you to take a bonus depreciation which is depreciation of the acquired piece of .

Equipment especially if you're a small business they will all you depreciate a piece of equipment in the year of acquisition which is which is a great deal i i would say you will kind of save a lot of money on your taxes that way i now see that my camera .

Probably is not working but anyway okay i'm i'm here with you you hear my voice no need to see my face uh let's continue here let me even zoom in a bit so special methods and they also refer to 535 publication 535 business expenses .

Which is the other one we have here and they continue on that you can generally use combination of methods but with the following restrictions and that's an important restriction for us if an inventory is necessary to account for your income you must use an accrual method for .

Purchases and sales see exceptions under inventories later generally you can use the cash method for all other items of income and expenses see inventories later so if your business needs if you trade inventories if you sell inventories if you resell inventories .

Most likely you will have to use an accrual method for that that means that you will expense inventories when only when you sell them okay if you use cash method for reporting your income you must use a cash method for reporting your expenses so your income and expenses should use the same .

Method you cannot kind of uh use a cash method for expenses uh so that you kind of accelerate no let's let's say that you cannot use accrual method for your expenses so that you recognize them as soon as you can and then you use cash method for your revenues so that you can postpone revenues as far as you can so your .

Revenue and expense methods must match and save is accrual if you use accrual for the revenues you must use accrual for the expenses and if you use a cache method this must be a cache method you can use um and again it's it's a situation for your .

Um flow through accounting when you are not taxed as a corporation when you run a small business and all of your income and expenses you calculate your business result and it goes into your individual tax return without being taxed as a business in that case your business income and .

Expense should be might be on an accrual basis and your individual income tax might be on a cash basis if you operate to businesses different businesses they must be if they are separate really separate you can run them under different methods of .

Accounting however if you somehow use that to shift profits or losses between your businesses uh then um then those businesses will not be considered separate and distinct and you will have you will have to kind of report it as a .

Same business and you will have to use the consistent method either accrual method for revenues of the expenses or cash method for revenues and expenses okay what do we have here cash method .

Most individuals if you are an individual if you receive a salary you use you basically use a cash method your salary is reflected in your tax return based on cash method and small businesses many small businesses use cash methods too however generally if you use merchandise .

You need to keep an inventory and use an accrual method for sales and purchases of merchandise let's see an example here as we already seen one so here we have accrual method of accounting here we have cash method so we basically expense the inventory with the cash method .

However in taxes regardless of the method you use you will have to capitalize that inventory that merchandise here let's go back income under the cash method you include in your gross income all items of income you actually or constructively receive during the taxed year .

Uh basically they say constructive that when you receive cash for something even if it's a prepayment you have to recognize an expense sorry you have to recognize an income even if you received a prepayment or if you render these services you recognize revenue only when you get cash .

And they have a constructive receipt concept here which means that you it's not to it's not have to be a hard cash you can get a cheque you can get a money in your bank account or if you have some form of the agent or intermediary .

Uh which uh which you have control over and if that entity receives your money it's it's already your revenue it's your income under i remind you that's under cash cash method .

So okay we have an example here you are a calendar year taxpayer you bond credited and made available interest to your bank account in december 2018. you didn't withdraw withdraw it or enter it into your books until 2019. you must you must include that income .

Because it constructively you have received it uh let's let's try to come up with an example here let's go to our example tab and we we will complicate a bit we will complicate that example a bit .

We earned an interest on cd um in year one of let's say 500. bank .

Uh credited that interest to us in year two and we these .

Draw interest in year three okay year one uh debit um okay debit .

Interest receivable 500 so that's an accrual basis credit uh credit interest income what what happens on the cash basis .

Nothing happens because no cash changed hands what happens for the cash basis of accounting uh nothing so in year one the interest wasn't constructively received by us so that's that's zeros .

That zeroes what happens under accrual basis of accounting for tax purposes for tax purposes we recognize it here year two uh we do not .

i would i would say that when when we got that interest available to us we kind of debit cash so we debit cash 500 we credit uh interest receivable 500 .

Uh here if uh because we didn't withdraw that interest in cash accounting we might not have reflected it yet but in tax cash accounting we recognize and we have interest income here um .

So that is when we recognize uh that interest in tax bases and of course these are all zeros uh year three and only in year three when we withdraw we might want to make it .

Debit cash credit uh interest income sorry toot uh sorry here yeah interest receivable interest income all is correct so this one we will be zeros zeros zeros .

And only here we get cash and we get interest income so that's that's a bit complicated example and it's not it's not very real uh but that is that is the way uh how you can understand uh what's what's going on with the business and with cash basis accrual basis and taxes .

As you might see for accrual basis we have like uh two entries here uh while while for tax basis we are mostly concerned with this this one uh because this this is basically not cash entry but .

We might also want to show that in the tax basis so in that case accrual taxation correspond to our cash taxation let's see what what else do we have here expenses under the cash method you deduct expenses in the tax year in which you actually paid them however you need to comply with uniform .

Capitalization rules and we will take a look at it a bit later today but what about expenses paid in advance if you are smart you might want to think that it might be beneficial for you to prepay a lot of .

Expenses in advance and that way you might you might want to um kind of save on taxes to recognize expenses earlier than then you've done them and for that reason they implemented a capitalization rule .

And they also implemented a special rule about expenses paid in advance and it's called 12 months rule under the 12th month rule a taxpayer is not required to capitalize amount paid to create certain rights or benefits for the taxpayers that do not extend beyond the earlier of 12 months after the right of benefit .

Begins the end of the tax year after the tax year in which payment is made so let's imagine let's imagine we are in december 31st 2020 december 31st 2020 what uh .

What amount of prepayments can we make to fully deduct in 2020 and our tax year ends december 31 2020 and the answer is we can prepaid up to 12 months assuming assuming our right of benefit begins like january 1st we theoretically can prepay 12 months .

Through december 31st 2021 and because our tax return ends on next tax return ends on december 31st 21 we will be able to deduct all 12 months and we we have an example here if you are a calendar year taxpayer and pay 3000 in 2018 um let's see .

Let me take a look at my camera for a moment it doesn't look like it's working so basically if we are calendar year taxpayer okay i got back here if your calendar year taxpayer and pay 3000 in 2018 for business insurance .

For three years the general rule is that the expense paid in advance is deductible only in the year to which it applies and so basically if you do it on july 1st you only apply half a year for the first year .

And same situation similar situation your calendar year taxpayer and pay 10 000 on july 1st for a business insurance policy that is effective for only one year beginning on july 1st the 12 months ruler price therefore the full 10 000 is deductible in 2018. let's see .

Let's now make an an example from that where is my file okay it's it will be a pretty long example so we prepaid 3000 in 2018 2018 we prepaid three thousand so credit cash we prepaid .

First we debited prepaid insurance okay sorry my kids want his phone charged uh i will be back in a second okay we are back uh let's come back to our examples multitudes .

Okay that's a benefits of working from home so we have initially we do um uh we have a recognize the prepayment and then uh okay that's july .

2018 now we have december 2018 and on that point we will debit and credit something so we will recognize insurance expense of 500. .

Because it's only half here and we credit uh prepaid insurance we credit prepaid insurance for that 500. okay now let's look in the cash accounting we will expand that immediately .

I have i have a special account here for that purposes i called it uh expense cash basis under tax under tax accounting we still recognize all the prepaids and we only expense it .

We only expense 500 in that year because of the 12 months rule and for accrual basis account tax accounting we will also have the same situation we will if we move into 2019 uh we will record a thousand .

Papa yeah okay so we debit insurance expense and credit um credit prepaid insurance and we will do basically the same in here okay .

So that's a situation with 12 months rule that's an example from the irs publication and here is a similar example the only difference with that example is that we got we got only 12 months of prepayments let me copy .

Copy all of that okay let's see we prepaid on july 1st we prepaid 10 000. uh so we credited cash ten thousand we debited what what .

What attack then we get december okay we got december uh initially we recognized prepaid insurance then on a monthly basis we recognized we recognize an insurance expense which will be yeah .

Uh an expense in accrual accounting and the next year we recognize the other half of expense too and we reduced our prepayment balance now in cash accounting in cash accounting it will always be like this .

Uh okay let's see let's see um okay so in cash accountant we write off the total immediately in tax accounting best based on cash basis .

We are also allowed to write that off immediately slides uh okay and if we use an accrual basis of of taxation our accrual basis taxation will match our account in accrual basis taxation so that's .

That's the part about here excluded entities uh there are an exclusions uh depending on the your form of business you will need to check um oh basically you are excluded .

Um okay i'm back i'm sorry uh it's a saturday anyway kids time uh let's see so if your company has gross receipts over in average over the last three years of 25 million dollars or more you cannot use cash .

You cannot use cash basis or if you're a tax shelter or if you have partnership with a corporation as a member as a partner and the same threshold three years 25 million dollars okay basically you need to meet that gross receipts .

Test to use a cash basis so 25 you need to remember 25 million dollars and if you are in a farming business you might have a different uh you you need to read separately on that and there are a few situations whether you can use or cannot use .

Uh the z basis let's see what what else do we have here we have an accrual basis of accounting and accrual basis for tax purposes most of the time corresponds to the uh tax .

To the accounting accrual method but you might have most of the time for revenues generated or expenses incurred however from time to time you have a transactions which will be which will receive different treatment especially related to acquisition and depreciation of fixed assets .

You report amount in gross income on the earliest of the following date when you receive payment when the income amount is due to you when you earn the income when the title passes and that's interesting because they say that you will recognize an income when you receive it .

Which means that they want you to uh recognize an income when you get a prepayment and they say if you recognize some income based on estimate if you adjust that estimate based on the fact in the future you can adjust that in the year when you determined that .

There was a difference advanced payments that's that's an interesting one that's where we can see some differences between accrual so basically irs wants you to accelerate revenue if you received advances generally you report an advance payment for good services or other items as .

Income in the year you received the payment however if you use an accrual method of accounting you can elect to postpone including the advance payment in income until the next year however you cannot postponed including any payment beyond that beyond that tax year for this purpose .

Advanced payments must be includable in gross receipts under the method of accounting you use for tax purposes and included in income in your applicable financial statements so basically they say if you use if you use accrual basis you can for boss you can kind of postpone .

Uh you can elect to postpone including the advanced payments in the income until until the next year okay financial statement any advance payment you include in gross receipts on your tax return must be included no later than the .

No later when the income is included on it and applicable financial statements uh or other financial strategies supplied by the series section for additional uh information in the list of applicable okay so basically what they say is that you need to .

If you got an advance and you treat it as an advance in your financial statements under accrual basis then you can postpone the irs recognizing that advance in irs revenues up to the time when up to the time when you actually .

Recognize the income in the financial statements advance payment for sales special rules apply to including income from advance payments or an agreement for future sales or other dispositions of goods held primarily for sale to customers let's see if they have some some examples here to consider .

You are a retailer you use an accrual method for accounting for the sale of goods when you ship the goods use it method for both tax and financial reporting purposes you can include advanced payments and gross receipts for tax purposes in either the tax year in which you receive the .

Payments or b the tax year in which you ship the goods however see exception for inventory goods later that's interesting uh i will copy that to consider uh consider that for some practical purposes let's move on .

Information exception for inventory goods if you have an agreement to sell goods properly included in inventory you can postpone including the advance payment in income until the end of the second tax year uh following the year you receive and advance payment .

If on the last day of the tax year you meet the following requirements you account for the advance payment under the alternative method discussed earlier you have received a substantial advance payment on the agreement and you have enough substantially similar goods on hand or available .

Through the normal source of supplies to satisfy the agreement and they give you an example here and i will come back so that that's a pretty complicated and unusual example uh we will come back to it in the later sessions on the next modules let's see let's .

Finish finish that up what about expenses under accrual method for taxation under unaccrual method of accounting you generally the doctor capitalize a business expense when both the following apply the all levels test has been met when all events have occurred that fix .

The fact or the liability and the liability can be determined with reasonable accuracy and economic performance has occurred so if you basically that accrual method for expenses that it matches accrual method of the accounting most of the time .

When they say that the liability is fixed uh so basically that you can determine the value you can determine the value most of the time uh and uh the liabilities fix means actually .

That you kind of incurred the liability for example the vendor transferred the uh like the customer and not sorry the vendor render it uses services and it's an expense .

Or for example you sold you sold the inventory and that's that's already that's already happened that's already sorry for a second kids okay so basically for the expense side for the income side they say that the irs wants uh some .

Advances receipts to be recognized earlier by they give you an option to recognize it later and for the expense side they mostly correspond to the to the accrual method of accounting what what else interesting do we have here .

So we have a related persons if you engage in the transaction with related persons uh it is it is possible uh if you use a various methods of accounting like if they use a cash basis and you use an accrual basis and if you engage in transactions which .

Are kind of intended to decrease your taxable income you will not be able to deduct those expenses so that's that's a statement and here we have um recurrence matching expenses in income .

Calls directly associated with the revenue of a period a properly allocable to that period to determine the accrual an expensive particular year results in a better match with the income to which it relates generally accepted accounting principles are an important factor again again we have a 12 months rule here an expense you pay in advance is .

Deductible only in the year to which it applies unless the expense qualifies for the 12 months rule under the 12 months rule uh the taxpayer is not required to capitalize amount paid to create certain rights or benefits for the taxpayers that do not extend beyond the earlier of the following .

If you have not been applying the general rule and expat pass in advance is deductible on the year to which it applies and or the 12 months rule you must get irs approval so basically they all of you they all you prepaid some expenses even under the accrual basis they all owe you to prepay some .

Expenses if 12 months rule apply and now on inventories an inventory is necessary to clearly show income when the production purchase or sale of merchandise is an income producing factor if you must account for inventory in your business you must use an actual .

Basis of accounting for your purchases and sales however see exceptions next okay so we have exceptions to figure taxable income you must value your inventory at the beginning and end of the each tax year to determine the value you need a method for identifying .

The items in your inventory and method for valuing these items the rules for value inventory are not the same for all businesses the method you use okay so you must have the rules to value the inventory but let's see what's what the exceptions are .

If you're a small business tax payer you can choose not to keep an inventory but you must still use a method for accounting for inventory that clearly reflects income if you choose not to keep an inventory you will not be treated as failing to clearly reflect income if your method of accounting for unit retreats inventory .

As non-incidental material supplies or conforms to your financial accounting treatment of our inventories if cavalry choose to keep an inventory general must use an accounting uh an accrual method of accounting and .

Value the inventory each year to determine the cost of goods sold and you use a three three-year average gross receipts of 25 million or more let's we are running off time now uh let's have a short break uh till 12 when we talk about homework .

Uh i will copy that exception because it doesn't sound it doesn't sound conclusive for me in terms of whether they are talking about only incidental inventories like a materials and supplies .

Or if if if they basically allow a small business taxpayer to deduct all amount of inventories because later here they say that you must include merchandise raw materials work in progress and finnish goods into the inventories and later here they come up with their methods you should .

Use to to value your year-end inventory okay so let's uh end up that stream and i will see you in 10 minutes for the homework stream uh let's see if i have that one already scheduled here .

Okay

RELATED ARTICLES

Most Popular