I would recommend to Bob that in benefit of him and his daughter, he should choose
to start his new business an S corporation or a partnership in order to avoid the double
taxation.
Milestone Two: Revenue Recognition and Accounting Methods
I.
Memorandum
B. Differentiate between accrual accounting and cash basis.
Based on the type of
business and the client’s accounting system, what is the impact when revenue is
recognized?
Under the accrual method of accounting revenues are recognized when they are earned
and the expenses are recognized in the period in which the related revenue is recognized.
Under the cash basis of accounting, revenues are recognized when the cash is received
and the expenses are recognized when they are paid.
Since Bob intends to open a used car business, I do not think using cash basis of
accounting would be appropriate. Closing one car sale can be a complicated task; imagine
closing 30 sales in one month. Using cash basis of accounting would make the tracking of
all the components (for example, down payments, receivables from the approved car
loans from the various lenders, sales tax payable, car registration fee payable to the DMV,
etc.) of each transaction very difficult maintain.
The impact on revenues if Bob uses cash basis as his accounting method rather than the
accrual method is that at the end of the year he could be reporting less revenues, and as a
consequence a lower net income. Many people think they are saving on paying taxes by
using this method, but in reality the income is only being deferred for next year. So,
eventually the income related to the current year’s sales will be reported in the income tax
return.
C. Based on the decision of accrual vs. cash basis, describe when revenue would be
recognized on the sale of inventory, and how the accrual reporting differs from cash
basis.
Based on the information we analyzed above, I believe the best alternative for Bob’s
business is to use the accrual method of accounting. By using the accrual method of
accounting, the revenue would be recognized at the moment when the inventory is sold,
not when the cash is received.
Per IRS Publication 334, under the cash method, the taxpayer must include in the gross
income all items of income received and deduct expenses in the tax year in which it was
paid. But, if an inventory is necessary to account for the income, generally an accrual
method of accounting for sales and purchases must be used.
The following taxpayers can benefit from using the cash method of accounting even if
they produce, purchase, or sell merchandise:
a.
A qualifying taxpayer with:
i.
An average annual gross receipts for each prior tax year ending on or after
December 17, 1998 is $1 million or less.
ii.
Business is not a tax shelter.
