07 accounting methods and periods

8/3/2019 07 Accounting Methods and Periods

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Revised February 2007 Page 1

ACCOUNTING METHODS AND PERIODS

After reviewing this chapter, you should be able to:

1. Explain the difference between the economic, accounting, and taxconcepts of income

2. Determine when a particular item of income is taxable under both thecash and accrual methods of reporting

3. Compare accounting method and accounting period choices among thevarious entities

4. Identify factors to be considered in changing the tax year or theaccounting method

Reference Materials: IRS Publication 17Your Federal Income Tax (2006)IRS Publication 334Tax Guide for Small Business (2006)IRS Publication 538Accounting Periods and Methods (Rev. March

2004)

In economics, income is defined as the amount an individual could consume

during a period and remain as well off at the end of the period as he or she was at the

beginning of the period. To the economist, therefore, income includes both the wealth

that flows to the individual and changes in the value of the individuals store of wealth.

Income is equal to consumption plus the change in wealth. Under the economists

definition, unrealized gains as well as gifts and inheritances are income. Furthermore, the

economist adjusts for inflation in measuring income. An individual has no income to the

extent that an increase in the measured value of property is caused by a decrease in the

value of the measuring unit. In other words, inflation does not increase wealth and,

therefore, does not cause an individual to be better off.

In accounting, income is measured by a transaction approach. Accountants

usually measure income when it is realized in a transaction. Values measured by

transactions are relatively objective as accountants recognize income, expenses, gains,

and losses that have been realized as a result of a completed transaction. Accountants

believe that the economic concept of income is too subjective to be used as a basis for

financial reporting and, therefore, have traditionally used historical costs in measuring

income instead of using unconfirmed estimates of changes in market value. In

accounting the meaning of the term realization is critical to the income measurement

process. Realization generally results from the occurrence of two events: (1) a change in


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the form or substance of a taxpayers property and (2) a transaction with a second party.

Thus, if a taxpayer sells some property for cash, a realization has occurred. The property

has been changed to cash and the transaction was with a second party. Conversely, the

mere increase in value of property owned by a taxpayer will not result in the realization

of income because there has been no change in the form of the property and no

transaction with a second party.

The income tax law essentially has adopted the accountants concept of income

rather than the economists. The reasons for this generally relate to matters of

administrative convenience and the wherewithal-to-pay concepts. The economic concept

of income is considered to be too subjective to be used as a basis for determining income

taxes. The need for objectivity in taxation is evident. If taxpayers were required to report

increases in value as income, some individuals would certainly understate values to

reduce their tax liabilities. The disputes over valuation issues would be constant, and the

courts would be unduly burdened. It would be practically impossible to fairly and

consistently administer an income tax law that was based on subjective valuations.

The wherewithal-to-pay concept holds that a tax should be collected when the

taxpayer can most easily pay it. A taxpayer who owns property that has increased in

value may not have the cash to pay the tax if the increase in value were subject to

taxation at the time it occurred. Taxing the gain when it is realized often means that the

tax becomes due at the time the taxpayer collects the sales price in cash. A taxpayer has

the greatest wherewithal to pay when income is realized. The wherewithal-to-pay

concept is the rationale for certain provisions of the tax law. For example, a taxpayer

collects the proceeds from an installment sale transaction after the sale takes place. The

tax law allows the taxpayer to report the sale using the installment method, under which

the gain is reported as the sales proceeds are collected. Thus, the tax becomes due when

the taxpayer has the wherewithal to pay. The wherewithal-to-pay concept is also used to

justify certain differences between tax law and financial accounting principles. In

financial accounting, prepaid income is not reported until it is earned, even if it is

collected before it is earned. In contrast, prepaid income is subject to taxation at the time

it is collected rather than when it is earned for both cash and accrual basis taxpayers (Pub.

538, pages 14, 16, and 17). At that time, the taxpayer has the cash available to pay the


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tax. It might be more difficult to collect the tax if the government waited until the

income was earned, because the money might have already been spent.

The year in which income is taxed depends on the taxpayers accounting method.

The three primary overall accounting methods are the cash receipts and disbursements

method (Pub. 553, page 14), the accrual method (Pub. 553, page 16), and the hybrid

method (Pub. 553, page 13). While taxpayers have the right to choose a method of

accounting, the chosen method still must clearly reflect income as determined by the IRS.

The IRS has the power to change the accounting method used by a taxpayer if, in the

opinion of the IRS, the method being used does not clearly reflect income. Furthermore,

the regulations require taxpayers to use the accrual method for determining purchases and

sales when a taxpayer maintains inventory (although certain exceptions exist). Income

would not be clearly reflected if beginning and ending inventories were ignored.

IRC Section 448 requires C corporations (and partnerships with corporate

partners), tax shelters, and certain trusts to use the accrual method of accounting.

Qualified personal service corporations, certain types of farms, and entities with average

gross receipts under $5 million are exempt from the requirement (Pub. 553, page 15).

Once an accounting method has been adopted, it cannot be changed without permission

from the IRS.

Most individual taxpayers and most noncorporate businesses that do not have

inventories use the cash receipts and disbursements method of accounting (Pub. 553,

page 14). Under this method, income is reported in the year the taxpayer actually or

constructively receives the income rather than in the year the income is earned. The

income can be received by the taxpayer or the taxpayers agent and be in the form of

cash, other property, or services. In the case of property or services, the amount included

in income is the value of the property or services. An account receivable or other

unsupported promise to pay is considered to have no value under the cash method, and as

a result, no income is recognized until the receivable is collected. The fact that prepaid

income is usually taxed when received rather than when earned often results in a

mismatching of income and expenses. Reporting prepaid income can have harsh results

because it is not offset by related deductions. If the income is taxed before the expenses


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are incurred, the taxpayer may not have enough cash to pay the expenses when they are

incurred.

A cash-basis taxpayer must report income in the year in which it is actually or

constructively received (Pub. 553, page 14). Constructive receipt means that the income

is made available to the taxpayer so that he or she may draw upon it at any time.

However, income is not constructively received if the taxpayers control of its receipt is

subject to substantial limitations or restrictions. This rule prevents the taxpayer from

deferring income that is otherwise available by merely turning his/her back on it. A

taxpayer cannot defer income recognition by refusing to accept payment until a later

taxable year. Examples of constructive receipt where taxpayers are required to report

taxable income even though no cash is actually received include:

A check received after banking hours Interest credited to a bank savings account Bond interest coupons that have matured but have not been redeemed Salary available to an employee who does not accept payment

An amount is not considered to be constructively received if: It is subject to substantial limitations or restrictions The payor does not have the funds necessary to make payment The amount is unavailable to the taxpayer

There are exceptions to the basic rule that cash-basis taxpayers report income

when it is actually or constructively received. The interest on Series I, Series E, and

Series EE U.S. savings bonds need not be reported until the final maturity date, which

varies but may be as long as forty years after the date of issue. Many taxpayers purchase

bonds with a maturity date that occurs after retirement, when the taxpayers expect to be

in a lower tax bracket. Special rules also apply to farmers and ranchers. Farmers may

report crop insurance proceeds in the year following receipt if the crop would have

ordinarily been sold in the following year. Ranchers who sell livestock on account of a

drought, flood, or other weather-related conditions may delay reporting income until the

following year if they can establish that the livestock sale would otherwise have taken

place in a later tax year. These rules help taxpayers avoid a bunching of income into one

year.


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Taxpayers using the accrual method of accounting generally report income in the

year in which it is earned (Pub. 553, page 16). Income is considered to have been earned

when all the events have occurred that fix the right to receive the income and when the

amount of income can be determined with reasonable accuracy. In the case of a sale of

property, income normally accrues when title passes to the buyer. Income from services

is earned as the services are performed.

A major exception to the normal operation of the accrual method is the rules

applicable to the receipt of prepaid income. Prepaid income is generally taxable in the

year of receipt. For example, if a lender receives January interest in the preceding

December, it is taxable in the year received whether the lender uses the cash or accrual

method. This treatment differs from financial accounting, where the interest would be

reported as it accrues. Two important exceptions to the general rule are worth noting.

Accrual-basis taxpayers may defer recognizing income in the case of certain payments

for goods and in the case of certain advance payments for services to be rendered (Pub.

553, pages 16 and 17). A taxpayer may defer advance payments for goods if the

taxpayers method of accounting for the sale is the same for tax and financial reporting

purposes. Revenue Proc. 2004-34 (2004-1 CB 991) permits an accrual basis taxpayer to

defer recognition of income for advance payments of services after the end of the tax year

of receipt. The portion of the advance payment that relates to services performed in the

tax year of receipt is included in gross income in the year of receipt. The portion of the

advance payment that related to services to be performed after the year of receipt is

included in gross income in the tax year following the year of receipt of the advance

payment.

The hybrid method of accounting is a combination of the cash and accrual

methods. Under the hybrid method, some items of income or expense are reported under

the cash basis and others are reported under the accrual method. The method is most

often encountered in small businesses that maintain inventories and are required to use

the accrual method of accounting for purchases and sales of goods. Such businesses

often prefer to use the cash method of reporting for other items because the cash method

is simpler and may provide greater flexibility for tax planning. A taxpayer using the

hybrid method of accounting would use the accrual method with respect to purchases and


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sales of goods but would use the cash method in computing all other items of income and

expenses.

The annual accounting period concept requires all entities to report the results of

operations on an annual basis. The period for which an entity reports its income and

expenses is referred to as the taxable year. A taxable year may be either a calendar year

(ending December 31) or a fiscal year (Pub. 553, page 2). A fiscal year is defined as a

period of 12 months ending on the last day of any month other than December, or a 52-

or 53-week taxable year. The 52- or 53-week fiscal year ends on the same day of the

week each year (Pub. 553, page 3). The year must end either the last time a particular

day occurs during the month (the last Wednesday in October) or the day that occurs

closest to the end of a particular month (the Friday closest to March 31, even if that

Friday happens to be April 2).

An entity establishes a taxable year by keeping its books on the basis of that year

and filing its tax return based on that taxable year. This requires the entity to formally

close its books on that date and file a timely tax return for the tax year selected. If the

entity does not close its books on that date or if it does not keep formal books, it must use

a calendar year. In addition, if the entity closes its books on a date that does not qualify

as a fiscal year (November 15), it must use a calendar year for tax purposes.

Taxpayers are generally free to choose which accounting period they will use as

their taxable year. However, the tax law limits the choices for partnership and S

corporations (Pub. 553, page 7). A sole proprietorship is not an entity separate and apart

from its owner and therefore must use the same tax year as its owner. Because of the

record-keeping requirement, most individuals use calendar years (Pub. 553, page 6).

Corporations are separate legal and taxable entities and have extensive flexibility in their

choice of accounting periods (Pub. 553, page 12). Without restrictions on the selection of

a taxable year, owners of conduit entities could obtain a tax deferral benefit by having the

entity select a taxable year different from that of the owners. Because of this potential

deferral, the tax law contains a set of rules that limits the choice of taxable years for

partnerships and S corporations.

A partnership tax year is selected on a hierarchical basis that attempts to match

the tax year of the partnership to that of the partners. First, the partnership must use the


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tax year used by those partners having a majority interest in partnership profits and

capital, called the majority-interest tax year (Pub. 553, page 7). If the majority interest

partners do not have the same tax year, the partnership must use the tax year of its

principal partners, referred to as the principal partner tax year. A principal partner is a

partner with at least a 5 % interest. When the principal partners do not have the same tax

year, the partnership must use the tax year that results in the least aggregate deferral of

income for the partners. Because the purpose of the partnership limitations is to affect

the least amount of deferral, under this rule, a partnership will always use the tax year of

at least one partner. A partnership can use a taxable year other than that prescribed by the

hierarchical rules if it can establish to the IRSs satisfaction that a valid business purpose

exists for having a different tax year. To establish a business-purpose tax year, the

partnership must obtain permission from the IRS by proving that the year selected does

not create, for either the partnership or its partners, significant deferral of income or

shifting of deductions. The type of business-purpose tax year granted most frequently is

the natural business tax year.

In general, an S corporation must use a calendar year (Pub. 553, page 8).

However, it can choose an alternate year under the ownership tax year or the natural

business year exceptions. An ownership tax yearis the tax year of more than 50% of the

owners of the corporation. Thus, the ownership tax year is similar in concept to the

majority-interest tax year of a partnership. A natural business year is defined as the

annual accounting period encompassing all related income and expenses. To establish a

natural business year, an S corporation (or a partnership) must have peak and off-peak

business periods. The natural business year is the end of the peak business period. A

mechanical test determines a natural business year (Pub. 553, page 10). Under this test,

an annual accounting period qualifies as a natural business year if the gross receipts from

sales or services for the final two months of the current year and each of the two

preceding years equal or exceed 25% of the gross receipts for the entire 12-month period.

Taxpayers are required to maintain the accounting records necessary to enable

them to file their annual tax returns. To properly characterize income and deduction

items, taxpayers must select an accounting method. In selecting a method of accounting,

taxpayers are required to use, for taxable income computation, the method of accounting


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that they regularly use for their books. The method must be used consistently from

period to period and must clearly reflect the income of the taxpayer. Once the accounting

method is adopted, the taxpayer must use it consistently from one period to the next. As

with accounting periods, entities have a significant degree of latitude in selecting their

accounting methods. However, certain provisions restrict the choice for certain types of

taxpayers. For example, a basic restriction imposed on entities that have inventories of

goods is that they must use the accrual method to account for sales and cost of goods sold

(certain exceptions apply). This requires entities with inventories to select either the

accrual or hybrid method to compute taxable income (Pub. 553, page 21).

A partnership can generally elect to use any accounting method. The election is

made at the partnership level and is independent of the method(s) of accounting used by

the partners. A partnership electing the accrual method forces its partners to report

income of the partnership on the accrual method, even if the partners use the cash

method. A partnership that has at least one corporate partner must use the accrual

method. This restriction is an extension of the corporate restriction to prevent using a

partnership to defer taxes through use of the cash method.

A corporation is generally required to use the accrual method of accounting (Pub.

553, page 15). Any method that accounts for some but not all items on the cash basis is

considered a cash method. The restriction on the use of the cash method is designed to

prevent a corporation from manipulating its cash receipt and disbursement policies to

obtain a tax advantage. Corporations and partnerships in which a corporation is a partner

may still elect to use the cash method if the average gross receipts for the three previous

years are $5 million or less (Pub. 553, page 15). A second exception allows a corporation

or a partnership with a corporate partner that is engaged in farming to use the cash

method, regardless of the amount of its gross receipts. If the entity is also engaged in a

separate nonfarming business, it must account for that portion of its business by using the

accrual method, unless the exception for average annual gross receipts applies. An S

corporation is allowed to use either the cash method or the accrual method. No

restrictions on the use of the cash method apply to S corporations, other than the general

restriction regarding inventories.


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Once an accounting method has been chosen, the taxpayer must continue to use it

until the IRS requires him or her to change methods, or a request is made by the taxpayer

to the IRS for permission to change and the permission is granted (Pub. 553, page 28).

Generally, the IRS will not require a taxpayer to change his or her accounting method

unless it believes a different method would more clearly reflect income. A change in

accounting method includes changes in the overall accounting method or changes in the

treatment of any material item. A material item involves consideration of the proper

timing for the inclusion of the item in income or the taking of a deduction. Changing

from the accrual method to the cash method (or vice versa) is a change in accounting

method. Changing the timing of a deduction for wage expense due to the incorrect

accrual of these items in previous periods by a cash basis taxpayer is a change in the

treatment of a material item of deduction and thus would be considered a change in

accounting method. The following situations require consent from the IRS (Pub. 553,

page 28):

A change from the cash method to the accrual method or vice versa A change from the cash method or accrual method to the percentage of

completion method or vice versa A change in the method or basis used in valuing inventories A change involving any other specialized method of figuring taxable

income, such as the crop method A change in the treatment of any other item of income or expense, or a

change that specifically requires IRS consent

These changes should be distinguished from a change in a tax return due to the

correction of an error. For example, if ending inventory was understated because a few

items were missed, the taxpayer need only file an amended return with the correct

figures. No permission is required from the IRS because there is no change in the

treatment of a material item. The following are examples of error correction:

Correction of mathematical or posting errors Errors involving the computation of tax liability Adjustment of income or deduction items that do not involve proper

timing for inclusion of items A change in the estimate of the useful life of a depreciable asset Changes in the treatment of any item that result from changes in

underlying facts


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A request for a change in accounting method is made by the taxpayer on Form

3115, Application for Change in Accounting Method, and should be filed within 180

days after the beginning of the taxable year of the desired change (Pub. 553, page 28).

The IRS has almost total discretion in granting or not granting these changes. Even if it

does give permission to change, the IRS usually imposes conditions dealing with the

timing of any adjustments to be made. Taxpayers must make adjustments to income in

the year of change to avoid duplicating or omitting items of income or deduction.

A new taxpayer will adopt his or her first tax year on or before the due date for

filing the return for that year. The taxpayer establishes the annual accounting period by

keeping and closing the books and records on the basis of that period. Once an

accounting period has been chosen, the taxpayer may not change it unless prior

permission is received from the IRS. Such a request is made by filing Form 1128 on or

before the 15th day of the second month following the close of the short period for which

a return would be required to effect the change. The IRS will approve a request for

change in taxable years only if the taxpayer can establish a substantial business purpose

for the change. Additionally, the taxpayer must agree to any terms, conditions, or

adjustments required by the IRS as a requisite to approving the change. Such

adjustments usually are required to avoid any distortion of income that might occur as a

result of the change. Certain changes in the accounting period of a taxpayer do not

require IRS consent. They are as follows:

The taxpayer changes to a 5253 week tax year that ends withreference to the same calendar month as the month ending his or herprevious tax year.

The taxpayer is an individual who marries a person with a different taxyear.

The taxpayer is a tax-exempt organization.


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REVIEW QUESTIONS


1. The wherewithal-to-pay concept suggests that:a. a tax should be collected at the time a transaction is completed.b. taxpayers in different economic situations should be treated differently.c. the ability to pay a tax is greatest when income is realized.d. losses may be reported on an installment basis.

2. Examples of income which are constructively received include all of thefollowing except:

a. interest credited to a savings account.b. a check received after banking hours.c. dividends available on December 31; unclaimed dividends will be mailed

out.d. a paycheck received from an employer when the employer does not have

funds in the bank to cover the check.

3. Which of the following advance payments cannot qualify for income taxdeferral?

a. advance collection of rent with associated servicesb. advance collection of rent without associated servicesc.

advance collection for servicesd. advance collection for merchandise

4. KL Computer Corporation, an accrual basis taxpayer, sells service contracts onthe computers it sells. At the beginning of January of this year, KL Corporationsold contracts with service to begin immediately in the month of sale:

One contract for 12 months $300One contract for 24 months $600One contract for 36 months $900

The amount of service contract income KL Corporation must report for this yearis:a. $ 300.b. $ 600.c. $ 900.d. $1,800.


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5. Helmut is a calendar-year proprietor. He began business on December 1 of thisyear. He uses the accrual method of accounting. Helmut had the followingcollections in December:

$9,000 in December, from clients who paid cash for services to beperformed next year.$7,000 in December, for services performed during December; depositedin an operating account on December 31 of this year.$5,000 in December, on accounts receivable for services performed inDecember; deposited in operating account on January 2 of the new year.

What is the amount Helmut must include in his income for December?

a. $ 5,000b.

$12,000c. $ 7,000

d. $21,000

6. One of the requirements that must be met in order to defer recognition of incomefor advance payments for goods is that:

a. the amount received is more than the taxpayers cost of the goods.b. the goods are on the taxpayers premises on the last day of the tax year.c. the taxpayers method of accounting for the sale for tax purposes is the

same as the method used for financial reporting purposes.d. the goods are produced in the United States.

7. Yong, who gives music lessons, is a calendar year taxpayer using the accrualmethod of accounting. On November 2 of this year, he received $12,000 for aone-year contract beginning on that date to provide 10 lessons. He gave 2 lessonsthis year. How much should Yong include in income this year?

a. $-0-b. $2,000c. $8,000d. $2,400


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8. Jones rented office space two years ago to Harris, receiving the first and lastmonths rent plus a security deposit of $800. In early January of this year, Harrismoved and Jones refunded $200 of the deposit and kept the remainder to cover$500 that was spent for repairs to the office space and one week of unpaid rentthat amounted to $100. How would this information be reflected on Jones taxreturn this year?

a. $600 income and $500 deductionb. $500 income and $100 deductionc. $600 income and no deductiond. $600 income and $100 deduction

9. Ray, an accrual-basis taxpayer, leases out an office building at $600 per month,starting in October. Ray receives rent for October and November. He also

charges a refundable security deposit of $800, which he also received in October.Rays tenant does not pay the December rent until January 2 of the next year.This year, Ray must report rental income of:

a. $1,200.b. $1,500.c. $1,800.d. $2,300.

10. Which of the following is not included in gross income when received?a. prepaid rentb. refundable security depositc. amounts received to cancel or modify a leased. copyright royalties

11. Which of the following types of income is taxed to the entity receiving it ratherthan being passed through to an owner or beneficiary who pays tax on theincome?

a. partnership incomeb. S corporation incomec. income in respect of a decedentd. C corporation income

12. Mr. Lam rents property and does not provide any services associated with therentals. He is also a cash basis taxpayer. If Mr. Lam collects advanced rent of


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$1,200 on November 1 of the year for a one-year lease, how much is reported asincome on this years tax return?

a. $1,200b. $ 100c.

$ 200d. $-0-

13. All of the following are acceptable tax accounting methods except:a. cash.b. accrual.c. hybrid.d. adjusted accrual.

14. Which method of accounting is used by most individual taxpayers?a. accrualb. cashc. GAAPd. hybrid

15. Farmers may report crop insurance proceeds in the year following receipt if thecrop ordinarily would have been sold in the:

a. earlier year.b. same year as the receipt.c. following year.d. none of the above is correct.

16. Illegal income is:a. nontaxable.b. deferred income.c. always a long-term capital gain.d. taxable.


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17. Which of the following entities directly bear the burden of income taxes?I. IndividualsII. CorporationsIII.

Partnerships

a. Only I is correct.b. Only II is correct.c. I and II are correct.d. I, II, and III are correct.

18. Rhonda is the financial vice-president and owns 40% of Myers Co. Myers is an Scorporation and reports taxable income before payments to Rhonda of $80,000.Rhonda receives a $40,000 salary. What is Rhondas income from Myers?

a. $32,000b. $40,000c. $56,000d. $72,000

19. A new corporations choice for its annual accounting period:I. must be approved by the IRS.II. must be the same as its majority shareholder.

a. Only statement I is correct.b. Only statement II is correct.c. Both statements are correct.d. Neither statement is correct.

20. A fiscal year can be:I. a period of 12 months ending on the last day of any month other

than December.II. a period of 12 months ending on any day during the month other

than December.



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21. Which of the following statements regarding a partnerships tax year is/arecorrect?

I. A partnership formed on July 1 must adopt a tax year ending onJune 30.II. A valid business purpose can no longer be claimed as a reason foradoption of a tax year other than the generally required tax year.


22. Which of the following taxable years are allowable by a newly formed partnershipwithout obtaining prior approval from the IRS?

I. A January 31 year-end if it is a retail enterprise with a naturalbusiness year ending January 31 and all of its principal partners areon a calendar year.

II. A calendar year if majority partners and principal partners havevaried year-ends.

III. A taxable year that is the same as that of its majority partners.a. Only I is correct.b. Only II is correct.c. Only III is correct.d. II and III are correct.

23. Dogg Corporation, Katt Corporation, and Rabitt Corporation are equal partners inCritter Partnership. The partners fiscal year ends are as follows:

Dogg Corporation February 28Katt Corporation May 31Rabitt corporation September 30

Which of the following statements is/are correct?I. Critter Partnership may elect to use any of the three dates that the

partners use.II. Critter Partnership may use any tax year.



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24. Snoopy Corporation, Garfield Corporation, and Dogbert Corporation are partnersin Comic Partnership. The partners fiscal year-ends and ownership interestsfollow:

Snoopy Corporation February 28 15% interestGarfield Corporation May 31 30% interestDogbert Corporation September 30 55% interest

I. Comic Partnership must use a calendar year end unless the IRSapproves an election for a different tax year.

II. Comic Partnership must use a September 30 fiscal year end.a. Only statement I is correct.b. Only statement II is correct.c. Both statements are correct.d.

Neither statement is correct.

25. Doug, Kate, and Gabe own Chicken, Inc., an electing S corporation. Theshareholders ownership percentages and fiscal year-ends follow:

Doug 55% interest February 28Kate 30% interest May 31Gabe 15% interest September 30

Which of the following statements is (are) correct?I. Chicken, Inc. must use a calendar year.II. Chicken, Inc. may elect to use a fiscal year ending February 28.


26. Which of the following businesses must use the accrual method of accounting?I. Dog Ear Pages, a local book store with annual gross receipts of

$950,000.II. Hometown Mortgage Corporation, which has annual gross receipts

of $10,000,000.



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27. Which of the following businesses can use the cash method?I. The Doncaster Group, a partnership with 3 equal partners, of

which one is The Arden Corporation. Average revenues for the

Doncaster Group, a consulting firm, over the past three years are$4,000,000.II. The Cobra Corporation, a computer retailer that has average annual

sales over the past three years of $2,100,000.


28.

Certain interest income is not taxable. Which of the following interest paymentswould be excluded from taxable income?

a. bank savings account interestb. savings and loan interestc. municipal bond interestd. credit union account interest

29. The accrual method of accounting:a. is required if the sole proprietor maintains inventory.b. is required if the sole proprietorship does not maintain inventory.c. may be elected by the sole proprietor if he or she maintains inventory.d. is not allowed on any individual tax return.

30. Cash basis accounting means:a. revenue is reported when earned.b. revenue is reported at the end of the fiscal period.c. revenue is reported when cash is received.d. revenues and expenses are matched.


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REVIEW QUESTION SOLUTIONS AND EXPLANATIONS


1. The correct answer is C, the ability to pay a tax is greatest when income isrealized. The wherewithal-to-pay concept is not addressed in IRS Publications,

but the concept can be observed in the graduated income tax rates that are inplace. The wherewithal-to-pay concept holds that a tax should be collected whenthe taxpayer can most easily pay it. Completing a transaction does not implyreceiving a cash flow; this is not wherewithal-to-pay. Selection B is sufficientlyvague as to not say anything at all. Losses do not imply a wherewithal-to-pay;losses are on the accrual basis at the time of the transaction, not when you receivethe cash.

2. The correct answer is D, a paycheck received from an employer when theemployer does not have funds in the bank to cover the check. A cash-basistaxpayer must report income in the year in which it is actually or constructively

received. Constructive receipt means that the income is made available to thetaxpayer so that he or she may draw upon it at any time (see ConstructiveReceipt of Income on pages 15 and 16 of Publication 17). Examples ofconstructive receipt where taxpayers report taxable income even though no cash isreceived include a check received after banking hours, interest credited to a banksavings account, bond interest coupons that have matured but have not beenredeemed, and salary available to an employee who does not accept payment. Anamount is not considered constructively received if it is subject to substantiallimitations or restrictions, the payor does not have the funds necessary to makethe payment, or the amount is unavailable to the taxpayer. If the dividends areavailable to you, and all you need do is drive over to get them, or they are ondeposit in your account, you have constructive receipt. Additional information onconstructive receipt can be found in Publication 334 (page 13) and Publication538, Accounting Periods and Methods (page 14).

3. The correct answer is B, advance collection of rent without associated services.Under Rev. Proc. 71-21, a taxpayer may defer advance payments for services ifthe payments are for services performed after the year of receipt. The rule foundin Revenue Procedure 2004-31 is applied to a variety of services, such as dancelessons, maintenance contracts, and rent with associated services. The rule doesnot apply to warranties and rent without associated services. Accrual basistaxpayers may defer recognizing income for certain payments for goods,generally if the tax treatment is the same as the financial treatment, and in the case

of certain advance payments for services. Information on this topic can be foundin a variety of IRS publications (Pub. 17, Rental Income, pages 64 through 69;and Pub. 334, Advance Payment for Sales and Advance Payment for Services,page 14).

4. The correct answer is C, $900. Income reportable on the 12-month contract is$300. The 24-month contract and the 36-month contract will each generate $300of current income ($600 12/24 = $300 and $900 12/36 = $300). This


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information can be found in Publication 538, Accounting Periods and Methods,under the heading Accrual MethodAdvance Payment for Services, on page 16.

5. The correct answer is B, $12,000. Under Revenue Procedure 2004-34, ataxpayer may exclude advanced payments received in the current year, where theservices (or some merchandise sales) are to be provided in the year following thecurrent year. Following this rule the $9,000 collected in December for servicesnext year can be excluded, the $7,000 collected for services provided this year isincluded, and the services performed this year but paid for in the year following ispicked up in the year the services are provided. This taxpayer is an accrual-basistaxpayer and recognizes income when services are provided, except for thesituation described above. The $7,000 plus $5,000 gives us $12,000 (seeAdvance Payment for Sales, on page 15 in Publication 334 and page 17 inPublication 538).

6. The correct answer is C, the taxpayers method of accounting for the sale for taxpurposes is the same as the method used for financial purposes. Accrual basistaxpayers may defer recognizing income for certain payments for goods,generally if the tax treatment is the same as the financial treatment, and in the caseof certain advance payments for services. The other options are way off base (seeAdvance Payment for Sales, on page 15 in Publication 334 and page 17 inPublication 538).

7. The correct answer is D, $2,400. Under Rev. Proc. 71-21, a taxpayer may deferadvance payments for services if the payments are for services after the year ofreceipt. Such payments are reported as the services are performed. The totaladvance payment is $12,000 for ten lessons to be received within one year,making each lesson worth $1,200 ($12,000/10 lessons). Two lessons provided this

year times $1,200 per lesson equals $2,400 recognized income for this year. Theaccrual method of accounting is discussed on page 13 of Publication 334.

8. The correct answer is A, $600 income and $500 deduction. The question isasking how to treat the $800 security deposit, which is not an advance payment.The $600 ($800 deposit less $200 refund) is revenue in the month that the moneybecame available to the landlord Jones. Before the payment of the $200 and theconfiscation of the $600 remainder of the security deposit, the amounts were heldin trust and not available to Jones due to fiduciary responsibility. (See SecurityDeposits on page 64 of Publication 17). The repairs performed on the officespace of $500 are deducted when incurred. Foregone income is not deductible

unless it was claimed previously as income (accrual income claimed may be takenas bad debt expense in the month when the accounts receivable can be proved tohave become uncollectable), which in this case it would not have been. Foradditional information on this subject see page 21 (Real Estate Rents) inPublication 334 and pages 63 to 69 in Publication 17.

9. The correct answer is C, $1,800. Accrual basis taxpayers report income in themonth it is earned, except for the example above relating to prepaid income (see


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page 72, Rental Income, in Publication 17). The entire three months rent isincome for the current year; $600 times 3 months equals $1,800 rent income. Therefundable security deposit is not income (see Security Deposits, on page 62 ofPublication 17).

10.The correct answer is B, refundable security deposit. Any amounts received onbehalf of another under a fiduciary responsibility, such as security deposits,escrow payments, sales tax, withholding tax on employee wages, clients portionof settlement payments made to attorneys, etc., are not reported as income until orunless they are forfeited to the person paid (see Security Deposits, on page 62 ofPublication 17). Prepaid rent with associated services can be deferred underspecial circumstances discussed above, in #3 and #7. Option A is possibly truedepending upon the circumstances. Option B is definitely true and is the betteranswer. Information on Option C can be found on page 22 in Publication 334,Real Estate Rents (Lease Cancellation Payments).

11.The correct answer is D, C corporation income. Sole proprietorships,partnerships, and S Corporations are pass-through entities that do not pay incometaxes directly but pass through taxable income to their owners, partners, members,and stockholders, who pay the tax on their individual income tax returns, usingForm 1040 (see Publication 17, Pass Through Entities, on page 189).

12.The correct answer is A, $1,200. Advance rent without any provided servicesdoes not qualify for income deferral until the services are provided. With a cash-basis taxpayer the amounts are reportable when received. No computation isnecessary; the amount is given to you in the question (see Publication 17, page 64,Advance Rent).

13.The correct answer is D, adjusted accrual. The cash method reports income andexpenses when paid with some notable exceptions, such as the installmentmethod, and depreciation. The accrual method generally reports income whenearned and expense when used and uses the actual transaction to record income,with some exceptions, discussed in #3 and #7 above. The hybrid method is acombination of accrual and cash methods. Adjusted accrual is not one of thethree primary overall accounting methods listed by the IRS. Informationconcerning the accounting methods recognized by the IRS can be found on page13 in Publication 334.

14.The correct answer is B, cash. Most individual taxpayers and most noncorporatebusinesses use the cash receipts and disbursements method of accounting.Internal Revenue Code Section 448 requires C Corporations and partnerships withcorporate partners, tax shelters, and certain trusts to use the accrual method ofaccounting, with exceptions. Methods of accounting are defined in question #13above.

15.The correct answer is C, following year. Farmers have a number of exceptionsthat set them off from other businesses in their tax reporting. Certain farms are


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allowed to use the cash basis of accounting. Additional information concerningthe tax accounting provision for farmers can found in IRS Publication 225,Farmers Tax Guide.

16.The correct answer is D, taxable. A gain from an illegal transaction such asbootlegging, extortion, embezzlement, or fraud is also includable in taxableincome. Illegal income is discussed in Publication 17, on page 87.

17.The correct answer is C, I and II are correct. Individuals (I) and corporations(II) pay income taxes. Partnerships (III) are pass-through entities; they do not payincome tax themselves but pass through the taxable income to the partners, whopay on the individual income tax return form 1040. Additional information onpartnerships can be found in Publication 541, Partnerships.

18.The correct answer is C, $56,000. The $80,000 income for the entire companyis reduced by a salary to Rhonda of $40,000, making the taxable income of thecorporation $40,000. Then Rhonda is entitled to 40% of the $40,000 corporate (S

Corporation) net income that will be distributed to her via the form K-1, and shewill report it on her Form 1040 Schedule E in the amount of $16,000. Rhondawill also receive a W-2 showing her salary of $40,000. Add the W-2 and the K-1and you get $56,000 income from Myers Co.

19.The correct answer is D, neither statement is correct. A new taxpayer (thisincludes corporations) will adopt his or her first tax year on or before the due datefor filing the return for that year. The taxpayer establishes the annual accountingperiod by keeping and closing the books and records on the basis of that period.Taxpayers are generally free to choose whatever accounting period they will useas their taxable year. C corporations are entirely free to select any taxable year,

while S corporations have some restrictions. Publication 538, Accounting Periodsand Methods, discusses the adoption of a tax year by a corporation on page 12under the heading Corporations (Other Than S Corporations and PSCs).

20.The correct answer is A, only statement I is correct. A fiscal year is defined as aperiod of 12 months ending on the last day of any month other than December ora 52/53-week taxable year. A 52/53-week fiscal year ends on the same day of theweek every year, either the last time a particular day occurs during the month orthe day that occurs closest to the end of the particular month, even if the date is inthe first week of the subsequent month. Fiscal years are discussed in Publication538, Accounting Periods and Methods, on page 3.

21.The correct answer is D, neither statement is correct. A partnership tax year isselected on a hierarchical basis that attempts to match the tax year of thepartnership to the tax years of the partners (I is false). A partnership can use ataxable year other than that prescribed by the hierarchical rules if it can establishto the Internal Revenue Services satisfaction that a valid business purpose(usually the natural business year is considered a valid business purpose) existsfor having a different tax year (II is false). Information on the adoption of a


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partnership tax year can be found in Publication 538 on page 7, under the headingPartnerships, S Corporations, & PSCs.

22.The correct answer is D, II and III are correct. See question 21. Statement I isfalse since one can pick the natural business year, should it not conflict with thepartners tax years, or pick the partners tax years without paying attention to thenatural business year. January 31 results in significant deferral of income andwould probably not be allowed. If both majority and principal partners havevaried year-ends, the partnership must use the tax year that results in the leastaggregate deferral of income for the partners; since the calendar year would beconsidered to have the least deferral of income in most cases, this is mostprobably true. The first tier is to set up a tax year that is the same as the tax yearof the majority partners; therefore, statement III is true (see page 7 in Publication538).

23.The correct answer is D, neither statement is correct. If the majority and theprincipal partners tax years are all varied, the partnership must pick the tax yearthat provides the least deferral of income (Pub. 538, Least Aggregate Deferral ofIncome, page 7). It is unlikely that any of the dates of the taxpayers tax yearswould be equally acceptable to the IRS; statement I is false. The least likely yearto pick would be that ending on September 30, since this year would result in themost distortion of income, because it is not close to the other two dates; therefore,statement II is false. For an example of the computation of a partnership tax yearwith the least deferral of income, see page 7 of Publication 538.

24.The correct answer is B, only statement II is correct. Comic Corporation mustuse the tax year that is the same as that of the majority interest partners. Themajority interest partner is Dogbert, with a 55% interest. Dogbert uses a fiscal

year ending September 30; therefore, statement II is true, and statement I is false(see page 7 of Publication 538).

25.The correct answer is B, only statement II is correct. The question is the sameas #24, except in this case Doug is the majority owner, with 55% interest in the SCorporation; therefore, the S Corporation may elect to use Dougs fiscal yearending February 28. An S Corporation generally must use a calendar year.Alternatively, an S Corporation can choose an ownership tax year, the year thatover 50% of the owners use, or a natural business year, a year where the businesspeaks in the three months prior to the end of the business year. Therefore,statement I, which says Chicken Inc. must use the calendar year, is false, since

Chicken Inc. can alternatively select the fiscal year ending February 28; selectionII is true. This is also very similar to #23. Please see that answer for additionalreferences to IRS Publication 538.

26.The correct answer is C, both statements are correct. Since Dog Ears is a retailerselling books, it must be on the accrual method because of their inventory.Hometown Mortgage Corporation has receipts in excess of the $5,000,000maximum in place during the year, and it must use the accrual basis. IRC Section


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448 requires C corporations and partnerships with corporate partners, tax shelters,and certain trusts to use the accrual basis of accounting. (Under Notice 2002-14,this $5 million threshold is increased for years ending on or after December 31,2001.) Additional information on this topic can be found in Publication 538, onpage 15, under the title Excluded Entities and ExceptionsGross Receipts

Test.

27.The correct answer is A, only statement I is correct. The Doncaster Group canuse the cash method since they pass the average-gross-receipts-under-$5-million-for-the-last-three-years test. Statement II is incorrect. Cobra Corporation is acomputer retailer who is specifically prohibited from using the cash method evenif they pass the $5 million gross receipts test. This question is similar to #26. Thereferences made to IRS Publication 538 are equally applicable to this answer.

28.The correct answer is C, municipal bond interest. Interest payments bymunicipal bonds are tax-free for federal income tax purposes (Pub. 17, page 58).Bank savings account, savings and loan, and credit union account interest are alltaxable income (Pub. 17, page 61).

29.The correct answer is A, is required if the sole proprietor maintains inventory(Pub. 538, page 21). In actuality the sole proprietor is required to use accrual forsales and inventory; that is the hybrid method (the business could also use theaccrual method).

30.The correct answer is C, revenue is reported when cash is received (Pub. 538,page 14). Cash basis accounting reports revenue when cash is received andexpense when cash is paid.


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07 accounting methods and periods

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