ACCOUNTING METHODS AND PERIODS

After reviewing this chapter, you should be able to: 1. Explain the difference between the economic, accounting, and tax concepts of income 2. Determine when a particular item of income is taxable under both the cash and accrual methods of reporting 3. Compare accounting method and accounting period choices among the various entities 4. Identify factors to be considered in changing the tax year or the accounting 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 52or 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 year is 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 with reference to the same calendar month as the month ending his or her previous tax year. The taxpayer is an individual who marries a person with a different tax year. The taxpayer is a tax-exempt organization.

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

2.

Examples of income which are constructively received include all of the following except: a. b. c. d. interest credited to a savings account. a check received after banking hours. dividends available on December 31; unclaimed dividends will be mailed out. 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 tax deferral? a. b. c. d. advance collection of rent with associated services advance collection of rent without associated services advance collection for services advance collection for merchandise

4.

KL Computer Corporation, an accrual basis taxpayer, sells service contracts on the computers it sells. At the beginning of January of this year, KL Corporation sold contracts with service to begin immediately in the month of sale: One contract for 12 months One contract for 24 months One contract for 36 months $300 $600 $900

The amount of service contract income KL Corporation must report for this year is: 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 this year. He uses the accrual method of accounting. Helmut had the following collections in December: $9,000 in December, from clients who paid cash for services to be performed next year. $7,000 in December, for services performed during December; deposited in an operating account on December 31 of this year. $5,000 in December, on accounts receivable for services performed in December; deposited in operating account on January 2 of the new year. What is the amount Helmut must include in his income for December? a. b. c. d. $ 5,000 $12,000 $ 7,000 $21,000

6.

One of the requirements that must be met in order to defer recognition of income for advance payments for goods is that: a. b. c. d. the amount received is more than the taxpayers cost of the goods. the goods are on the taxpayers premises on the last day of the tax year. the taxpayers method of accounting for the sale for tax purposes is the same as the method used for financial reporting purposes. the goods are produced in the United States.

7.

Yong, who gives music lessons, is a calendar year taxpayer using the accrual method of accounting. On November 2 of this year, he received $12,000 for a one-year contract beginning on that date to provide 10 lessons. He gave 2 lessons this year. How much should Yong include in income this year? a. b. c. d. $-0$2,000 $8,000 $2,400

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8.

Jones rented office space two years ago to Harris, receiving the first and last months rent plus a security deposit of $800. In early January of this year, Harris moved 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 rent that amounted to $100. How would this information be reflected on Jones tax return this year? a. b. c. d. $600 income and $500 deduction $500 income and $100 deduction $600 income and no deduction $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. b. c. d. $1,200. $1,500. $1,800. $2,300.

10.

Which of the following is not included in gross income when received? a. b. c. d. prepaid rent refundable security deposit amounts received to cancel or modify a lease copyright royalties

11.

Which of the following types of income is taxed to the entity receiving it rather than being passed through to an owner or beneficiary who pays tax on the income? a. b. c. d. partnership income S corporation income income in respect of a decedent C corporation income

12.

Mr. Lam rents property and does not provide any services associated with the rentals. 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 as income on this years tax return? a. b. c. d. $1,200 $ 100 $ 200 $-0-

13.

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

14.

Which method of accounting is used by most individual taxpayers? a. b. c. d. accrual cash GAAP hybrid

15.

Farmers may report crop insurance proceeds in the year following receipt if the crop ordinarily would have been sold in the: a. b. c. d. earlier year. same year as the receipt. following year. none of the above is correct.

16.

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

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17.

Which of the following entities directly bear the burden of income taxes? I. II. III. a. b. c. d. Individuals Corporations Partnerships

Only I is correct. Only II is correct. I and II are correct. I, II, and III are correct.

18.

Rhonda is the financial vice-president and owns 40% of Myers Co. Myers is an S corporation and reports taxable income before payments to Rhonda of $80,000. Rhonda receives a $40,000 salary. What is Rhondas income from Myers? a. b. c. d. $32,000 $40,000 $56,000 $72,000

19.

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

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

20.

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

a. b. c. d.

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

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21.

Which of the following statements regarding a partnerships tax year is/are correct? I. II. A partnership formed on July 1 must adopt a tax year ending on June 30. A valid business purpose can no longer be claimed as a reason for adoption of a tax year other than the generally required tax year.

a. b. c. d.

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

22.

Which of the following taxable years are allowable by a newly formed partnership without obtaining prior approval from the IRS? I. A January 31 year-end if it is a retail enterprise with a natural business year ending January 31 and all of its principal partners are on a calendar year. A calendar year if majority partners and principal partners have varied year-ends. A taxable year that is the same as that of its majority partners.

II. III. a. b. c. d. 23.

Only I is correct. Only II is correct. Only III is correct. II and III are correct.

Dogg Corporation, Katt Corporation, and Rabitt Corporation are equal partners in Critter Partnership. The partners fiscal year ends are as follows: Dogg Corporation Katt Corporation Rabitt corporation February 28 May 31 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. a. b. c. d. Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

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24.

Snoopy Corporation, Garfield Corporation, and Dogbert Corporation are partners in Comic Partnership. The partners fiscal year-ends and ownership interests follow: Snoopy Corporation Garfield Corporation Dogbert Corporation I. II. a. b. c. d. February 28 May 31 September 30 15% interest 30% interest 55% interest

Comic Partnership must use a calendar year end unless the IRS approves an election for a different tax year. Comic Partnership must use a September 30 fiscal year end.

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

25.

Doug, Kate, and Gabe own Chicken, Inc., an electing S corporation. The shareholders ownership percentages and fiscal year-ends follow: Doug Kate Gabe 55% interest 30% interest 15% interest February 28 May 31 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. a. b. c. d. 26. Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

Which of the following businesses must use the accrual method of accounting? I. II. Dog Ear Pages, a local book store with annual gross receipts of $950,000. Hometown Mortgage Corporation, which has annual gross receipts of $10,000,000.

a. b. c. d.

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

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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. The Cobra Corporation, a computer retailer that has average annual sales over the past three years of $2,100,000.

II.

a. b. c. d.

Only statement I is correct. Only statement II is correct. Both statements are correct. Neither statement is correct.

28.

Certain interest income is not taxable. Which of the following interest payments would be excluded from taxable income? a. b. c. d. bank savings account interest savings and loan interest municipal bond interest credit union account interest

29.

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

30.

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

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REVIEW QUESTION SOLUTIONS AND EXPLANATIONS ACCOUNTING METHODS AND PERIODS 1. The correct answer is C, the ability to pay a tax is greatest when income is realized. 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 in place. The wherewithal-to-pay concept holds that a tax should be collected when the taxpayer can most easily pay it. Completing a transaction does not imply receiving a cash flow; this is not wherewithal-to-pay. Selection B is sufficiently vague 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 receive the cash. 2. The correct answer is D, a paycheck received from an employer when the employer does not have funds in the bank to cover the check. A cash-basis taxpayer must report income in the year in which it is actually or constructively received. Constructive receipt means that the income is made available to the taxpayer so that he or she may draw upon it at any time (see Constructive Receipt of Income on pages 15 and 16 of Publication 17). Examples of constructive receipt where taxpayers report taxable income even though no cash is 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, and salary available to an employee who does not accept payment. An amount is not considered constructively received if it is subject to substantial limitations or restrictions, the payor does not have the funds necessary to make the payment, or the amount is unavailable to the taxpayer. If the dividends are available to you, and all you need do is drive over to get them, or they are on deposit in your account, you have constructive receipt. Additional information on constructive receipt can be found in Publication 334 (page 13) and Publication 538, 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 if the payments are for services performed after the year of receipt. The rule found in Revenue Procedure 2004-31 is applied to a variety of services, such as dance lessons, maintenance contracts, and rent with associated services. The rule does not apply to warranties and rent without associated services. Accrual basis taxpayers 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 found in 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 $300 of 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, a taxpayer may exclude advanced payments received in the current year, where the services (or some merchandise sales) are to be provided in the year following the current year. Following this rule the $9,000 collected in December for services next year can be excluded, the $7,000 collected for services provided this year is included, and the services performed this year but paid for in the year following is picked up in the year the services are provided. This taxpayer is an accrual-basis taxpayer and recognizes income when services are provided, except for the situation described above. The $7,000 plus $5,000 gives us $12,000 (see Advance Payment for Sales, on page 15 in Publication 334 and page 17 in Publication 538). 6. The correct answer is C, the taxpayers method of accounting for the sale for tax purposes is the same as the method used for financial purposes. Accrual basis taxpayers 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. The other options are way off base (see Advance Payment for Sales, on page 15 in Publication 334 and page 17 in Publication 538). 7. The correct answer is D, $2,400. Under Rev. Proc. 71-21, a taxpayer may defer advance payments for services if the payments are for services after the year of receipt. Such payments are reported as the services are performed. The total advance 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. The accrual method of accounting is discussed on page 13 of Publication 334. 8. The correct answer is A, $600 income and $500 deduction. The question is asking 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 money became available to the landlord Jones. Before the payment of the $200 and the confiscation of the $600 remainder of the security deposit, the amounts were held in trust and not available to Jones due to fiduciary responsibility. (See Security Deposits on page 64 of Publication 17). The repairs performed on the office space of $500 are deducted when incurred. Foregone income is not deductible unless it was claimed previously as income (accrual income claimed may be taken as bad debt expense in the month when the accounts receivable can be proved to have become uncollectable), which in this case it would not have been. For additional information on this subject see page 21 (Real Estate Rents) in Publication 334 and pages 63 to 69 in Publication 17. 9. The correct answer is C, $1,800. Accrual basis taxpayers report income in the month 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 is income for the current year; $600 times 3 months equals $1,800 rent income. The refundable security deposit is not income (see Security Deposits, on page 62 of Publication 17). 10. The correct answer is B, refundable security deposit. Any amounts received on behalf of another under a fiduciary responsibility, such as security deposits, escrow payments, sales tax, withholding tax on employee wages, clients portion of settlement payments made to attorneys, etc., are not reported as income until or unless they are forfeited to the person paid (see Security Deposits, on page 62 of Publication 17). Prepaid rent with associated services can be deferred under special circumstances discussed above, in #3 and #7. Option A is possibly true depending upon the circumstances. Option B is definitely true and is the better answer. 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 income taxes directly but pass through taxable income to their owners, partners, members, and stockholders, who pay the tax on their individual income tax returns, using Form 1040 (see Publication 17, Pass Through Entities, on page 189). 12. The correct answer is A, $1,200. Advance rent without any provided services does not qualify for income deferral until the services are provided. With a cashbasis taxpayer the amounts are reportable when received. No computation is necessary; 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 and expenses when paid with some notable exceptions, such as the installment method, and depreciation. The accrual method generally reports income when earned 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 a combination of accrual and cash methods. Adjusted accrual is not one of the three primary overall accounting methods listed by the IRS. Information concerning the accounting methods recognized by the IRS can be found on page 13 in Publication 334. 14. The correct answer is B, cash. Most individual taxpayers and most noncorporate businesses use the cash receipts and disbursements method of accounting. Internal Revenue Code Section 448 requires C Corporations and partnerships with corporate partners, tax shelters, and certain trusts to use the accrual method of accounting, with exceptions. Methods of accounting are defined in question #13 above. 15. The correct answer is C, following year. Farmers have a number of exceptions that 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 concerning the 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 as bootlegging, extortion, embezzlement, or fraud is also includable in taxable income. 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 pay income tax themselves but pass through the taxable income to the partners, who pay on the individual income tax return form 1040. Additional information on partnerships can be found in Publication 541, Partnerships. 18. The correct answer is C, $56,000. The $80,000 income for the entire company is reduced by a salary to Rhonda of $40,000, making the taxable income of the corporation $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 she will report it on her Form 1040 Schedule E in the amount of $16,000. Rhonda will also receive a W-2 showing her salary of $40,000. Add the W-2 and the K-1 and you get $56,000 income from Myers Co. 19. The correct answer is D, neither statement is correct. A new taxpayer (this includes corporations) 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. Taxpayers are generally free to choose whatever accounting period they will use as their taxable year. C corporations are entirely free to select any taxable year, while S corporations have some restrictions. Publication 538, Accounting Periods and Methods, discusses the adoption of a tax year by a corporation on page 12 under 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 a period of 12 months ending on the last day of any month other than December or a 52/53-week taxable year. A 52/53-week fiscal year ends on the same day of the week every year, either the last time a particular day occurs during the month or the day that occurs closest to the end of the particular month, even if the date is in the first week of the subsequent month. Fiscal years are discussed in Publication 538, Accounting Periods and Methods, on page 3. 21. The correct answer is D, neither statement is correct. A partnership tax year is selected on a hierarchical basis that attempts to match the tax year of the partnership to the tax years of the partners (I is false). A partnership can use a taxable year other than that prescribed by the hierarchical rules if it can establish to the Internal Revenue Services satisfaction that a valid business purpose (usually the natural business year is considered a valid business purpose) exists for 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 heading Partnerships, S Corporations, & PSCs. 22. The correct answer is D, II and III are correct. See question 21. Statement I is false since one can pick the natural business year, should it not conflict with the partners tax years, or pick the partners tax years without paying attention to the natural business year. January 31 results in significant deferral of income and would probably not be allowed. If both majority and principal partners have varied year-ends, the partnership must use the tax year that results in the least aggregate deferral of income for the partners; since the calendar year would be considered to have the least deferral of income in most cases, this is most probably true. The first tier is to set up a tax year that is the same as the tax year of the majority partners; therefore, statement III is true (see page 7 in Publication 538). 23. The correct answer is D, neither statement is correct. If the majority and the principal partners tax years are all varied, the partnership must pick the tax year that provides the least deferral of income (Pub. 538, Least Aggregate Deferral of Income, page 7). It is unlikely that any of the dates of the taxpayers tax years would be equally acceptable to the IRS; statement I is false. The least likely year to pick would be that ending on September 30, since this year would result in the most 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 year with the least deferral of income, see page 7 of Publication 538. 24. The correct answer is B, only statement II is correct. Comic Corporation must use the tax year that is the same as that of the majority interest partners. The majority 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 same as #24, except in this case Doug is the majority owner, with 55% interest in the S Corporation; therefore, the S Corporation may elect to use Dougs fiscal year ending February 28. An S Corporation generally must use a calendar year. Alternatively, an S Corporation can choose an ownership tax year, the year that over 50% of the owners use, or a natural business year, a year where the business peaks 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; selection II is true. This is also very similar to #23. Please see that answer for additional references to IRS Publication 538. 26. The correct answer is C, both statements are correct. Since Dog Ears is a retailer selling books, it must be on the accrual method because of their inventory. Hometown Mortgage Corporation has receipts in excess of the $5,000,000 maximum 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, on page 15, under the title Excluded Entities and ExceptionsGross Receipts Test. 27. The correct answer is A, only statement I is correct. The Doncaster Group can use the cash method since they pass the average-gross-receipts-under-$5-millionfor-the-last-three-years test. Statement II is incorrect. Cobra Corporation is a computer retailer who is specifically prohibited from using the cash method even if they pass the $5 million gross receipts test. This question is similar to #26. The references made to IRS Publication 538 are equally applicable to this answer. 28. The correct answer is C, municipal bond interest. Interest payments by municipal 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 all taxable 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 for sales and inventory; that is the hybrid method (the business could also use the accrual 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 and expense when cash is paid.

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