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Lesson 1: Introduction, Background, and Review
Accounting Methods
Keep in mind that the accounting methods you learned in financial accounting (a.k.a., generally accepted accounting principles (GAAP)) are created by the Financial Accounting Standards Board (FASB). Congress and the IRS create the tax rules. Those differing sources mean the rules can legitimately differ. Generally, GAAP encourages businesses to choose permissible accounting methods that accelerate income and defer deductions. For taxes, which require a cash outlay, businesses’ incentives are to defer income and accelerate deductions. Be careful that you don’t impose the financial accounting rules when you’re working in the tax area.
A taxpayer’s accounting method determines the year in which an item of income or a deduction is reported on the business’s tax return. The two options are the cash method or the accrual method. Click below to learn more about these accounting methods.
Cash Method
Under the cash method, businesses report income when it is received or made available to the taxpayer and deduct expenses when those expenses are paid. If a cash-method business operating on a calendar year sends a bill to a client on December 20 and receives payment on January 15, the business would report the revenue on the tax return in the later year, when it received the revenue. Similarly, if a cash-method business operating on a calendar year receives a bill from a vendor on December 20 and sends payment on January 15, it would report the expense on its tax return for the later year, when it was paid.
One exception for all cash method businesses is if they have substantial inventories. In that case, the inventories must be accounted for using the accrual method.
Accrual Method
Under the accrual method, the business reports income when it earns it and deducts expenses when they are incurred. The receipt or spending of cash may be irrelevant to the timing of income and expense recognition. An accrual method business will record income when it has satisfied the all-events test. The business will record expenses when it has satisfied both the all-events test and the economic performance test.
All-Events Test
The all-events test for income requires recording of income when
- all events have occurred that determine the business’s right to receive the income, and
- the amount of income can be determined with reasonable accuracy.
If a business signs a contract with a customer, the business is not obligated to record that income for taxes, since the business has not yet fulfilled its obligations under the contract. Only when the contract terms have been satisfied has a business using the accrual method satisfied the all-events test. However, if an advance payment is received at the contract signing, the taxpayer has the option of recording the income for taxes at the time of receipt, or they can defer recording it for taxes until the income is earned by fulfilling the contract.
The all-events test for expenses allows the deduction of an expense when
- all events have occurred that determine the business’s obligation to pay the expense, and
- the amount owed can be reasonably determined.
As in the previous paragraph, the companies may fulfill this test and create an obligation when a building or drug development is partially completed and the obligation to pay has been created.
Economic Performance Test
Businesses fulfill the economic performance test for expenses when services or goods are actually provided to the taxpayer. Whatever needed to happen for the transaction to be complete has happened. For example, when the pharmaceutical company delivers the drug under development, or the construction company completes the building, and the taxpayer takes delivery on a good or service. The obligation for the taxpayer to pay now exists, so the test is fulfilled.