Essay: Cash Method of Accounting

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  • Subject area(s): Accounting essays
  • Reading time: 8 minutes
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  • Published on: August 22, 2017
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  • Number of pages: 2
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The cash method of accounting for tax purposes allows business taxpayers to recognize revenue and expenses when actual monies are received. Income is reported when a customer hands over money for the sale of goods or for services rendered. However, income received near the end of the tax year requires the use of the constructive receipt doctrine. Constructive receipt is determined by when the taxpayer has control over the income. The best scenario of constructive receipt would be the day when funds are credited to a bank account. Expenses are reported when checks are written to cover payables and when the funds are released on the end of the debtor. One major disadvantage of using the cash method is that a successful flow income could actually be from events that occurred sometime previously (Cash vs Accrual Accounting for Small Businesses 2016) (Murray 2016).

Mr. Turin, the case’s plaintiff, utilizes the cash method of accounting for tax purposes. Operations are set up so the plaintiff’s company recognizes revenues when customer payments are received and expenses are recognized once debt to creditors is paid in full. Most revenues are considered recognized within a month of when the paving services are rendered. Expenses are deducted when a paving job is complete as well as payment is received for purchase of materials. The cash method allows Mr. Turin to better monitor the cash flows of his paving company through knowing what customers are paying and what bills are being paid. In similarity to other construction-based companies, there is a flexibility present with using the cash method that allows the business owner to see how much taxable income there will be at year-end. Revenue transactions that occur near year-end are required by constructive receipt to be recorded when the funds are in possession of Turin’s paving company. Therefore, payments received by customers in possession (whether by check or direct deposit) must be included in the tax year received (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016) (Murray 2016) (Viens 2013).

B. Accrual Method

The accrual method of accounting for tax purposes allows taxpayers to recognize revenue and expenses when they are supposed to be paid. Sales of goods or services rendered are reported on the day they occur opposed to when the receivables are paid by customers. Expenses are treated similarly as they are recorded on the date incurred opposed to when they credited from the cash account. The accrual method is beneficial to taxpayers because it gives a clear projection as to what monies are coming into the business and what monies are going out of the business. This results in seeing if the company will receive a net income or net loss for the year. However, the accrual method poses a disadvantage to a business taxpayer which is that figures in the cash account may be off since transactions are not occurring on the dates actually received or paid (Cash vs Accrual Accounting for Small Businesses 2016) (Viens 2013).

The Commissioner, in this case, believes that Turin’s paving company needs to use the accrual method of accounting for tax purposes. According to S 1.471-1, inventory valuation is required to properly calculate taxable income. It is to be believed that the asphalt purchased for paving services should be counted as sellable merchandise. The inventory includes finished goods, work in progress goods, as well as a portion of raw materials and supplies. Therefore, any business that is possession of merchandise needs to use the matching principle to recognize income and expenses. When a piece of merchandise is sold, the sale creates two transactions on that day; one to record the revenue and one to record the expense. The revenue transaction includes a debit to Accounts Receivable (or Cash) and a credit to Sales (or another revenue account). To counter the revenue, the expense transaction is a debit to Cost of Goods Sold and a credit to Merchandise Inventory. If Mr. Turin’s purchases of asphalt are considered pieces of merchandise, the recording of revenues and expenses are going to occur on the day the merchandise is sold (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016) (S 1.471-1 Inventories 2016).

C. How did Turin assert his position?

Turin declared that purchases of asphalt are received around the time of job performance. It is very likely that estimates are created prior to ordering materials to ensure that accurate amounts are purchased. Once the asphalt has been used for a job, the paving company no longer owns the material. The Commissioner used S 1.471-1 to define the asphalt as inventory as it is a raw material to be used in an income-producing venture. None of the materials are stored in a warehouse, but the cost of the asphalt should still be accounted for. The appellate tax court disagreed with the Commissioner with the reasoning behind using the accrual method. The ordered asphalt is only momentarily owned by Turin’s company before being used and should not be considered as merchandise. Emulsified asphalt is a combination of three ingredients: water, asphalt cement, and an emulsified agent that turns into a liquid when released. Once a bag of asphalt has been opened, the mixture within the bag starts to liquefy. The emulsified agent cannot return to solid form, so none of the asphalt can be used for another job. Therefore, all of the raw material gets used during the job and Turin is not responsible for claiming the inventory (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016) (S 1.471-1 Inventories 2016) (Emulsified Asphalt- Definition & Properties 2016).

Exceptions can be made for business taxpayers with inventory to still use the cash method. If Turin’s company makes less than a million dollars in gross receipts over the course of a year, he is not required to account for the inventory or use the accrual method. Section 446 states that the business taxpayer must account for taxable income using the same accounting method used for daily business operations. Since Turin uses the cash method for recognizing revenue and expenses, he might be able to apply for the exception if the gross receipts for the year is under $1,000,000. Another exception is if Turin makes between one million to ten million for a period of three years, he is exempt from using the accrual method. There is a different set of guidelines that need to be followed, but the inventory owned by the company can be deducted as non-incidental materials and supplies. In the case of extra asphalt from a project, Turin can still use the cash method for figuring out his taxable income if there is inventory present. However, the exceptions are not necessary for this case since Turin is permitted by the appellate tax court to continue using the cash method (Publication 538- Inventories & Exceptions 2012) (Joyner 2016).

The issue that led the Commissioner to question the accounting method used by Turin results from a valuation discrepancy of revenues and expenses. He believed that Turin needed to utilize the accrual method as parts of inventory are not represented in the calculation to make the matching principle valid. The appellate tax court rendered the Commissioner’s argument of wrongdoing inadequate as the discrepancy had nothing to do with classifying inventory. The asphalt used in everyday business operations are only used for the job and is not owned by Turin for very long. The discrepancy in figures presented to the court actually comes from outstanding customer debts not included in year-end figures. Revenues received using the cash method can only be recognized when the money is received, so Turin could not recognize any revenues for receivables not paid for. Once the old receivables are receivable, Turin can recognize the revenues and include the figures in taxable income. The final decision on this case agreed with the plaintiff that the discrepancy in receivables are not grounds to require a change in accounting method (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016).

D. Revenue Recognition Key Points

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