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Essay: Cash Method of Accounting

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  • Subject area(s): Accounting essays
  • Reading time: 8 minutes
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  • Published: August 22, 2017*
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  • Words: 2,137 (approx)
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  • Cash Method of Accounting
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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

Revenue recognition requires four criteria to be met before the aforementioned revenue can be recognized on the books. Firstly, revenue is recognized when there is evidence present that a revenue-creating event has occurred. Once the transaction has happened, the second criteria is that revenue has to be earned. The delivery of goods or services rendered constitute for revenues being earned. Once the revenue has been earned, it needs to have a value that can be easily determinable at the time of sale. Finally, the fourth criterion is that revenues earned and determined are expected to be paid for within a reasonable period of time from time of billing. Revenue recognition is mostly used in the accrual method of accounting, but does play a role in cash-based accounting as well (Li 2016).

Revenue Recognition-Cash Based Accounting

Revenue is recognized for cash-based accounting taxpayers when payments from customers are received. In some cases, cash-based accounting taxpayers do not list accounts receivable or inventory on their balance sheets. The plaintiff in the case study, Mr. Turin, uses the cash-based accounting method for reporting revenues. His company, for the most part, receives payments for paving services rendered within thirty days of completing work. For example, Turin does $1,000 of work for a client on March 17th. Turin later receives the $1,000 payment from the client on April 12th. Turin records the receipt of revenue on April 12th since that is when the cash reached his possession. The transaction is recorded as: Cash is debited for $1,000 and Service Revenue is credited for $1,000. Expense recognition is done in a similar method as expenses are not recorded until the payment is sent to the creditor and monies withdrawn from the account. (Cash vs Accrual Accounting for Small Businesses 2016) (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016).

Revenue Recognition- Non-Matching Principle-Cash-Based Accounting

There are occasions when services are rendered that are not recognized as revenue. One of the more common occasions is when customers are behind in making payments for services. Outstanding customer accounts could be resulted from forgotten payments or falling behind. The discrepancy created from the deductions of expenses from recognized revenues is why the Commissioner questioned Turin’s accounting method of choice. It is possible that Turin will receive the outstanding payments owed within the next tax year. Even after the payment are received, there might still be a discrepancy until the outstanding customer accounts are cleared (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016).

Revenue Recognition-Inventory- Accrual-Based Accounting

Turin’s company is not required to report inventory since the asphalt is only in the company’s possession for a few moments. Due to that consideration, the company does not need to record any secondary transaction when services are rendered since nothing is being sold. When the revenue is recognized for payments made for services rendered, cost of goods sold and merchandise inventory are not involved. This makes tracking expenses easier as Turin is only responsible for what he pays for the asphalt as well as other expenses related to the business. Businesses with inventory need to include a section to the balance sheet regarding purchases and cost of goods sold for merchandise (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).

Revenue Recognition-Matching Principle-Accrual Based Accounting

The matching principle is quite often used in accrual-based accounting to help recognize revenue. Revenue taken in over the sale of merchandise needs to be matched up to expenses that incur during the sale. The date of the transaction is the day the event happened, not when the payment is received. Also, a big difference between accrual and cash methods is that accrual method taxpayers accept sales on account which is classified as credit sales. If Mr. Turin had inventory that he sold to a customer, there is two transactions to report the revenue and expense. For example, Turin sold a few bags of asphalt for $1200 on account on July 8th. The revenue received is recorded on July 8th since that it is the day the revenue incurred. The transaction is recorded as Accounts Receivable is debited for $1,200 and Sales Revenue is credited for $1,200. The second transaction is recorded as Cost of Goods Sold is debited for $1,200 and Merchandise Inventory is credited for $1,200 (Cash vs Accrual Accounting for Small Businesses 2016)(Codjia 2016) (Jim Turin & Sons, Inc., Petitioner-appellee, v. Commissioner of Internal Revenue, Respondent-appellant, 219 F.3d 1103 (9th Cir. 2000) 2016).

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