 Hello and welcome to this session in which we will discuss the tax accounting methods and specifically we're gonna be discussing the accrual method What is the big idea here? Well, the accounting method determines when to recognize the revenues and when to recognize the expenses Why is that important? Well, that's important because the revenues once we recognize it for tax purposes Then it is taxable and the expenses once we recognize it for tax purposes It's deductible deductible means it gives us a tax deduction, which is good Now what is the IRS objective? The IRS they want to us to recognize revenue as soon as possible And they want to delay the expenses because the job of the IRS is to do what is to raise money to the government And how do you raise money? You delay you you delay the expenses and you accelerate You want the the taxpayer to recognize revenue? There are three permissible over all accounting methods, which are the cash basis or cash receipts and cash disbursements Which we already covered the accrual method You should be familiar with the accrual method if you are an accounting student because I'm assuming you took financial accounting You took intermediate accounting and there's the hybrid method, which is a Combination of the accrual and the cash method now as we work through the accrual method We're gonna notice there are many exceptions to the rules and we're gonna work many examples to illustrate those exceptions So let's go ahead and get started in Explaining the accrual method of accounting before we proceed any further I have a public announcement about my company farhat lectures comm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of lectures, multiple choice questions, true-false questions as well as exercises Go ahead start your free trial today Income first, let's look at revenue or income accrual method when do we recognize income or revenue for Under the accrual method. Well, if it's earned, what does that mean? What does it mean you earn the income? It means that all event has occurred to establish the taxpayer right to it It means you did the work and now you can tell the customer you have to pay me I have the right for the payment This is when you have earned it and obviously it has to be reasonably Estimatable in other words, you know exactly the amount that you expect to receive Now bear in mind income cannot be the third beyond the tax year if it's already included in taxpayer applicable Financial statement. What does that mean? It means once you recognize remember we have two sets of books We have gap and we have IRS Once a revenue is recognized for gap once it's recognized for gap. That's it It has to be recognized for the IRS and we're gonna look at an example Also an accrual tax payers amount of income is recognized based on its right to receive the income So what we do is what is your right to receive the income and it's based on that? And let's take a look at this accrual income example unity corporation a calendar year taxpayer uses accrual basis of Accounting it's entitled to 6% of spectrum corporation, which has a physical year of June 30th For that particular year x3 spectrum reported net income of 280,000 once spectrum receives Once spectrum reports net income. We have the right of six percent. We means unity corporation For the following six month, which is December 31st 20 extra net income was 180,000 now remember you unity is a calendar year. So unity's year is 1231 So how much they would recognize for 1231 x3? Well, they could recognize only The 280,000 times 6% They cannot take 180,000 times 6% because that's not final. That's the first six months Remember we are entitled to 6% of their annual income Maybe by the end of the year they will go down. This will go down to zero Because we don't have the right to this income yet because it's dated not finalized the year however, unity would not agree a crew Spectrums profit for the last six months, which ends December 31st because the right of income does not accrue Until the close of the spectrum tax year So you have you can accrue the income once you have the right to it You don't have the right for that yet. Let's look at another example Evergreen enterprises and a cruel taxpayer has provided landscaping services to a client and has the right to receive $80,000 the client signs a notes receivable now. I have to be very careful To evergreen enterprise that has a face value of 80,000 well simply put this notes receivable They promise to pay exactly 80,000. So the face value of that is 80,000 However, it has right now a current fair market value of 75 if you want to sell this note today And why would somebody why would somebody sell the note if you have the note receivable if you have the promise from the client And you don't want to wait for the 80,000 so notes receivable Maybe you can cash this six months later. You can cash it for 80,000, which is the face value But if you want to sell it today, you can only get 75 How much would you include the corporation must include the gross income of 80,000? The amount it has the right to receive rather than the fair value, which is 75 So just make sure you know this about notes receivable. It's how much the right to receive which is 80,000 Not the fair value. Let's talk about advanced payment What's advanced payment is when the customer pays upfront for the services before they receive the service And that's very common. Many businesses. They receive money upfront before they receive the service For an accrual taxpayer, remember you have to perform the service Okay, there's a special deferral method that can be used Here's what it is in the year of receiving the advanced payment the taxpayer reported the amount Reported in the financial statement on the tax return. Remember we have gap and We have IRS when it comes for year one when it comes for year one The the IRS allows you to report whatever you reported for gap to report for IRS now you might be saying That's not generous. Well, that's generous. Why because here's how the IRS works The IRS says you have the money in your hand. Once there's once you receive the payment It doesn't matter whether you perform the service or not. You have the ability To pay and if you have the ability to pay you should pay your taxes, but they have the special rules They would say for year one only for year one only here's what we're gonna do regardless of how much you received We're gonna look at your gap and how much you reported for gap We would allow you to report for IRS. That's only for year one, but when it comes to year two Everything else all the remaining amount you have to You have to report for taxes now for gap that that could go to year three year four year five But IRS would allow it which is kind of they're giving you one year break Which is not fine and the following year the remaining balance of the advanced payment is included in gross income Regardless of how it's reported on gap and let's take a look at an example StarTech is an accrual taxpayer that has adopted the deferral method for advanced payment And they sell high-tech electronics and two-year service contract on the electronics on this on November 1st They sold a 24 month service contract and received $280 for financial reporting purposes Here's what they're gonna do. They're gonna report for x3 $30 for x4 140 and for x5 110 so this is how they are spreading this 280 this is for gap g a AP here's what's gonna happen for IRS Although they receive the money upfront for year x3 They can they can they have the option to only report $30 now if they want to report the full amount The IRS will say go ahead and do it. We're not gonna. We're they're not gonna complain about this, but the IRS says look since You're using the deferral method. We're gonna give you a break in other words You only have to report $30 which is the same amount as wherever you reported for gap However in year x4 you have to report the remaining which is 250 and you have to report this in x4. So this is how it works for federal income tax purposes You would report 30,000 For x3 same as the financial reporting and the remaining and the 250 will be reported in x4 There was always exceptions and here are some exceptions to the prepaid certain type of income prepaid rental income prepaid interest warranty Guaranteed contract insurance premium Those you you cannot have any deferral for them once you receive them you have to report them So in other words just be careful if it's a prepaid rental prepaid interest warranty now here It was a service contract. You have that option But if it says prepaid rental there is no more you can no more defer it just whatever you received that year You have to report because you have the ability to pay remember rental interests those are the big ones warranty or guarantees insurance premium as well, okay and Payment related to financial instruments. They must be recognized in the year They are received no deferral, okay when an accrual taxpayer has the right to an income is disputed So let's assume you have to you have the right to the income But the customer is disputing and the income remains in collected in other words the customer don't want to pay Okay, simply put there's a disagreement between you and the customer Well, typically no income is recognized until the dispute is resolved simply put prior to the settlement You don't have the right to the income yet It has not been fully occurred and that's the assumption to recognize the income You have the right to it since there's a dispute the assumption as well since this There's a dispute will let you wait until that dispute is settled when that's that dispute settled its income Let's switch from income to deductions for deduction. We have this rule all events and economic performance has to be Has to be has to occur so to determine if a liability is treated as an expense or a capital expenditure for an accrual Taxpayer three-part test is applied. The first test is called the all event test The second test is the amount has to be reasonably determined Which is that's always the case whether it's for an expense or a revenue You have to know what's the amount reasonably determined if it's not 100% determined and the third thing is there's an economic Performance test. So what is the all event test? What is this test all event test? It means all the necessary event have have happened for the to confirm the existence of the liability Meaning what meaning the taxpayer legally owes the money to another party simply put Somebody did some work for you. They completed the work and the other party They can ask you for the money because they did the work Well, if that's the case if you are responsible then you have met all event test Now amount can be reasonably estimated. It means you have to kind of be able to know the amount. What about economic performance? economic performance For a liability it depends on the nature of that liability and when we say liability it means liability for an expense For example, if an accrual taxpayer owes money for received services The economic performances is met when the services are provided. So for talking about Services, when do you meet the economic test? Well, when when they provide the service they met their economic test then you are responsible for this now There are many Examples that we can give just they're gonna give you an idea for example Services rendered directly to the taxpayer the taxpayer arranges for equipment repair to be conducted When do you have an expense when the repair work is completed now? The economic performance is satisfied for example services scheduled to be delivered for a specific duration an example Will be a service contract over a period of time for example maintenance or cleaning. How do you recognize the expense? Well, you recognize the expense over the contract period you can separate it by month or somehow Count, you know the amount of the service they provided out of the total but over the contract period you would recognize the expense Let's assume the utilization of the owner's property by the taxpayer simply put you are renting something In other words, you are using someone else's asset Well, if it's rent you distribute over the duration of the use of a rent period. This is when the performance is satisfied Let's assume the taxpayer obtained particular property could be supplies and any property. Well If it supplies when you receive the supplies, this is when the economic performance occur and this is when it's satisfied Therefore you do have an expense. Let's take a look at few examples a calendar year a cruel taxpayer Lightning event court organized a wrestling match held in a company stadium on December 31st, 2020 x3 And what they did they hired clean tax services was hired to clean the stadium for $6,000 But did not actually carry out the work until January 1st, 2020 x4 Okay, so the match took place December 31st 2020 x3 now from a financial accounting perspective You are recognizing the revenue and x3 therefore you need to recognize all the related expenses in 20 x3 however for tax purposes you don't recognize the expense because the They did not did the cleaning until January 1st 20 x4 and you pay them $6,000 on January 3rd. It doesn't matter when you pay them. Okay, but the point is for tax purposes They cannot take the deduction of 6,000 and 20 x3 Because the clean tax service company did not perform. They did not satisfy the economic performance. They did not do the work until January 1st now for financial accounting, you would recognize the expense and 20 x3 to match it with the revenue All the financial accounting rules would require lightning events to accrue the 6,000 cleaning expense and x3 to match it with revenue However, the economic performance test was not met until 20 x4 when cleaning tax performed the service So that's they satisfy the economic performance. Therefore lightning events deduct the expense and 20 x4 Let's take a look at another example Green grow agro core cultivate lands owned by individual the contract between this company and the landlord is for three years And upon the contract expiration and 20 x3 The company agreed to apply organic fertilizers to the farmland Even though all the event test has was satisfied at the end of 20 x3 The company did not provide the organic fertilizer until 20 x4 So they did not satisfy all their obligation until 20 x4 Well, the agreement obligated green grow to supply both property and services because that's the agreement and they did not finish until 20 x4 Therefore the deduction is not allowed until 20 x4 when you fulfill your obligation. This is when you can take the deduction There is this something called two and a half month rule and this is established by Congress to allow For compensation to be deducted even if it's paid Two and a half month after the year end. So you can basically do what you can accrue Compensation expense as long as it's paid but two and a half month of the employer year end It would not be necessary considered the third compensation under those circumstances a cruel taxpayer Can deduct can deduct in the year it was earned by the employee as long as you pay them two and a half months So this is year one as long as you pay Two and a half month by year two. You can take the deduction in year one. This is what we are saying here Okay, however, if the compensation is paid more than two and a half month after year end Then you cannot take the deduction until the year the employee received it and reported as income then you have to wait Let's take a look at an example golden corporation and a cruel taxpayer After all employees a year-end bonus equal to 1% of sales growth compared to the prior year Golden cannot determine the bonus until it finalizes its year-end financial statement. So for year x3 The bonus account the bonus amount in the year in early January and pays the bonuses to employee on February 12 20x4 so they were able to Compute the bonus and pay the bonus February 20x4 Well, since golden pay the 20x3 bonus within two and a half month and February February is two and a half month of year end It takes it can take the compensation in 20x3 tax return now bear in mind the employees would report this income under x4 That's when they received it now. Let's change the scenario a little bit Let's assume in 20x3 They updated their accounting software and found some discrepancies and sale reporting after year-end So the issue Delayed the computation of the 20 year 20x3 bonus until early April of that year 20x4 On April 22nd, they paid the bonus to the employees. Guess what? No deduction in 20x3 at this date By April 22nd, this is two and a half month after December 31st So golden cannot take the deduction in 20x3. They can take it in 20x4 Now the employee will also take the will compute the income will report the income in 20x4 So they both Take the deduction in the income in 20x4 the employee income and x4 the employer that deduction is in x4 There are also something called reoccurring item exceptions. In other words, there are certain expenses That if they reoccur and they meet certain conditions We can accrue them a four conditions are fulfilled the economic performance requirement is Accelerated enabling year-end accrual to be deducted. Okay, this is this is what's called the reoccurring item exception What are those conditions? Well first meeting all event test And determine the liability amount accurately. So you have met that test You have met the economic performance should occur on or before the earlier of the tax return filing date So before you file the date or eight and a half month after the taxable year-end So you have a little bit of time to satisfy the economic performance Also, the item must be reoccurring. It means it's kind of a monthly thing or something that reoccurring on regular basis and if accruing results If accruing it result in better revenue and expense matching Or if the amount is immaterial, so if the amount is immaterial, that's fine And if accruing it's a better matching it matches the expense with the revenue It gives you a better matching as long as these are math You will be able to deduct certain what we call reoccurring expenses. Let's look at an example Nature mark frequently sells good that are currently in stock but won't be shipped for another week Now the all event test for sales is met So they satisfy the sales allowing the recognition of gross revenue income even though the good has not been shipped as of year end But they met all the requirement Now nature mark is responsible for paying for the shipping cost Okay, although the company can reasonably determine the obligation for shipping They did not met this economic performance because they did not ship it. Okay, because they did not physically deliver the goods as of yet Although they did not do it accruing shipping costs on sold item would lead to a better alignment of expense with revenue Now what they say is this well since Shipping is related to the revenue. We recognize revenue. Why not recognize shipping? Well under those reoccurring item exceptions The company can accrue the shipping cost on items sold but not shipped yet under these exceptions Reserves we need to know about reserves the all event in economic performance test restrict the use of reserves for income tax purposes What is reserve? basically This this concept reserve is commonly used for financial accounting to match expenses with revenue What could be an example of it? It could be warranty for example when you make a sale in year one It's assuming you make a sale You if you have warranties related to that sale you would include the warranty For that year as well. You create a reserve says how this is how much warranty or guarantees I'm responsible for and you will expense it in year one. This is what the reserve is too much revenues with expenses Well, those are not allowed for tax purposes However, small banks can utilize bed debt reserve also with the bed that if you have a bed that you cannot accrue You already know this when you talked about that you cannot accrue allowance because that's a form of reserve However banks can reserve Can small banks can utilize a bed debt reserve? also Service-based accrual taxpayer Might be permitted to omit accrual for revenue that seems to be incollectable based on prior experience Indirectly allowing a tax reserve So what happened is this if you perform a few performance service For a client and you don't think you're going to be collecting the money Well, this is it should be unusual you should not be doing this but let's assume That's the case you're taking a chance and you know based on prior experience You cannot collect the money then you don't have to record the revenue Which is in effect in effect Given you a reserve because if you're because they're saying don't account for the revenue It's the same thing as accounting for the revenue then write in it off as a bed debt. It's indirect reserve Let's talk about the hybrid method the hybrid method is a method where you would use both cash And accrual for example You would use the accrual basis for sales and cost of goods sold While using the cash method for other income and expenses And this is what create what we called a hybrid method It means you are using both cash and accrual The code allows this approach as long as the taxpayers income is accurately represented So if the accrual method is used for business expense, it must also be used for business income So if you're using it for expenses, you must include it for income for accrual Let's take a look at hybrid method example A pet care at pet care vet clinic. They offer boarding services veterinary services and pet supply In medicine they sell those and that's part of their inventory an annual sale Sales their annual sales is around four million of which 40 percent sales of pet supplies Which is again what inventory they have inventory Here what they do pet care uses a hybrid method how they employ accrual for sales of supplies And medicine remember this is inventory do the significant impact of inventory on income So for supplies for pet of supplies and medicine they use accrual However for services they report the cash they use the cash method, which is it's acceptable That that's what they want to do now bear in mind what we learned in the cash method A company like pet care they can use the cash method also for their inventory because they are considered a small Company and for a small company you can use the cash method for inventory. Remember we have that exception But they choose to do that if they are doing that then they are using a hybrid method for sales of goods That has that's related to inventory hybrid sales of services It is cash method. What should you do now go to far hat lectures? Look at the additional resources lectures multiple choice through false That's going to help you understand this topic better whether you are an accounting student a cpa candidate or an enrolled agent Good luck study hard and of course stay safe