 Income tax 2023-2024, combination accounting method. Get ready and some coffee because we need to know a lot of information to do income tax preparation 2023-2024. Most of this information comes from Publication 334, tax guide for small business for individuals who use Schedule C Tax Year 2023, which you can find on the IRS website at iris.gov, iris.gov. Looking at the income tax formula, remember in the first half of the income tax formula, basically an income statement. Most income statements having income minus expenses resulting in net income. Here having income minus various deductions resulting in taxable income. The sole proprietor Schedule C rolling into line one income, which is kind of funny because the Schedule C itself is also a form of income statement. Having business income minus business expenses otherwise known as business deductions resulting in, in essence, net business income rolling into line one income of the income tax formula, basically representing the formula of the 1040 form. This being the first page of the form 1040 where the Schedule C ultimately rolls into line number eight additional income from Schedule 1. This is the Schedule 1 additional income and adjustments to income part one. The Schedule C rolling into line three business income or a lot or loss from the Schedule C. This is the Schedule C profit or loss from business has a P&L profit and loss or first a word from our sponsor. Yeah, actually we're sponsoring ourselves on this one because apparently the merchandisers they don't want to be seen with us. But that's okay whatever because our merchandise is better than their stupid stuff anyways. 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If you would like a commercial free experience consider subscribing to our website at accountinginstruction.com or accountinginstruction.thinkific.com income statement format income minus expenses. Now we've been talking then about the format of the schedule C which is going to be a major financial statement form format basically the income statement or profit and loss as opposed to the balance sheet, which makes sense for an income tax because we need to calculate the income minus expenses in order to apply then the tax. The major accounting methods we think about are the cash based method, which is usually an easier method to use, unless you have a cruel components to it, like you have to deal with inventory accounts receivable and or accounts payable. We have the accrual method which is typically thought to be more accurate and better for comparison year over year, which is why publicly traded companies are basically required to use the accrual method and then double checked upon that they are appropriately using it for conformity purposes through an auditing process so that investors have the most clear method possible for investment decisions for taxes. Then we have to follow of course the IRS rules, which give us some leeway as to have some kind of cash based method in some cases, or possibly have to use the accrual method in some cases, at least for part of our books, such as if we have inventory. So now we can think about a combination method, noting and remembering when we look at a cash based method, for example, we're never really totally on a cash based system because the IRS is still going to force us to do some accrual things sometimes, such as the purchase of equipment, something that we can't just expense even if we paid cash for but rather have to put on the books as a depreciable asset allocating the cost over the useful life. And so we can also imagine that if we have different cycles of our business like the revenue cycle and the expense cycle, for example, possibly a payroll cycle, then some of those cycles might be on more of a cash based system and some might be more on an accrual based system. In other words, you might have to track your inventory on an accrual based system because putting inventory on the books as an asset is an accrual thing. But the rest of your books might basically conform to a cash based system, or you might have to be tracking accounts receivable because accounts receivable is the way you bill your clients and therefore your revenue cycles basically on an accrual system. But when you pay your bills, you don't track accounts payable just paying them with the use of your bank feeds, possibly, and therefore it kind of conforms more to a cash based system. So and that way you can kind of think of yourself in a hybrid type of method. Now the reason this is really important is of course that you have to have a method that's appropriate for your business and you want to make sure that you selected the appropriate method for taxes. Because once you've selected a method, which typically happens in the first year of the C Corporate of the Schedule C, then it's difficult to change it. You could, it's possible, but you typically have to get approval or have some justification from changing methods because consistency is a general accounting principle which is mirrored or emphasized by the IRS of course. So combination method, you can generally use any combination of cash accrual and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. So you might have special methods in cases that are a little bit unusual such as for example, job cost systems for construction. If you have long jobs, then the revenue recognition principle doesn't always apply perfectly because usually the revenue recognition principle says you recognize revenue when the job is complete, meaning you did the goods or services. You provided the services or gave the goods in a retail store. That's easy because you just give inventory with services normally it's when the work is done. But if it's a five year job, now the question is well shouldn't I be recognizing revenue throughout those five years or should I wait until the job, the building or whatever is complete at the end of five years. You could have different methods in order to recognize revenue and those cases deviating from the normal revenue recognition such as percentage of completion or completed contract. So however the following restrictions apply. So if an inventory is necessary to account for your income, you must generally use an accrual method for purchase and sales. See however inventories later. So inventory as we have seen is an area where it might force you to be on an accrual method but noting here that it may only force you to be on an accrual method for the tracking of inventory because putting the inventory on the books as an asset as well as expensing it when you purchase it is an accrual component. The other purchases that you might make may still be on like a cash based system. And again there could be some exceptions to inventory basically for small businesses. So if you have inventory you want to make sure that you're working out what your accounting process is and what the tax process will be choosing the proper and appropriate method on the tax return for the first year of operations. So you use the cash method for all other items of income and expenses. If you use the cash method for figuring your income you must use the cash method for reporting your expenses. So they're trying to have some consistency on the revenue method and the expense method if you use the cash method for figuring your income. Note that normally for many small businesses the question is whether or not they have to move from a cash method to an accrual method on the revenue reporting side of things. In other words oftentimes the question might be I would like to as a small business be on the cash method because I think that would be easier but I'm in the type of industry that's forcing me to be on an accrual method for the revenue recognition side of things. And this will often happen if I have to track accounts receivable for example and like a law firm you're going to do the work first oftentimes and then invoice the client. When we invoice the client that's when revenue is going to be recorded and accounts receivable is going to go up and then we'll have to collect the revenue at a later point in time. So that means that if you're tracking accounts receivable you're basically have an accrual method generally so that's going to be the general idea normally. People might want to try to be on a cash based system but need to deviate on the revenue side to the accrual basis due to their revenue tracking and having to track the accounts receivable. So if you use an accrual method reporting your expenses you must use an accrual method for figuring your income. So again normally in practice it's kind of the reverse right the small businesses are forced to go from a cash method to an accrual method because they have to track the accounts receivable. And then on the expense side of things they're often going to be on the cash method or you can think of it as a cash method because they don't have accounts payable. They're not tracking accounts payable but rather they're just expensing their items as they become due paying them as they become due. So if you used accounting software like a QuickBooks the expenses like the utility bill and so on and so forth might just be coming through the bank feeds either with credit cards or cash payments and you're basically expensing them as they become due which you can think of as basically a cash based system. However you can also think of it as either a cash or accrual based system because either system are going to record the expense at the same point in time but for different reasons. Meaning if you pay the if you record the utility bill when you pay the utility bill on a cash based system you will record it as an expense because the cash was paid at that time. On an accrual based system you would still record it at the same point in time because that's when the work was done right. There's no difference in the timing generally on the expense side of things. So again most small businesses are in the situation oftentimes of saying I have to deviate from possibly a cash based system on the revenue side because of the industry I'm in and then keeping on a cash based system at least logistically on the expense side because they're using in essence their bank feeds to basically just electronically pay their expenses. Okay so if you use a combination method that includes the cash method treat the combination method as the cash method. Inventories generally if you produce purchase or sell merchandise in your business you must keep an inventory and use an accrual method for purchase and sales of merchandise so there could be an exception possibly for small businesses but we've seen this multiple times at this point. The inventory typically is an accrual item because the inventory is usually going to be tracked as an asset even if you paid for it right. So you didn't expense it when you bought it you put it on the books as an asset which is an accrual thing to do and then you're going to expense it as cost of goods sold when you sell the inventory. So you can see the timing that's happening there is an accrual thing so exception for small business taxpayers though so if you are a small business taxpayer you can choose not to keep an inventory but you must still use a method of accounting for inventory that clearly reflects income so now they're saying there could be certain situations where possibly you have inventory that you're selling but they're not requiring you to track inventory possibly you're not holding on to a lot of inventory you have a just in time kind of system you purchase the inventory or you make something quickly and then sell it therefore there's not a huge timing difference between you know when the inventory is purchased or made and when you sell it and so it might not be worth the complication and that case of tracking the inventory and so you might fall into that kind of category so if you choose not to keep an inventory you won't be treated as failing to clearly reflect income if your method of accounting for inventory treats inventory as non-incidental material or supplies or conforms to your financial accounting treatment of inventory if however you choose to keep an inventory you must generally use an accrual method of accounting and value the inventory each year to determine your cost of goods sold in part 3 so if you have inventory that you're tracking it's substantial to the business you can't just expense it when you purchase or make the inventory because you might be holding on to a significant amount of it and that would greatly distort your income reporting in the proper year then of course you're gonna have to put on the books as an asset and you're gonna have to try to calculate the inventory and you might need a cost of goods sold calculation or at least for the schedule C you'll have to do a cost of goods sold calculation which means you're gonna have to calculate the income for at least the beginning of the year and the end of the year so small business taxpayers you qualify as a small business taxpayer if you a have average annual gross receipts of twenty nine twenty nine million dollars or less for the three prior tax years and B are not a tax shelter as defined in section four four eight D three if your business has not been in existence for at least three tax year period used in figuring average gross receipts based on your average on the period it has existed so in other words we have this three year thing what if I haven't been in business for three years well then you can base average on the period it has existed so and if your business has a predecessor entity include the gross receipts of the predecessor entity for the three tax year period when figuring so what if I had another entity and now it's the predecessor entity but it's the first year of the current entity maybe then you can look at the predecessor entity for that three year calculation if your business or predecessor entity had short tax years for any of the three tax year period annualize your business gross receipts for the short tax years that are part of the three tax year period in other words what if the tax year was one year was the first year of business and I was only in business for half the year well then you would expect the business income for that year to be much lower which would throw off the average so you would have to then annualize that one year that was a half year or whatever so it would be equivalent to a full year so you can get an accurate average of a three year time frame okay so see publication five three eight for more information treating inventory as non incidental material or supplies so if you account for inventories as materials and supplies that are not incidental you deduct the amounts paid or incurred to acquire or produce the inventory able items treated as non incidental materials and supplies in the year in which they are first used or consumed in your operations inventory treated as non incidental materials and supplies is used or consumed in your business in the year you provide the inventory to your customers so financial accounting treatment of inventories your financial accounting treatment of inventories is determined with regard to the method of accounting you use in your applicable financial statement as defined in section four five one b three or if you do not have an applicable financial statement with regard to the method of accounting you use in your books and records that have been prepared in accordance with your accounting procedures so obviously if you're talking about Laura if you were talking about publicly traded companies that have inventory they would typically have to track the inventory on you know like an accrual type of system if we're not publicly traded then we might be a small business that's trying to just be in compliance with the tax code but even then whatever our normal accounting system is to track the inventory you would think that you know that would be that might be a system that we're gonna have to use to kind of track obviously again the inventory so and so and then that would be helping us to construct the income statement used to create the tax return on the schedule so if you're using a tax software for example you might have a perpetual inventory system tracking the inventory as you sell the inventory items or you might be using some kind of periodic inventory system possibly using some kind of flow assumptions not first and first out last and first out weighted average to calculate the inventory in some way shape or form so changing your method of accounting for inventory if you want to change your method of accounting for inventory you must file form three one one five application for change in accounting method so again we kind of like to avoid typically the change in the accounting method because we have to request it and therefore it would be nice if we can get things set up properly for the first year of operations on the schedule so that we get we have everything we don't have to change accounting methods for inventory or cash versus a cruel and so on and so forth but if you do need to do that then you can obviously request possibly a change so items included in inventory if you are required to account for inventory is include the following items when accounting for your inventory merchandise or stock in trade obviously if we sell inventory then you can think of the same things we would have used in the business as inventory depending on how we are using them in other words if we had a tractor or free you know if we if we have a forklift and we used it in the business to move things then the forklift would be equipment but if we sell forklifts then the forklifts are inventory right there's a general so raw materials if you actually make inventory then it becomes more complex now you're manufacturing inventory instead of just purchasing it marking it up and selling it that means you can have raw materials that are going to be included in like wood for example to make guitars as the end product the raw materials are going to be in there as well as the work in process so manufacturing company has now the wood that is in process to then make the finished product and then you'll have the finished product supplies that physically become a part of the item intended for sales valuing inventory you must value your inventory at the beginning and end of each tax year to determine your cost to goods sold schedule C line 42 to determine the value of your inventory you need a method for identifying the items in your inventory and a method for valuing these items so obviously normally you know you would be using some kind of system possibly like a first and first out system a flow assumption system gets a little bit more complication complicated for for manufacturing when you're making things and then you have to deal with the fact that sometimes you might have inventory on hand that has deteriorated in value so you're holding on to something that was worth something but now it's deteriorated so how do you account for that kind of kind of thing these are you have to report this on the schedule C with a cost of good sold calculation which will include a beginning and ending inventory number so inventory valuation rules cannot be the same for all kinds of businesses the method you use to value your inventory must conform to generally accepted accounting president principles for similar businesses and must clearly reflect income so in other words the tax code is the code that we're conforming to if we're a small business if we were a large business for example publicly traded we would be subject possibly to other regulations such as generally accepted accounting principles if we wanted to like sell on a publicly traded stock exchange or something like that. For example the tax code for small business we don't we're not going to be selling on a stock exchange we're trying to conform to the tax code but the tax code sometimes will defer to things like the generally accepted accounting principle because they should be the best practices so generally we should be valuing the inventory they've deferred kind of to what the normal practice would be for inventory valuation of a similar industry so your inventory practices must be consistent from year to year consistency is a core concept for accounting and obviously again the IRS is reflecting that.