 Income tax 2022-2023, Accounting Methods Overview. Let's do some wealth preservation with some tax preparation. Support Accounting Instruction by clicking the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. Most of this information comes from the tax guide for small business for individuals who use Schedule C, Publication 334 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula, we're focused on line one income. Remembering that the first half of the income tax formula is in essence an income statement, although just an outline of scaffolding other forms and schedules flowing into it. For example, the Schedule C, the business income, which is in essence another form of income statement, having income minus expenses or business deductions. The net income then flowing into line one income of the income tax formula. This is page one of the 1040. We're focused on line number eight. Schedule C would flow into the Schedule 1, which would flow into here, page one of the form 1040. This is a Schedule C form. Profit or laws from business where we can see in essence an income statement, income minus expenses or business deductions. All right, let's talk about the accounting methods now accounting methods. Remember the main two that should kind of come to mind is an accrual accounting method and a cash based accounting method. Many people think of those things as complete opposites of each other, but they're not really opposites of each other. You could have a combination of the two methods and that will often be dependent upon the type of industry that someone is in. So for example, small businesses might be paying their expenses on a cash based type of system. And that would be an easy thing to do oftentimes from a bookkeeping perspective. But sometimes they might not be able to be on a cash based system for the receipts on the revenue side because possibly they are in the type of industry where they have to invoice their clients and deal with accounts receivable, which is an accrual kind of component. So then the question is, are we on a cash based system? Are we on an accrual based system? Sometimes inventory, for example, is something that pushes us over to needing to have more of an accrual based system like with the accounting. The account like CPA account. Periods, it's important to get the accounting method correct if we can the first time because the IRS is going to be skeptical of us changing accounting methods. It may be possible to do it, but we might have to request a change in accounting method. The IRS being skeptical of people changing accounting methods because you can kind of manipulate the cutoff dates and manipulate your tax bills if you were able to constantly change from say an accrual method to a cash based method. Now note when you look at most of the income tax other than a schedule C, most of the times we're on a cash based system. So when we pay for things like on a schedule A, can we deduct our our sale our taxes for the state taxes on the schedule A or charitable contributions and so on and so forth. Those are typically drawn from a cash based system. We have to actually have paid them in the tax year in order to deduct them. And that's usually an easier system to use because we can track the cash payments that took place on. So we may be able to do that on the business side as well. But when you look at bigger businesses than usually the standard method to be used there is an accrual method which is thought to be more accurate because in an accrual method we record income and expenses when we have earned the income and when we have incurred the expense. Notice that if you have a cash based system you can actually do more manipulative stuff. You can basically try to prepay that your cash or delay the payments that you're going to be receiving and try to manipulate the cutoff dates which can manipulate your taxes by just basically adjusting when you're going to be paying and receiving instead of tying the expenses and income to when you actually earned the revenue and when you actually incurred the expense. However, the cash based method is often easier. So therefore there's this back and forth this interplay between a cash based and accrual based method. Sometimes the IRS will require an accrual based method under certain circumstances such as possibly if you had a lot of inventory. They might say hey look inventory is an accrual type of thing because you have to track the inventory as an asset. Those are assets, undeniable assets. And therefore it's more likely that you would be on you know an accrual system than a cash system. Okay, that said let's dive into it. An accounting method is a set of rules used to determine when and how income and expenses are reported. So your accounting method includes not only the overall method of accounting you use but also the accounting treatment you use for any material item. So you choose an accounting method for your business when you file your first income tax return that includes a schedule C. So when you first start out you want to make sure that you get your accounting method correct when you start out because again the IRS gives you some leeway to choose an accounting method but once chosen then they're going to want you to stick to that accounting method. You may be able to change but it might be a little bit burdensome to make the change. You might have to request an accounting method change and so on. So after that if you want to change your accounting method you must generally get IRS approval. If you want to do that you can see the change in accounting method later. So kinds of methods generally you can use any of the following accounting methods. You got the cash method you've got an accrual method and then you got special methods of accounting for certain items of income and expenses. In essence a combo method in essence a hybrid method. In other words you might have for example your expenses being paid on a cash based method your revenue on an accrual based method because of the industry you're in for example. So you have combination method using elements of two or more of the methods. So that's a combination method. The special methods could you could have special kind of accounting treatment for certain things. So for example if your normally revenue is recognized on an accrual method when you earn the revenue but there's sometimes there's deviations from that when you're in a kind of situation where you do long term contracts like in construction of like a building or something like that. Meaning you're not going to complete the actual building for multiple years possibly. Does that mean you shouldn't record any of the income until you actually complete it and then you've got like revenue recognition principles completed contract or percentage of completion kind of methodology that can come into play. But that's usually for you know larger companies oftentimes that have those long time long term kind of contracts that might be industry specific. Many small businesses might be in a situation where they're using a combo of accrual versus cashed methods because for example they might have to use an accrual method depending on the industry if they have to do the work before they invoice a client. So you must use the same accounting method to figure your taxable income and to keep your books. So in other words the iris is going to be skeptical if you're saying I'm going to use an accrual method for my books but a cash method for my taxes. Why would you do that? It looks like you're just doing that in order to cheat on your taxes somehow because it would be easier to use a cash message for both your bookkeeping or your accrual method for both sides right. So the iris is going to say hey look whatever method you're using to keep your books that should be primarily the same method you're going to be using to do your taxes. Now how would the iris know what methods you do your books with? Well they would have to audit you in order to basically know that but in principle if you're doing one accounting method on your books and then you're totally changing the accounting method from accrual to cash or something for taxes it looks like you're doing that to try to avoid taxes some way and that's why the iris wants you to use the same method that you would use when you do your normal bookkeeping for taxes. So also you must use an accounting method that clearly shows your income. Clearly the iris wants an accurate accounting method so if you have accounting methods that are not accurately showing income then that's not a good accounting method. Business and personal items. You can account for business and personal items under different accounting methods. For example you can figure your business income under an accrual method even if you use a cash method to figure your personal items. In other words most of your deductions like on a form 1040 for example on the schedule A and above the line deductions and whatnot are on a cash based type of system. That doesn't mean that your business income on a schedule C can't be on an accrual method. Generally when we're talking about the business income that's kind of separate than the rest of the tax return which may still be on kind of like a cash based system oftentimes. So two or more businesses. So if you have two or more separate and distinct businesses you can use a different accounting method for each if the method clearly reflects the income of each business. So now you've got two schedule Cs because you're you're doing two different businesses possibly a married couple for example they have two two businesses or a sole proprietorship that has two distinct businesses. One it might make sense to have an accrual method and the other it might make sense to have a cash basis method. You can use two different methods because they're two different businesses. We should be keeping the accounting separate for those two businesses. So they are separate and distinct only if you maintain complete and separate books and records for each business.