 Income tax 2023-2024. Accounting methods overview. Get ready and some coffee because we're looking to get the tax man off our back with income tax preparation 2023-2024. Most of this information can be found in 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 a funny income statement most income statements having income minus expenses resulting in net income here having income minus various deductions resulting in taxable income noting that the Schedule C from the sole proprietor rolls into line one income of the income tax formula which is a little strange given the fact that the Schedule C is basically an income statement in and of itself having business income minus business deductions otherwise known as business expenses resulting in in essence net business income which rolls into line one income of the income tax formula this is the first page of the form 1040 the schedule c ultimately rolling into line eight additional income from schedule one this is the schedule one additional income and adjustments to income where the schedule c rolls into part one line three business income or loss from the schedule c here is a schedule c profit and 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my head and yes i know six pack isn't spelled right but three letters is more efficient than four so i trimmed it down a bit okay it's an improvement if you would like a commercial free experience consider subscribing to our website at accounting instruction dot com or accounting instruction dot think of it dot com come minus expenses all right so now we're looking at the accounting methods remembering schedule c basically an income statement an income statement made one of our major financial statement reports from an accounting or bookkeeping standpoint the two major reports being a balance sheet and income statement the balance sheet representing where we stand at a point in time the income statement representing the performance statement what we have done over a time frame with regards to taxes of course we're looking at a yearly basis looking at the performance income minus expenses to help us to determine what we're going to be calculating our taxes on so accounting methods what kind of method are we going to be using we're diving back in to some degree and the bookkeeping side of things which always brings up that question when you're a tax preparer how much bookkeeping do you want to be taking on what's your network look like with regards to your cutoff between the bookkeeping you do and the tax preparation that you do so we have to have some bookkeeping knowledge to do any kind of taxes typically with regards to businesses because we're at least going to have some variations in terms of the bookkeeping that we're provided and the tax preparation that we do because of differences in the tax code versus normal bookkeeping such as possibly using a mileage method for automobiles or something like that or having to write off like the home office for example we also have to make sure that we get the bookkeeping reported properly in terms of the method being used and accounting period in the first tax return and then it should be easier going forward from that point because it should be the same going forward from that point all right so an accounting method is a set of rules used to determine when and how income and expenses are reported so obviously when we think about those set of rules from a bookkeeping standpoint most accountants or like CPAs for example will first think of generally accepted accounting principles or rules that govern for example publicly traded companies the primary rule being an accrual based system but remember for taxes we might use an accrual based system but we're basically beholden to the tax code the tax code is the thing that is determining the ultimate rules with regards to tax reporting which is probably going to get a lot of their information from the best practices of financial reporting but also have some distinctions because of whatever the rules or whatever is trying to be done by the tax code so your accounting method includes not only their overall method of accounting you use but also the accounting treatment you use for any material item when we're saying material item we don't mean like master here we mean that it makes a difference to taxes meaning the dollar the dollar amount is not so small that it doesn't have a difference in terms of decision making for example so you choose an accounting method for your business when you file your first income tax return that includes a schedule C for the business so like with the accounting period where we said hey if you want to be a calendar year then or something other than a calendar year make sure that you do that on the first tax return or else it's going to be difficult to change it same with the accounting method you would like to get it right the first time whatever method you're going to be use cash method or an accrual method or some hybrid between the two you want to get it right the first time because consistency is a standard policy in accounting in general and the tax code of course follows that kind of general accounting principle as well that doesn't mean that you cannot change methods after having filing the tax return but you might have to request that you get permission in some cases or qualify to be able to change the method which is a tedious thing to do something that you don't typically want to go through so get it right the first time so after that if you want to change your accounting method you must generally get IRS approval see change in method in accounting method later so kinds of methods generally you can use any of the following accounting methods so obviously you've got the cash based method so the cash based method is usually easier to kind of do because of course we're going to recognize income when we receive income money cash we're going to record the expenses when we spend money or cash however the cash based system is also easy to manipulate which is the reason why publicly traded companies and the regulatory authorities and rules governing them such as generally accepted accounting principles the sec and so on use an accrual method and then try to regulate that kind of accrual method so in other words if we're on a cash based method that might be a nice a fairly easy method to use but we also have to note that there probably are going to be some deviations that we need to make that are an accrual deviation because the tax code is going to require us to do it and there are some instances where we might need to use an accrual based method just because of the nature of our business which we'll talk more about in future presentation so for example if you are on a cash based system if you were trying to manipulate your income to pay more or less taxes in the current year you you might try to say hey look i'm going to try to collect more cash later meaning having my customers not pay me this period but rather pay me next period so that although i earned the money i didn't get the cash until after december well that's manipulating things and you would think that's not the nature of what we really want to happen in a fair accounting system we would rather have it in income when you earned it on the expense side if you wanted to lower your income this year your net income you might try to pull expenses by prepaying for things such as paying five years of rent in advance this year the tax code will typically have limits and not allow you to do those kinds of things because now you're manipulating the cash based system so in order to you know avoid taxes right so we'll talk more about that later an accrual method the accrual method is typically the method that we think of from an accounting standpoint that publicly traded companies for example would use as the standard for most businesses in terms of proper reporting for kind of comparative purposes comparing one period to the next although it can be a little bit more difficult to do the bookkeeping for an accrual method so there are pros and cons for it and it's a little bit more difficult for the iris to try to audit an accrual method system because they can't just track when the cash was spent and we can't for every taxpayer have an auditing system as we do with publicly traded companies having a separate firm audit you know the the every small business right so that's why we have that's kind of the trade-offs between these two methods so special methods of accounting for certain items of income and expenses now note that you might have situations where basically you're kind of like on a cash-based method for the revenue cycle and or maybe a cash-based system method for the expense cycle but you have an accrual system for like the revenue cycle for example and and that might that might be for example like if you invoice people and you do work like an accountant for example or a law firm then you have to invoice people so your natural bookkeeping system then on the revenue side would be that you're gonna you're going to record revenue when you invoice them before you get the cash meaning your income statement is going to be recording income on an accrual-based system you're going to be recording income before you got the cash and then when you then you're going to collect on the accounts receivable but on the expense side of things you might be using a cash-based system because you're basically paying your expenses when they become due now note that there's a little bit of a nuance here because on the expense side you could call that an accrual system or a cashed system it just so happens that both system would would result in the same reporting of expenses one reporting the expenses because that's when you did when you when you paid for it cash basis and the other because that's when you consumed the work but the point I'm trying to get to here is that you could kind of think of yourself as a cashed based or accrual based system by cycle or particular kind of accounting activity resulting in basically some kind of hybrid method we also have for example some companies that have revenue recognition issues such as construction companies where they do projects for a long period of time normally under a revenue recognition accrual concept you don't recognize revenue until you finish the project but if the project is going to be a five-year long project you could argue that hey shouldn't we be recognizing revenue as we earn it along the way which means you would be using some other kind of revenue recognition like a percentage of completion type of method so you run into problems there that are special possibly to certain types of industries and then you have a combination combination method using elements of two or more of the above methods so note that even if you're on a cashed based method you're still the code is still going to force you the tax code to be doing some accrual things so you're going to be on a cash based system except when the tax code doesn't let you prepay something and you're still going to have to record how the tax code tells you to record in that way which might be more for an accrual method or except when you buy property plant and equipment because then you're going to have to do an accrual thing putting it on the books as an asset even though you paid cash for it for example so in that case you might be on a cash based method but you still are doing accrual things according to the tax code or you might be telling the iris hey look i'm doing some kind of combination between the two and again you want to basically lay that out in the beginning so that so that you can be consistent with that going forward as long as you're consistent that's kind of the key from an accounting standpoint because what the iris is skeptical of will be that people are changing their methods in order to manipulate the cutoff periods and pay less taxes or at least defer taxes in some way so you must use the same accounting method to figure your taxable income and keep to your books income and keep to your books meaning you should basically be doing your books in the same method as the tax return if you're doing your taxes and you're using a different accounting method than you're using for your books then the iris would possibly assume that you're doing that because you're doing some kind of tax manipulation now that doesn't mean that we won't have some changes that we are going to need to make in order to go from the the bookkeeping method to the tax method such as like if you use the mileage method to write off your car or the home office or things like that but in general if you're using account an accrual method on your bookkeeping you would think that you would be using the accrual method as you report the schedule c from your bookkeeping into the income statement form of the schedule c on the tax return if you're using a cash based method same so also you must use an accounting method that clearly shows your income obviously it needs to be accurate in terms of showing your income business and personal items so you can account for business and personal items under different accounting methods so for example you can figure your business income under an accrual method even if you use the cash method to figure your personal items so you might be saying hey look i've got a small business i'm going to be reporting on a schedule c but i'm also reporting on a schedule a itemized deductions the itemized deductions as we saw before or as we've talked about in a prior section or a course are are are items that are federal income taxes but not natural kind of deductions that you would expect in a income tax system in other words what kind of deductions would you expect is natural to an income tax system those deductions in which you needed to expend the money to generate revenue because you would expect that you should apply the tax not on gross income but on the net income otherwise you would be taxing some businesses that don't have expenses would would differently than those that have it you know expenses related to them right so that whatever you needed to spend in order to generate the revenue that's a natural income tax deduction and that's why the schedule c actually makes sense right that's not that's an income statement that makes sense for taxes but the schedule a has all these personal deductions which have some other objective in mind right they're trying to nudge us or influence our behavior or they've got lobbyists that got the deductions and there are something so for example charitable deductions uh the the home deduction for mortgage interest and so on these are deductions that are personal and so you would think why would why would we be deducting those well for some reason other than those are the expenses in order to generate the revenue and those are usually on a cashed based system so the fact that those are in a cashed based system doesn't mean that your income statement has to be in a cashed based system you can have your income statement for the schedule c possibly an accrual based system if appropriate while still reporting the other expenses on your schedule a and on the schedule one of the 1040 for example on a cashed based system all right two or more businesses if you have two or more separate and distinct businesses you can use different accounting methods for each if the method clearly reflects the income of each business now as we'll see shortly some things might influence whether you can move whether you have to use an accrual method so for example inventory often complicates things and makes it more likely that you might need an accrual system because accounting for inventory as an asset is basically an accrual type of thing that needs to be done uh in in that case so you might have two businesses let's say for example one business is a service business where you do gig work and you just get paid on the gig work well that would be pretty easy to do on a cashed based system the other business possibly you sell inventory in which case it might be more appropriate to be using an accrual based system so you can imagine then you have business number one which is on a cashed based system because it's gig work business number two on a separate schedule c now now has an accrual method because you deal with inventory and then your personal deductions reported on the schedule a as well as possibly on the schedule one also basically on a cashed based method because that's what those schedules typically do so they are separate and distinct only if you maintain complete and separate books and records for each business so in other words the iris is going to be skeptical if you'd have one set of books and then you're splitting them up into two schedule c's using two accounting methods in order to basically manipulate the income again they would need to be of course two separate businesses where you're tracking two different set sets of books and therefore justifiably reporting them on two different schedule c's and then picking the appropriate accounting method for each of those businesses