 Income tax 2022-2023. Combination accounting method. 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 online. One income remember in the first half of the income tax formula is in essence an income statement. Although it's just an outline and a scaffolding other forms and schedules flowing into it. For example, the Schedule C, the business income, which is in essence an income statement in and of itself income minus expenses. The net then net income flowing into the income line of the income tax formula. This is the first page of the form 1040. The schedule C would flow into the schedule one, which would then flow into the first page of the 1040 here on line eight. This is the schedule C profit or loss from business where we can see we have an income statement in essence income minus the expenses or business deductions. So we're continuing on with our discussion of accounting methods. Remember the two methods you want to keep in mind are going to be the cash method and then the accrual method. Most other methods can be thought of as kind of a combination between the two. In other words, those two methods aren't really opposites from each other because you can think of a method where you're basically using pieces of an accrual method and a cash method. And even if you're on a cash method, you're going to be forced even then to use some accrual concepts as we discussed when you're doing like capitalization of property plants and equipment, for example. Also note that you want to make sure that you get your accounting method properly recorded when you first set up your schedule C on the first tax return. Because although you have a pretty fairly wide leeway to pick the accounting method you want to use once chosen, it's difficult to change the accounting method because the IRS wants consistency with the accounting method. If you were to change the accounting method going back and forth from a cash to an accrual method, then you can kind of manipulate the timing of the income and expenses and you can try to do some tax manipulation in that case. So the IRS wants to limit that by saying you can choose what methods you want, but then in essence you keep to that method. And of course there are some circumstances where the IRS might require, say, an accrual method in some cases, for example. Alright, so now we're on a combination method. So you can generally use a combination of cash, accrual, and special methods of accounting if the combination clearly shows your income and expenses and you use it consistently. So the consistency is once again the key component here. However, the following restrictions apply. If an inventory is necessary to account for your income, you must generally use an accrual method for business and sales. So in other words, the inventory, if you're dealing with inventory, you've got to be careful on the method that you're going to choose because you might be able to kind of be under the threshold where you have to be required to report on an accrual method. But generally you may be required to report on an accrual method if you have inventory because reporting inventory is an accrual thing. Meaning, when you buy the inventory, if you were on a cash method, you would just expense it when you buy it. But if you're holding onto a substantial amount of inventory, it makes sense to put it on the books as an asset and putting it on the books as an asset is an accrual type of thing. We then expense it when we sell the inventory in the form of the cost of goods sold. So that would mean that you would have to kind of account for that inventory situation on an accrual basis generally so that we can match up the cost of the inventory that was sold, usually the biggest expense if you're just buying and selling inventory with the time frame that you earn the revenue. Otherwise what would happen is you might have bought the inventory last year or two years ago and then if you expensed it two years ago, you're not matching the expense of the inventory to the revenue that was generated in the current year when you actually sold the inventory. That's the idea. We want to match those two things up generally. So you can use the cash method for all other items of income and expenses. So notice that you might, that's kind of a hybrid kind of method where you can see that would be practical in a lot of small businesses because a lot of the expenses that you have for small businesses, you might try to rely on bank feeds, for example, in order to record them. So you have electronic transfers, you might try to set up your QuickBooks file or something like that so that you can record all the outflows with basically bank feed type of transaction which is in essence a cashed based kind of system. So then if you use cash method for figuring your income, you must use the cash method for reporting your expenses. So you've got to be matching the idea here that we want to be matching the income and the expenses in the same time period. In other words, the income that you consumed should be matched to the revenue that you consumed it to generate. That's the matching principle which the accrual is better at doing than the cashed based system, but you want some consistency with those methods. If your method is altering them more than a cashed based system to be out of whack, you would think that would not be typically good from a bookkeeping standpoint and not what the IRS is looking for here either, I would think. So if you use an accrual method for reporting your expenses, you must use an accrual method for figuring your income. So if you use a combination method that includes cash method, treat the combination method as the cash method. Now note this gets a little bit confusing because a lot of times when people think of the difference between a cash method and an accrual method, we kind of think that every transaction is going to be different between an accrual and an accrual method. So in other words, if you set up your expenses like a lot of small businesses do to be paying when they clear the bank when you do an electronic transfer, you could say, okay, that's clearly a cashed method in that you're letting the transfer of the cash drive when you're going to be recording it. But if you recorded that transaction on an accrual based method, you would mainly have the same transactions there. In other words, if you paid the phone bill and you paid it through a bank feed when you paid the phone bill, then you would record the expense at the point in time you paid it based on a cashed based method. But you would also be recording it at the point in time you paid it generally because it's pretty close to the time that you consumed the use of the phone on an accrual based method. It's just for different reasons. On a cashed based method, you would be recording it at that point in time because you paid the cash on an accrual method. You would be recording the expense at that point in time because it's close to the point in time that you actually consumed the consumption of using the telephone. It's only when those two things are not connected, they're not close to each other that you're going to have basically a difference in reporting of the timing of the expenses in a similar kind of thing on the income side. Okay, so continuing on 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 sale of merchandise. So as we saw, the inventory is often an issue because it's an accrual component when you put it on the book as an asset. Instead of just expensing it when you pay for it, you're doing an accrual thing when you record the expense of cost of goods sold when you sell the inventory as opposed to when you bought the inventory. You are once again doing an accrual type of thing from an income statement side of things. We want to be matching up the revenue that was generated from the sale of inventory and the expense, the cost of goods sold of the inventory. So exception for small business taxpayers. 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 if you choose not to keep an inventory, you won't be treated as failing to clearly reflect income in your method of accounting for inventory, treats inventory as non-incidental material or supplies or conforms to your financial accounting treatment of inventories. So however, if 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 three of Schedule C. So note that if you're in a situation where you sell stuff, but really you kind of buy stuff in particular or an adjusting time type of system or in part of your job cost system, you buy inventory, and then you consume it and you build something or you sell it right away. That would mean that you're not really holding on to inventory at that point. And if you're in a small business, you might be able to do your accounting even though you're selling inventory without tracking an asset of inventory. You could basically, in essence, expense the inventory as cost of goods sold when you purchase it because you purchased it close to the point in time that you are actually going to sell it, sell the inventory. So it's still those two things, the income and the expense of cost to get sold should still be close in the same time frame because you're not really holding on to the inventory. If, however, you are holding on to inventory, you have to track the inventory, then clearly you can't really avoid that situation. So you'd have to do basically an accrual method you would think in that case. Now if you're using an accrual method, you can see this part three of the Schedule C, which is basically a cost of goods sold calculation. You're going to have to figure out which sometimes can be a little bit tricky because it's kind of a perpetual inventory calculation of the cost to get sold. The formula, you may know the formula. It's going to be beginning inventory, which is the ending inventory should match the ending inventory from the prior tax year plus the purchases, which you purchase for inventory minus the ending inventory, which is probably something that you have on records. You might not have the purchases and you might back into the purchases and that will equal the cost to good sold. And oftentimes if you use accounting software, you might know the cost to good sold as well. So you might back into, in essence, the purchases using algebra in some cases to fill out that part three of the Schedule C. So small business taxpayers, you qualify as a small business taxpayer. If you A, have average annual gross receipts of $27 million or less for the three prior tax years and B are not a tax shelter as defined in Section 448D3. If your business has not been in existence for all of the three tax year period used in figuring average gross receipt base your average on the period it has existed. And if your business has a predecessor entity, include the gross receipt of the predecessor entity from the three tax year period when figuring average gross receipts. If your business or predecessor entity had had short tax years for any of the three year period, analyze your business gross receipt for the short tax year that are part of the three year period. You can see publication 538 for more information if you want to drill down on that. 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 inventoryable 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. So, again, the general idea is that they want you to kind of follow what you're doing on the book's side of things. Now, obviously, if you're a small business and you're reporting on a Schedule C, it's not like you're a publicly traded company that's creating financial statements that are required for external reporting to investors. So you might not be reporting, obviously, external financial statements of your small business on the Schedule C unless you need something like a loan or financing or something like that. But the general idea is that the system you're using for the bookkeeping that would be used to create your financial statements would generally be kind of the system that you would use for your taxes in terms of an accrual method, cash method, or a combo. So for 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 451B3. 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 changing your method of accounting for inventory. So what about if I need to change it? And possibly that may happen if you're on a cash-based method and you're saying, I think it might be more appropriate for me to be on an accrual-based method given the fact that I have inventory and possibly that that inventory has increased or something like that. So if you want to change your method of accounting for inventory, you must file Form 3.1.1.5 application for change in accounting method. So you've got to ask the IRS for permission. So see change in accounting method later. You would think that if you had a rational reason for it, meaning inventory has gone up and I was on a cash-based method. And I think the inventory has gone up to the point where it would be more appropriate for me to use an accrual method, at least with regards to the inventory sales and whatnot. Then you would think they would accept that kind of rationale. If you just were like, whatever, willy-nilly, I just want to change it because I want to change it kind of thing. Then they might argue you would think for consistency. So items include an inventory. So if you are required to account for inventories, include the following items when accounting for your inventory. So you've got the merchandise or stock and trade. Obviously if you just buy stuff, market up and sell stuff, the stuff you're buying and planning to sell is inventory. And then we've got the raw materials. So the other kind of inventory situation we have is one in which we're going to be making things. Either using a job cost system or a process cost system oftentimes where we're going to buy raw materials. We're going to start to work on them, work in process, and then we'll have the finished goods that are putting the raw materials together with our overhead in our labor. Work in process, that's the middle step of that manufacturing process. When the finished goods aren't done, they're still kind of raw. They're not raw anymore, but they're not finished either. And then you've got the finished products when we converted the raw materials into that finished goods, ready to sell. Supplies that physically become a part of the item intended for sale. So value an inventory. You must value your inventory at the beginning and end of each tax year to determine your cost of goods sold. Schedule C line 42. So we're going to have to do that cost of good sold calculation beginning inventory plus purchases minus ending inventory equals cost of goods sold in essence. Meaning that means that our beginning inventory should match what was the ending inventory in the prior tax return if we had a prior tax return for the business. In other words, if it's not a new business. And then we're going to have to have the purchases which again might be the area that you kind of back into using Algebra minus the ending inventory, which oftentimes you would determine making a physical count and just and using your accounting records to determine what ending inventory is equals the cost of goods sold, which you might have in your accounting records if you're using a perpetual inventory system, for example, already to calculate the cost of goods sold, which means you can possibly back into the purchases if you need to in that condition. So to determine the value of inventory, you need a method for identifying the items in your inventory and a method for valuing these items. So usually you've got the cost, but then obviously the cost of the inventory could have changed over time, usually going down over time. So if you're holding on to old inventory, it may not be worth what it was when you bought the inventory. You might have to use a flow assumption first in first out life of weighted average inventory. Inventory evaluation rules cannot be the same for all kinds of businesses. The method you use to value your inventory must conform to generally accepted accounting principles for small business and must clearly reflect income. So your inventory practices must be consistent from year to year. Obviously that consistency once again something that we have to be consistent with otherwise there could be manipulation. So if you changed from, for example, flow assumptions first in first out to last in first out to weighted average, you can severely change the value of your inventory and that would be manipulative thing to do for most part. So more information. For more information about inventory, you can see publication 538.