 and welcome to this session in which we will discuss tax accounting methods. Now what is the big idea when we say accounting method? Well accounting method tells us when do we recognize the revenue and when do we recognize the expense. We learn about accounting methods in our financial accounting courses such as financial accounting and intermediate accounting. For tax purposes we also have different accounting methods whether that is cash whether that's a cruel whether that's hybrid. We have to determine how to use those accounting method in recognizing revenue and in recognizing expenses which are deduction. Now think about the IRS objective. What is the IRS objective? Well the IRS objective is to raise is to raise the money collected for the government. Therefore generally speaking the government want you to recognize revenue immediately why because they wanted this revenue to be taxable and when it comes to expenses they want you to delay the expenses and as a result we have three generally permissible overall method of accounting for tax purposes. One is called cash receipts and disbursement we know it from financial accounting as the cash basis of accounting. There is the accrual method we should be kind of familiar with the accrual method because at this point you took financial accounting you took intermediate accounting and there's the hybrid method as the hybrid method suggests it's a combination of the accrual and the cash method. In this session we are going to see which method is allowed under what circumstances and there are many many exceptions and we're going to work many examples. In this session specifically I will focus on when can you use the cash method and just show you a few examples about the cash method. I will keep accrual method for another session because we need more time and I don't want this recording to be very long so we're going to focus on the cash method. Let's go ahead and get started. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to 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. Cash receipts and disbursement method also known as the cash method when it comes to income income is recognized when it's actually received because it's the cash method when you receive it or we have something called constructively received. What does it mean constructively received? Let's assume you have the check in the mailbox well you have access to it you can walk to the mailbox by December 31st and pick up the check but you chose to keep to keep it till January 3rd well guess what if the check is in the mailbox as of the end of the year and you didn't pick it up until the following year well it was available in year one not year two or for example the money was credited to your brokerage account in that particular year so you have either stocks bonds or bank account and interest and dividend was credited to your account well you did not receive it yet it's in your bank account though you can use it you can withdraw it you can transfer it it's constructively received so whether it's received actually or constructively received you would recognize the income. How about expenses? When are expenses deductible? Well expense is deductible since we are using the cash method when they are paid. How about prepaid? What is prepaid? Prepaid is when you prepay your expenses upfront. In other words you have an expense and what you do rather than wait the pay the expense on a monthly basis or on regular basis you prepay the expenses. Some examples will be you might prepaid your rent you might prepaid the your utilities expense you you prepay something upfront so for example you are in September and you prepay in September from September year one till September year two so you prepay this whole period and you are still in year one the question is when can you deduct this payment because if it's paid well but you prepaid you have year one and year two well the IRS is a little bit generous here they say you have what's called a one-year rule for the prepaid. What is that one-year rule? You are permitted to deduct the expenditure in year one for the right that do not extend beyond the earlier of 12 months after the first date on which the taxpayer realized the right so what is realizing the right? So permit the taxpayer to deduct the expenditure for the right the right means you are using the expense you are enjoying you are utilizing the expense so as long as that expense as long as that right do not extend beyond the earlier of notice the earlier of 12 months after the first date on which the taxpayer realized the right so we're going to assume you're paying in September first and you are enjoying this right the prepaid insurance your coverage start on that date or the end of the tax year the end of the tax following year of the payment well the following year is year two make sure that right that green part that enjoyment that utility that benefit do not extend beyond year two in other words it doesn't extend beyond year two December 31st year two as long as that's the case then guess what you can deduct the expense in the year paid now the best way to illustrate this concept is to look at an example let's assume on December 1st x3 maple a calendar year taxpayer paid 25 000 for 12 month insurance policy property insurance policy with coverage starting February 1st x4 and the benefit ends January 31st x5 let's take a look at a timeline here this is x3 this is x4 and this is x5 those are the years in in place maple paid on December 1st so sometime here they paid this is when they paid the money the policy doesn't kick in so the policy doesn't start until February 1st this means the right to that right to the benefit don't start until February 1st and goes from February 1st till January well move it back one month till January 31st year x5 so the benefit goes from February 1st till January January 31st well can we use the one year rule one year rule to deduct the expense to deduct the 25 000 in year three now why do we want to deduct the 25 000 in year three the assumption is this you want more deduction up front more deduction now from the time value of money you get more benefit so as a taxpayer you want to deduct the full amount in year x3 can you do that well you can't why because it expends since the date expends beyond the earlier of 12 months after February 1st okay so notice what's happening the the benefit extend 12 months after February 1st or 2004 or the the end of the next year so notice it doesn't stop here if it stopped at x4 the benefit you would have been fine but it goes to x5 so it beyond it it goes it goes over basically three period three years period one i'm gonna put period one is x3 period two and this is period three so notice if it stops here you would have been fine okay but it does not stop here and it's does not stop at this at x4 therefore we cannot take it why because the earlier of the next visit next year tax year it goes beyond it goes to January 31st year x5 now let's change the scenario a little bit so the 12 month rules don't apply let's assume you pay it in year x3 December 15th let's assume you paid it in December 15th okay and it ends now we're changing the scenario then it ends December 14th year x4 so now notice now we're not going into year year x5 so we're gonna remove x5 because it has nothing to do with year x5 so you paid it in December 15th x3 and the benefit goes immediately from that date to x4 December 14th let's assume even you paid it December 1st okay then under under those circumstances the benefit does not extend beyond the earlier of December 14 x4 or December 31st x4 so yes the benefit don't go over x4 therefore guess what the one year benefit would apply and the company maple will be able to deduct the 25 000 in year x3 so this is the one year rule simply put the way you want to look at it is something like this you have a year one year two just make sure whatever you pay if it's for one year whatever you pay make sure the benefit don't extend over year two so if the benefit goes let me say the benefit don't go beyond year two the earlier of 12 months after the date that you that you start and to receive the benefit or the end of the next year so once it goes under the third year what do you have to do then you have to prorate this insurance you have to think rattably take the 25 000 divided over the period covered and this is when you take your deduction there are restrictions on the cash method on the cash receipts and cash disbursement okay for example you need to know that cash method cannot be used by corporations there's always exceptions we're going to show you the exceptions or partnership with a corporate partner not partnership partnership with a corporate partner once we cover the partnership we will see the methods that we can use and also the cash method cannot be used by tax shelters make sure you memorize this every time you see a tax shelters just say cash method cannot be used don't worry why we need to know what tax shelters are just know cash method cannot be used okay now there are exceptions as i told you there is always exception for the rules farming business there are many exceptions for farming business which will not go over also qualified personal service company they're called pscs those companies they could be c corporation which is a corporation but what happened is the employees they perform the service for example lawyers account and doctors architect and the employees slash owner own substantially all the stock simply put they are the owner slash manager slash ceo of the company so own employee own substantially all the stock regardless of the cash receipts now there's also an exception for c corporation okay a corporation or a partnership with a corporate partner that is not a tax shelter whose average annual growth gross receipt for the past three years are 20 29 million or less is also exempt they could use the cash method if they choose what does that mean it means you look at the corporation and they look at their gross annual receipts year one year two and year three they look at the past three years and they average this number up over the past three years if the average gross receipts if they are making sales average gross receipts less than 29 million and this number will change for example this is i believe for year 2023 if you're looking 2024 2025 i could assure you they go up every year so it could be a different number regardless what the number is there the threshold they look at the past three years and if you're studying for your cpa exam you don't have to worry about the number specifically if you're studying for your enrolled agent make sure to know what that number is because it changes from year to year as long as your gross receipt is less than 30 million average for the past three years then you can use the cash method you are allowed you don't have to use it but you are allowed once you go above that number you are no longer allowed to use it that's what we are saying here also you cannot allow to use the cash method if you are a tax shelter just need to know how about if you have inventory and cost of goods sold why is that important remember what we learned in financial accounting in financial accounting when we buy inventory we debit inventory for let's assume ten thousand dollar we credit accounts payable for ten thousand dollar so inventory is an asset then when we sell this inventory let's assume we sold it for fifteen we debit cash for fifteen thousand credit sales for fifteen thousand debit cost of goods sold for ten thousand and credit inventory for ten thousand so we did here is first we bought the inventory the inventory was an asset inventory was right here and we did not expense it we did not made a cost of goods sold until we made the sale so what we are doing here we are matching the inventory to the sale okay therefore generally speaking regulation mandate that a cruel method for measuring sales and cost of goods sold when inventory are significant to the business and this ensures that income and cost of goods sold are matching clear reflection of annual income that's fine that's all good make sense however the tax cuts and jobs act of 2017 which is there was a major change of the law brought changes permitting small businesses what are small businesses less than 29 million in gross annual revenue which is the this is what you know less than this average for the past three years again this number could change but if you are considered a small business you can guess what use the cash method even if inventory is relevant to the to your operation so what does that mean it means even if you have inventory even if you have inventory you could still use the cash method as long as you are considered a small business which is what less than that threshold 29 million or whatever the government decides that threshold to be you are okay you can buy the inventory expense the inventory now why do they have this rule for in quote small businesses because they want you to have deductions deduction reduces your taxable income deduction reduces your taxes and when you buy inventory you stimulate the economy you can deduct it then you buy more and when you buy more you employ manufacturers when you employ manufacturers they make more they make more money they pay more taxes everyone is happy it stimulates the economy that's the that's the assumption there's always special rules for small farmers which they give them more leniency let's take a look at an example when it comes to personal service companies so you understand how it works aram and noah consult a consulting firm is a c corporation owned by 10 cpas that provide accounting tax and audit services its average annual gross receipts are to 35 million okay since this entity is qualified personal business corporation it has no inventory it's eligible to use the cash method now remember the 35 million it's above the 29 the threshold for that particular year now you could be viewed in this recording in 2027 and you'd say well we're below the threshold now we're assuming the threshold here is 29 million you're above the threshold but you don't have inventory in your qualified service company remember that's an exception let's take a look at another example relaxation have an ink is a c corporation that operate a chain of massage parlours its average annual gross receipts are 36 million okay now stopping right here relaxation must use the approval method okay c corporation its average granular receipt for the prior three years exceeds 29 million then they have to use it if its average annual receipts in the prior three years were 29 million or less it can use the cash method we're assuming here that the average annual gross receipts for the past three years is 36 million if it was less they can use it now if relaxation were the sole proprietorship a partnership without a c corporate partners or an s corporation for that matter it would be allowed to use the cash method regardless of the gross receipts since it's not subject to the requirement of accrual accounting and also relaxation have an massage parlour we're going to assume it has no inventory no inventory now in this session we use the we emphasize the cash method or the cash receipts and cash disbursement tax accounting method and we see when we can use it we see when we cannot use it in the next method in the next session what we're going to be focusing on is the accrual method accrual and hybrid because once we talk about the accrual hybrid is pretty straight forward what should you do now go to farhat lectures look at additional mcq's examples that's going to do what that's going to help you understand tax accounting methods and this is important whether you are a cpa candidate accounting students or an enrolled agent good luck study hard and of course stay safe