 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. You can have the income tax formula. We're focused on line one income. Remember on 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 an income statement in and of itself, income minus expenses or business deductions gets to the net income, which in essence rules into line one income of our income tax formula. This is the first page of the form 1040. We're looking at line number 11, Schedule C, flowing into the Schedule 1, flowing into the first page of the 1040 here on line number eight. This is a Schedule C, profit or loss from business where we can see the income and the expenses in essence an income statement. Speaking of income statements, let's take a look at the accrual method. Remember when we're talking about taxes and the methods being used for the business income reported on, say, a Schedule C, we wanna make sure we get the method correct starting out with because it's gonna be less easy for us to change the method in the future. The primary two methods that come to mind are a cash method and an accrual method, although you can have basically a hybrid between the two methods and remember that it's usually the industry that's gonna drive whether or not you're on a cash or accrual method. So when you're picking between the two, you wanna take that into consideration. So for example, if you deal with inventory, Doing inventory. You might have to deviate from a cash method to an accrual method. The general process or thought process would be cash method may be easier from a bookkeeping standpoint. So you might choose that method. However, some things deviate from a cash based method even if you're a small business and therefore you have no control over that because that's the industry you're in, such as for example, if you deal with inventory or for example, if you deal with any kind of business where you have to do the work first and then build the customer and deal with accounts receivable, tracking the accounts receivable that is an accrual kind of component in and of itself. Now just to recap note that other parts of the tax return when you're thinking about schedule A, when you're thinking about above the line deductions, for example, those are usually in a cash based system. If you have normal charitable contributions on the schedule A, for example, you will have to pay for them in the year that you're taking the deduction. That's more of a cash based system. But when you're looking at the schedule C, you might have a different method for the business, the schedule C that you would be electing on the schedule C. Large businesses or the general concept of what's best accounting for business is usually an accrual method because it's actually more difficult to kind of manipulate your books on an accrual method than a cash method. If you're on a cash method, you could try to manipulate your books by basically adjusting when you're gonna receive and make payments. We talked on the cash basis last time where the IRS put some limitations on that kind of ability, because they say things like if you prepay for something, then we're gonna want you to account for it differently. And so when you try to manipulate the reporting of the income based on your payment, so the cash method, they'll try to restrict that. But in general, the cash method in of its nature, it makes it easier to kind of do that. On an accrual method, you have to record income when you actually earned it, which is more of a specific timeframe. Notice that when you got the cash, that's kind of like I compare it to kind of like smoke versus the fire. The actual reporting of the income should happen when you earned it. That's the actual location of the fire in that analogy. The smoke is when you actually got paid on it. You might've gotten paid at the same point you did the work, you might've gotten paid before you did the work. You might've got paid after you did the work, but the work is the point in time that you earned the income and that's where the revenue should be reported. So if you're reporting it on a cash based system, you're kind of reporting it when you see the smoke, which is kind of around the fire, the actual location. If you're on an accrual method, they're trying to pinpoint the actual time that you earned the revenue. That's a little bit more difficult sometimes than tracking the cash method. So that's the general outline. Okay, so under an accrual method of accounting, you generally report income in the year earned and deduct or capitalize expenses in the year incurred, as opposed to a cash based method where you would be reporting income when the cash was received and deductions when the cash was paid. Note that many transactions, you will record the same transaction under an accrual or cash based method. In other words, if you did work and you got paid at the same point in time, say you were a restaurant, you gave someone food, they paid you under a cash based system, you would record revenue at that point in time because you received cash. Under an accrual based method, you would record revenue at that point in time because you did the work. They'll still be recording revenue at the same time, but for different reasons. It's only when, for example, you do the work first and then you record the revenue later, now you have a difference. On an accrual based method, you would record the income when you did the work. On a cash based method, you wouldn't record it until you've got the actual cash. Okay, so the purpose of an accrual method of accounting is to match income and expenses in the correct year. So accrual method is thought to be more accurate from a bookkeeping standpoint because we're trying to match the income that you actually earned, even though you may or may not have received the cash yet and that should tie out to the expenses that you incurred in order to generate the income. In other words, I want the expenses that I used to consume goods and services to generate revenue for the same time period in which I generated the revenue. I want to match those two things up. And if you use a cash based method, they can get a little out of whack sometimes. So income, general rule. So under an accrual method, you generally include an amount in your gross income for the tax year in which all the events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. So now you've basically earned the income. You can determine how much you have earned with the income. Possibly you issued an invoice would be the common thing in bookkeeping when you record the income, because you did the work, you're invoicing, meaning you increase the accounts receivable and the other side's going to revenue at that point in time. So if you're on a cash based system, it wouldn't be till you received the cash, right? So let's see then for a taxpayer within a applicable financial statement or other financial statements as the secretary may specify, all events test for an item of gross income is considered met no later than when taking into account in an applicable financial statement or such other financial statement. So let's see an example. Are you a calendar year accrual method taxpayer? You are in a calendar year accrual method taxpayer January through December. You're using an accrual versus cash method. You sold a computer on December 28th, 2022. You build the customer in the first week of January, 2023, but you did not receive payment until February, 2023. You must include the amount received for the computer in year 2022 because that's when you basically did the work. You completed the job. If you sell the computer, you're selling inventory. Then that happened when the inventory now leaves you and is in the possession or in control of the recipient. That's when you completed the job, right? Whereas if you did bookkeeping or something, you completed the job when you finished, you know, the bookkeeping. So income, special rules. The following are special rules that apply to advanced payments, estimating income and changing a payment schedules for services. So estimated income. So if you include a reasonable estimated amount in gross income and later determine the exact amount is different, take the difference into account in the tax year in which you make the determination. So in other words, like 2022, you estimate what the income is going to be. And then in the following year, there was a difference. There was a change, because you didn't actually get paid yet, right? And then there was a change that happened between the estimated earnings and what you actually got paid. You've recorded the income when you earned it based on the estimate, but now the actual amount is different. What do you do? Do you go back to the prior year and make an amended tax return to fix it? Typically we don't want to do that. We would like to make the adjustment in the current year.