According to section 446 of the General Rule for Methods of Accounting, there are three permissible accounting methods used to calculate income throughout the year (Legal Information Institute.). These include cash, accrual, and disbursement methods. This paper focuses on the cash and accrual basis.
The accrual basis of accounting deal with recording revenues and expenses whenever they are earned and incurred respectively. Usually, the purpose of this method is to match the annual income and expenses. The accrual method of accounting utilizes two tests to establish when it is appropriate to record an income ( Labrador & Olmo, 2019) . These include the economic performance test, which is often met when the other party renders a property or service. All event test requires reporting of the revenue after all the events have occurred, thus allowing the taxpayer to receive the property.
Delegate your assignment to our experts and they will do the rest.
Regarding the cash basis of accounting, revenues are usually recognized when the cash is received while the expenses are recognized after making the payment through cash. Often, the cash method of accounting does not know account receivable and payables. All transactions are conducted using money ( Feldman & Libman, 2011) . Therefore, it is often preferred by small entities as it allows easy tracking of a business transaction as well as money coming in and leaving the business. In this case, taxation is not conducted unless the money has been deposited. Similarly, all the business transactions are not recorded unless the money has been received. Unlike the accrual basis where expenses are recorded once they are accrued, in cash basis, they are recognized once they are incurred.
Revenue Recognition
The accrual and cash basis of accounting methods differ in various ways. First, the revenue and expenses tend to be recognized differently. Additionally, the two methods affect the cash flow adversely (Pope, 2015). The applicability of the methods can be determined by the form of business a taxpayer decides to engage in. For instance, in the case of starting a partnership or a corporate, Bob may not have the chance to select the cash basis as an option, unless the revenue of the company would be less than $ 5,000,000 within the last three years (Legal Information Institute).
Moreover, Bob's entity would require to maintain an inventory record. In this case, the accrual method is more appropriate as it would allow the reflection of taxable income appropriately. For instance, in fact, Bob decides to sell the car, the company's inventory would decrease, and the sales recognized for the year when the transaction took place. These would require to be recorded appropriately for proper accounting.
Nonetheless, if Bob is interested in starting a small venture like a sole proprietorship, the use of cash accounting can be efficient. It ensures that the business personnel obtains the actual money received and released from the business through purchases. Avoiding the cases of debits and credits can enable the company to thrive and succeed in the market.
Bob wants to transfer 40% of his interests in the business to his daughter. In this, a partnership would be appropriate as it would make both Bob and the daughter directors of the company. Also, he can get to benefit from her contribution either in management, skills, or even expertise.
Recommendation
As a recommendation, Mr. Bob should consider settling for the accrual accounting over cash. This is because the accrual method of accounting provides business management with the overall cash flow of the business, illustrating a different period of income and expenses. It helps the management with more information that can be used in decision making (Rupert et al. Often, investors tend to prefer companies utilizing accrual accounting over cash. Usually, companies using the former as the method of accounting appear stable and more permanent. This would be crucial in case Bob needs investors to finance his business (Legal Information Institute). Finally, it is an acceptable GAAP method. Financial statement for entities using the accrual method is considered accurate as they reflected when the actual transaction took place as opposed to cash exchange.
Economic Impact
The accrual method of accounting help taxpayers to comprehend these finances based on the duration when the given transaction took place. When using the accrual method, revenues are recognized and reported immediately. Nonetheless, when using cash, they are realized when the seller receives the cash. Usually, taxpayers seek to minimize their tax liability. When utilizing the accrual methods, it allows individuals and businesses to lower their taxable income by deciding when to bill the customers.
Besides, business personnel may ask suppliers and vendors to send their invoices in a specific period that they are assured of low taxes. Section 162 of the accounting principles enlists ways through which an entity can reduce the taxable income through maximization of the expenses ( Feldman & Libman, 2011) . Usually, businesses tend to increase their costs in particular years as a way to offset their taxable income on occasions that one estimates the possibility of obtaining higher annual earnings. In this case, accrual may allow Bob to learn the technique and ensure a balance. This is not possible with the cash method.
Conclusion
Generally, using cash basis in accounting is simple and easy to recognize the revenues of a business in a given year. Usually, it provides business personnel with an exact cash flow of the company. Nonetheless, it is not applicable in all form of business. The Internal Revenue Code imposes restrictions where cash accounting cannot be used in entities like partnerships, limited liabilities, and corporations. The restriction is not applicable in case these entities have an average sale of below 5 million dollars for three years. For accrual accounting, it is challenging to recognize revenues. Nevertheless, the process can be more comfortable through budgeting and appropriate strategy, and it is it can be beneficial to a business, especially in reducing the expenses.
References
Feldman, M., & Libman, A. (2011). A crash course in accounting and financial statement analysis . John Wiley & Sons.
Labrador, M., & Olmo, J. (2019). Management accounting innovations for rationalizing the cost of services: The reassessment of cash and accrual accounting. Public Money & Management , 39 (6), 401-408.
Legal Information Institute. 26 U.S. Code § 162- Trade or business expenses. Legal Information Institute https://www.law.cornell.edu/uscode/text/26/162
Legal Information Institute. 26 U.S. Code § 446- General rules for methods of accounting. Legal Information Institute. https://www.law.cornell.edu/uscode/text/26/446
Pope, T. R. (2015). Prentice Hall's Federal Taxation 2016+ Myaccountinglab with Pearson Etext . Prentice Hall.
Rupert, Timothy J., Thomas R. Pope, and Kenneth Edward Anderson. "Chapter 11, Accounting Periods and Methods." Prentice Hall's Federal Taxation 2016. Boston: Pearson, 2016. N. pag e. Print.
