Accounting Methods and Periods

Question 1

What accounting methods do sole proprietorship use?

Answer 1

Cash, accrual, and hybrid

Question 2

Individuals: when do they report?

Answer 2

Always on the calendar year-end

Question 3

What account doesn’t exist under cash method?

Answer 3

Accounts receivable.

Question 4

Individual Accrual: When does unearned income (prepaid income) recognized? Under GAAP?

Answer 4

In the year received.

GAAP: When earned.

Question 5

I Accrual: Exception for service income recognition timing?

Answer 5

TP can elect to defer recognition into the next year IF the service is to be provided within the following year.

Question 6

I Accrual: What must TP do if income is included in FS?

Answer 6

Must include the pmts in gross income in the year of receipt.

Question 7

I Accrual: when can TP elect to defer recognition of advance pmt for goods?

Answer 7

When the method of accounting for sale is the same for tax and financial reporting purpose.

Question 8

I Rental income: when is prepaid rent taxed for cash based TP? Accrual based TP?

Answer 8

Cash: Always when received.

Accrual: Above plus when (1) all the events have occurred to attach the taxpayer’s right to receive the income and (2) the amount of income can be determined with reasonable accuracy.

Question 9

I Rental income: when is lease deposit taxed?

Answer 9

If refundable, not till it is clear the owner will keep it at the end of the lease term. Taxed only when the lessor receives an unrestricted right to it.

Question 10

I Rental income: when is leasehold improvement taxed? At what value?

Answer 10

If it is made in lieu of rent.

At FV.

Question 11

Business with inventory: what accounting method must be use in general? 3 Exceptions?

Answer 11

• Accrual.
  1. Certain businesses like a small one could be qualified to use cash method, but it must use accrual method for purchases and sales (hybrid method).
  2. If TP’s annual gross receipt do not exceed $1 million, he can use cash method for all items.
  3. If the TP is delivering service and not a corporation, and annual gross receipts exceed $1 million but are less than $10 million, he can use cash method for all items.

Question 12

When is income taxed?

Answer 12

When realized - received. Can’t be realized when valuation is not possible.

Question 13

Inventory: What methods can be used?

Answer 13

Always ok with FIFO.

LIFO is allowed if it is also used for financial reporting.

Question 14

Inventory: what are 2 major impacts of using LIFO when prices are rising?

Answer 14

1. Higher COGS.

2. Lower taxable income.

Question 15

Inventory: At what value is the inventory determined?

Answer 15

At lower of cost or market (replacement cost or reproduction cost).
Must be at cost if using LIFO.

Question 16

Inventory: What is the method manufacturers, certain retailers, and wholesalers are required to use?

Answer 16

Uniform capitalization method - capitalize (include) all the direct and indirect costs allocable to property they produce and for property bought for resale. Rather than expensing in the period.

Question 17

Uniform capitalization method: Which indirect production costs must be capitalized?

Answer 17

Virtually all.

Question 18

Uniform capitalization method: Anyone is exempt to use it?

Answer 18

Small personal property dealers - those with $10 million or less in gross receipts during the preceding 3 yrs.

Question 19

Uniform capitalization method: Are costs for storage if off-site included? Marketing selling? Research? Quality control? Advertising? Distributions? Taxes? Utilities, repairs, rent, depreciation? General and administrative expenses?

Answer 19

Storage: yes.
Marketing: no.
Research: no.
QC: yes.
Advertising. Distributions: no.
Taxes: yes except income tax.
Utilities ets: yes.
GAE: no.

Question 20

What must TP do if voluntary changing accounting method? Does this include change from incorrect methods to correct ones? Exception?

Answer 20

Any adjustment to income (increase) should be spread over 4 years starting with the year of change.
Yes.
If the adjustment is less than $25,000, all income can be included in the year of change.

Question 21

Accounting method change: what must TP do if the change is involuntary due to IRS examination?

Answer 21

Any positive adjustment to income is included in the earliest tax year under examination.

Question 22

Accounting method change: Does all method change must be reported? What about the ones designated as “automatic change” by IRS? On which form?

Answer 22

Yes.
Yes (automatic means IRS will automatically approve the change and there is no fee involved).
Form 3115.

Question 23

How is income reported when installment sales is used (pmts are received over a period of time)?

Answer 23

The gross profit from the sale is recognized as cash is received;
Recognized gain = cash received x gross profit percentage.

Question 24

Installment method ex:
In yr 1, TP sold real property for $200,000. Received $100,000 cash and $100,000 plus accrual interest next year. The buyer assumed a $50,000 mortgage. The adjusted basis was $75,000. TP incurred $10,000 expense.
Gross profit and recognized income?

Answer 24

First compute amount realized:
$200,000 + $50,000 - $10,000 = 240,000.
Gross profit = 240,000 - 75,000 = 165,000

Gross profit percentage (gross profit/contract price):
165,000 / 200,000 = 82.5%.

Income: 100,000 x 82.5% = $82,500 in year 1 and 2 each

Question 25

Installment sales: Does it apply to both gains and losses?

Answer 25

No, only to gains.

Question 26

Installment sales: Who can’t use it?

Answer 26

Dealers for sales of inventory.

Question 27

Installment sales: what’s the rule for depreciation recapture?

Answer 27

All depreciation recapture must be recognized in the yr of sale as ordinary income.

Question 28

Installment sales: what’s the rule re: gain if the installment note is sold?

Answer 28

The entire gain must be recognized immediately.

Question 29

Installment sales: how will the portion of gain be treated if the installment obligation doesn’t have a market interest rate?

Answer 29

Treated as imputed interest.

Question 30

Is installment method required?

Answer 30

No, TP can elect to recognize gains currently.

Question 31

Installment sale, depreciation recapture ex:
An assets is sold for $100 - Sec. 1245 property. Adjusted basis: $40. Depreciation claimed: $35. $100 will be paid in 2 installment of $60 in Year 1 and $40 in Year 2.

Answer 31

Amount realized (100) - Adjusted basis (40) = Realized/recognized gain (60).
Year 1 recapture: $35. (if the entire $100 was received, $35 = Sec. 1245 ordinary income and $25 = Sec. 1231 gain).

Year 1 installment income:
Gross profit is reduced by $35: $60-$35=$25. Gross profit %: 25/100=25%. $60x25%=$15 + $35 (recapture) = $50.

Year 2 income: $40x25%=$10.

Question 32

Prepaid expenses under cash method: when can TP take deduction? If deduction is not allowed, what must TP do? Does this rule apply to prepaid interest?

Answer 32

As long as benefits from the expenditure do not extend beyond the earlier of:

• 12 months after benefits first begin or
• The end of the year after the year in which the pmt was made.

The expense must be amortized over the benefit period.

No. It must be always amortized over the life of the loan.

Question 33

Accural method: What are items TP can deduct when actually paid?

Answer 33

Refunds, rebates, awards, prizes, provision of warranty work or service contracts, taxes, and insurance premiums.

Question 34

Capitalization rules: what does the cost of a Unit of Property (UOP) include?

Answer 34

All related expenditures incurred before the date the asset is placed in service, even repairs.

Question 35

Capitalization rules: what does a single UOP include?

Answer 35

All components that are functionally interdependent.

Question 36

Capitalization rules: Must TP capitalize employee compensation and overhead costs?

Answer 36

Can elect to do so or expense them.

Question 37

What are 3 criteria that allow TP to expense lower cost items (safe harbor)?

Answer 37

1. has written procedures in place that provide for the expensing of amounts below a specified dollar amount, or that have a useful life of 12 months or less.
2. Expenses the items for its accounting/book records.
3. Insures that items costing more than $5,000 are capitalized ($2,500 if the company does not have acceptable/audited FS).

Question 38

Capitalization rules: Should routine maintenance be capitalized or expensed? What is the criteria? Examples?

Answer 38

Expensed.
Maintenance to keep UOP operating efficiency,
Testing, cleaning, inspecting, replacing parts.

Question 39

Capitalization rules: what’s the rule in order to be “routine”?

Answer 39

The expenditure will be needed more than once during the asset’s life.

Question 40

Capitalization rules: What are 4 types of expenses that can’t be treated as routine maintenance (must be capitalized)?

Answer 40

1. It improves UOP (treated as a betterment).
2. A loss has been deducted against the property’s basis, or the basis has been reduced as part of a sale/exchange.
3. The asset has deteriorated and the expenditures restore the UOP to operating condition.
4. It adapts a UOP to a new or different use.
5. It is for maintenance, improvement, or repair of network assets or certain spare parts.

Question 41

What’s the criteria to be “small taxpayers”?

Answer 41

Those with $10 million or less average annual gross receipts in the 3 preceding tax years.

Question 42

What can qualifying small taxpayers deduct that other TPs can’t?

Answer 42

Can deduct improvements made to an eligible building property (one with an unadjusted basis of $1 million or less).
IF the total amount paid during the tax yr for repairs, maintenance, improvements, and similar activities performed on the eligible building does not exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.

Question 43

Which form is installment sale income reported?

Answer 43

Form 6252

Question 44

Moving expense: when can it be deducted?

Answer 44

When it is related to starting of a new job in a distant location:

• Distance from new job to former residence is at least 50 miles apart than distance from old job to former residence.
• Employed at least 39 wks of 12 months fowling the move.

Question 45

How can TP calculate the tax of a corporation for a short period?

Answer 45

Annualize income and calculate the tax on annualized income, then multiply the computed tax by the number of months in the short period divided by 12.

If a corporation filed a short-year return for 3 month, the income for that period is first multiplied by 4 (12 months/3 months) to annualize the income for 12 months. The corporate tax liability is then computed on this amount for the full 12 months. That amount is the multiplied by 3/12 to prorate for the short tax year.

Question 46

Installment sale: depreciation recapture determined?

Answer 46

Lessor of;

realized gain on the sale or depreciation taken.

Question 47

Installment sale: What is the classification of depreciation recapture? How does this impact the adjusted basis?

Answer 47

Reported as ordinary income.

Added to the original adjusted basis.