Bryant - Course 4. Tax Planning. 13. Tax Accounting Methods

Question 1

Module Introduction

Federal income tax is the dominant form of taxation in the United States. In addition to federal income tax, most states, and some cities and counties, also impose an income tax to which corporations and individuals are subject. The calculation of income for these taxes often depends on accounting principles. In order to understand and calculate taxable income, a planner must consider the taxpayer’s method of tax accounting. The term “method of tax accounting” is used to include the overall methods of tax accounting and the accounting treatment of specific items.

The Tax Accounting Methods module will explain the different accounting periods, changes in accounting periods and accounting methods, and inventory costs and their impact on taxation.

Answer 1

Upon completion of this module you should be able to:
* List the rules for adopting and changing an accounting period,
* Explain the differences between cash, accrual, and hybrid accounting,
* Determine the tax treatments in case of duplications and omissions that may result due to changes in accounting methods, and
* List the methods used for inventory costs.

Question 2

Module Overview

In order to have a clear understanding of tax accounting methods, you must keep in mind that taxable income is computed on the basis of the taxpayer’s annual accounting period, which is ordinarily 12 months (i.e., either a calendar year or a fiscal year). A fiscal year is a 12-month period that ends on the last day of any month other than December.

The tax year must coincide with the year used to keep the taxpayer’s books and records. Taxpayers who do not have books, such as an individual with wage income, must use the calendar year. The year in which income is taxed depends on the taxpayer’s accounting method. The three primary overall accounting methods are the cash receipts and disbursements method, the accrual method, and the hybrid method.

Finally, a change in accounting methods usually results in duplications or omissions of items of income or expense. When this happens the net amount of the change must be taken into account. There are different methods for reporting the amount of change. But, in general, once an accounting method is chosen, it cannot be changed without IRS approval. There are, however, a few exceptions to the rule.

Answer 2

There will be a discussion on inventories, which may be valued at either cost or at the lower of cost or market value. The costs that must be included in inventory are found in IRC Section 263A and are referred to as the Uniform Capitalization Rules (UNICAP). The specifics of these rules are beyond the scope of this course and are not usually part of the financial planner’s role.

To ensure that you have an understanding of tax accounting methods, the following lessons will be covered in this module:
* Accounting Periods
* Accounting Methods
* Inventories Overview
* Changes in Accounting Methods

Question 3

Accounting Periods

The taxpayer’s annual period on the basis of which taxable income is computed is called an accounting period. An accounting period is either a calendar year or fiscal year typically consisting of 12 months. The tax year must coincide with the taxpayer’s books and records. Taxpayers who do not have books, such as an individual with wage income, must use the calendar year. The tax year is elected on the first tax return that is filed by a taxpayer and cannot be changed without consent from the IRS.

A taxpayer with a seasonal business may find a fiscal year to be advantageous. During the slow season, inventories may be lower and employees are available to take inventory and perform other accounting duties associated with the year-end.

Answer 3

To ensure that you have an understanding of accounting periods, the following topics will be covered in this lesson:
* Partnerships
* S Corporations and Personal Service Corporations
* Required Payments and Fiscal years
* Changes in Accounting Periods

Returns for Periods of Less Than 12 Months
Upon completion of this lesson, you should be able to:
* List the different kinds of accounting periods
* Explain the purpose of having stringent guidelines to govern accounting periods
* Impact of tax rules on accounting periods, and
* Exceptions in the rules governing accounting periods.

Question 4

What tax year must a partnership use?

Answer 4

A partnership must use the same tax year of the partners who own the majority (greater than 50%) of partnership income and capital. If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners (those with more than a 5% interest in the partnership). If the principal partners do not have the same tax year, the partnership must use the taxable year that results in the least aggregate deferral of income to the partners. An exception is made for partnerships that can establish to the satisfaction of the IRS a business purpose for having a different year.

The purpose of the strict rules for selecting accounting periods is to prevent partners from deferring partnership income by choosing a different tax year for the partnership. For example, calendar-year partners might select a partnership year that ends on January 31. Because Partnership income is considered to be earned by the partners on the last day of the partnership’s tax year, reporting the profits would thus be deferred 11 months because the partnership tax year ends after the partner’s year. Consequently, the income of the partnership earned in 2023 would be deemed earned by the partner in 2024 and not taxed until that year.

Question 5

If a majority of the partners do not have the same tax year, they should use the __ ____??____ __ tax year.
* principal partners’
* limited partners’

Answer 5

principal partners’

If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners (those with more than a 5% interest in the partnership).

Question 6

S Corporations and Personal Service Corporations

What tax year are S corporations and personal service corporations required to adopt?

Answer 6

Generally, S corporations and personal service corporations are required to adopt a calendar year unless the corporation has a business purpose for electing a fiscal year. Taxpayers willing to make certain required payments or distributions may choose a fiscal year.

An improper election to use a fiscal year automatically places the taxpayer on the calendar year. Thus, if the first return is filed late because of oversight, the option to choose a fiscal year is lost.

Question 7

Establishing a Corporate Tax Period Example:

Eagle Corporation has adopted a 52-53-week year. Eagle’s tax year begins on December 29, 2023. Assume that a new tax rate schedule applies to tax years beginning after December 31, 2022. The new tax rate schedule is applicable to Eagle because, in the absence of the 52-53-week year, its tax period would have started on January 1, 2023.

Answer 7

While most tax years end on the last day of a month, the tax law allows taxpayers to use a tax year that always ends on the same day of the week, such as the last Friday in October. This means that the tax years will vary in length between 52 and 53 weeks. Taxpayers who regularly keep their books over a period that varies from 52 to 53 weeks may elect the same period for tax purposes. A 52-53-week taxable year must end either the last time a particular day occurs during a calendar month (e.g., the last Friday in October) or the occurrence of the particular day that is closest to the end of a calendar month (e.g., the Saturday closest to the end of November). Under the first alternative, the year may end as many as six days before the end of the month but must end within the month. Under the second alternative, the year may end as many as three days before or after the end of the month.

Although the 52-53-week year may actually end on a day other than the last day of the month, it is treated as ending on the last day of the calendar month for “effective date” changes in the tax law that would otherwise coincide with the year-end.

Question 8

If Partnerships and S corporations make the Section 444 election, what are they required to do?

Answer 8

Virtually all C corporations (other than personal service corporations) have flexibility in choosing an accounting period. Other taxpayers, such as partnerships and S corporations, may use a fiscal year if they have an acceptable business purpose. However, most of these businesses are unable to meet the rather rigid business purpose requirements outlined by the IRS. As a result, these businesses end up using the calendar year and have to concentrate most tax work in the early months of the year. Concern over this problem led Congress to enact IRC Section 444, which allows partnerships, S corporations, and personal service corporations (such as incorporated medical practices) to elect a taxable year that results in a tax deferral of three months or less. For example, a partnership with calendar-year partners may elect a September 30 year-end.

Partnerships and S corporations making the Section 444 election, however, must make annual required payments by April 15 of the following year. The purpose of the required payment is to offset the tax deferral advantage obtained when fiscal years are used.

Question 9

How do you calculate the required payment?

Answer 9

The amount of the required payment is determined by multiplying the maximum tax rate for individuals plus 1% (38% in 2023) times the previous year’s taxable income times a deferral ratio. The deferral ratio is equal to the number of months in the deferral period divided by the number of months in the taxable year. An adjustment is made for deductible amounts distributed to the owners during the year. If the deductible amount due is $500 or less, no payment is required. If a business elects something other than a calendar year-end, it will have to make tax payments for the time value of money benefit it gets for the tax deferral on reporting the income. The business can deduct the amount distributed to the business owners during the year (as they will be reporting this income on their return). However, they will have to pay income taxes on any amount above $500.

Question 10

Required Payments & Fiscal Year Example:

ABC Partnership begins operations on October 1, 2023, and elects a September 30 year-end under Section 444. The partnership’s net income for the fiscal year ended September 30, 2023, is $100,000.
* What is ABC’s required payment?
* When is it due?

Answer 10

ABC must make a required payment of $9,500 ($100,000 x 38% x 3/12) on or before April 15, 2024.

Question 11

What must personal service corporations do to elect a fiscal year-end?

Answer 11

Personal service corporations may elect a fiscal year-end if they make minimum distributions to shareholders during the deferral period. Personal service corporations are incorporated medical practices and other similar businesses owned by individuals who provide their services through the corporation. In general, the rules prevent a distribution pattern that creates a tax deferral. This is achieved by requiring that the deductible payments made to owners during the deferral period be at a rate no lower than during the previous fiscal year.

Question 12

When is a change in Accounting periods allowed?

Answer 12

Once adopted, an accounting period cannot normally be changed without the approval of the IRS. The IRS will usually approve a change only if the taxpayer can establish a substantial business purpose for the change (e.g., changing to a natural business year). A natural business year ends at or soon after the peak income-earning period (e.g., the natural business year for a department store that has a seasonal holiday business may end on January 31). A business without a peak income period may not be able to establish a natural business year and may, therefore, be precluded from changing its tax year. In general, at least 25% of revenues must occur during the last two months of the year in order to qualify as a natural business year.

Question 13

What are the instances for which IRS approval is not required to change to another accounting period?

Answer 13

• A newly married person may change tax years to conform to that of his or her spouse so that a joint return may be filed. However, the election must be made in either the first or second year after the marriage date.
• A change to a 52-53-week year that ends with reference to the same calendar month in which the former tax year ended.
• A taxpayer who erroneously files tax returns using an accounting period other than that on which his or her books are kept is not required to obtain permission to file returns for later years based on the way the books are kept. Corporations under the following specified conditions may switch to another accounting period even without IRS approval: There has been no change in its accounting period within the past ten calendar years; the resulting year does not have a net operating loss (NOL); the taxable income for the resulting short tax year when annualized is at least 90% of the taxable income for the preceding full tax year; and if there is no change in status of the corporation (such as an S corporation election).
• An existing partnership can change its tax year without prior approval if the partners with a majority interest have the same tax year to which the partnership changes or if all principal partners who do not have such a tax year concurrently change to such a tax year.
• A corporation meeting the following specified conditions may change without IRS approval: (1) There has been no change in its accounting period within the past ten calendar years. (2) the resulting year does not have a net operating loss (NOL), (3) the taxable income for the resulting short tax year when annualized is at least 90% of the taxable income for the preceding full tax year, and (4) there is no change in status of the corporation (such as an S corporation election). A statement should be attached to the return indicating that each condition is met.

Question 14

When is a change in tax years required?

Answer 14

There is one instance, however, when a change in tax years is required: A subsidiary corporation filing a consolidated return with its parent corporation must change its accounting period to conform to its parent’s tax year. Application for permission to change accounting periods is made on Form 1128 (Application to Adopt, Change or Retain an Accounting Period), on or before the due date of the return including extensions. The application must be sent to the Commissioner of the IRS, Washington, D.C. The IRS may establish certain conditions for the taxpayer to meet before it approves the change to a new tax year.

Question 15

What are the 4 steps in changing an Accounting Period?

Answer 15

• Step 1
  Accounting Period - An initial accounting period is determined by the corporation.
• Step 2
  Purpose for Change - The taxpayer must establish a substantial business purpose for the change.
• Step 3
  Form 1128 - Application for permission to change accounting periods is made on Form 1128. The application must be sent to the Commissioner of the IRS, Washington, D.C.
• Step 4
  IRS Approval - The IRS reviews Form 1128 and either approves the change in the accounting period or establishes conditions that must be met in order for the change to be approved.

Question 16

What are the 2 occasions that a taxpayer’s accounting period may be less than 12 months duration?

Answer 16

• The first instance is when the taxpayer’s first or final return is filed and the second one occurs if the taxpayer changes accounting periods.
• Taxpayers filing an initial tax return, executors filing a taxpayer’s final return, or corporations filing their last return are not required to annualize the year’s income. There are no provisions for personal exemptions or tax credits to be prorated. These returns are prepared and filed, and taxes are paid as though they are returns for a 12-month period ending on the last day of the short period. An exception permits the final return of a decedent to be filed as though the decedent lived throughout the entire tax year.

Taxpayers who change from one accounting period to another must annualize their income for the resulting short period. This prevents income earned during the resulting short period from being taxed at lower rates.

Question 17

What are the 4 Steps to Annualize Income?

Answer 17

Step 1

Determine Modified Taxable Income - Individuals must compute their taxable income for the short period by itemizing their deductions.

Step 2

Multiply Modified Taxable Income - Modified Taxable Income is multiplied by (12 ÷ # of months in short period).

Step 3
Compute the Tax on the Resulting Taxable Income - Use the appropriate tax rate schedule to compute the tax.

Step 4
Multiply the Resulting Tax - Multiply the tax result by (# of months in short period ÷ 12).

Question 18

Section One Summary

The tax year is elected on the first tax return that is filed by a taxpayer and cannot be changed without consent from the IRS. The taxable income of any taxpayer is computed on the basis of the taxpayer’s annual accounting period which is usually 12 months. The IRS will usually approve of a change only if the taxpayer can establish a substantial business purpose for the change.

Most income tax returns cover an accounting period of 12 months. However, on two occasions, a taxpayer’s accounting period may be less than 12 months: When the taxpayer’s first or final return is filed, or when the taxpayer changes accounting periods.

In this lesson, we have covered the following:
* Partnerships: Generally must use the tax year of the majority owners of the partnership. If the majority of partners do not have the same tax year, they are required to use the tax year of the principal partners who have more than 5% ownership.
* S Corporations and Personal Service Corporations are generally required to adopt a calendar year for their accounting period unless they have a business purpose for electing a fiscal year.

Answer 18

• Required payments and fiscal years: Almost all C Corporations have flexibility in choosing an accounting period. However, most other forms of business such as partnerships, S Corporations, and personal service corporations are unable to meet the rigid business purpose requirements outlined by the IRS, so these businesses are allowed to use a fiscal year provided they make certain required payments to the IRS to eliminate the tax benefit of deferring the taxability of income due to the fiscal year election.
• Changes in the accounting period cannot be changed without consent from the IRS. The IRS approves of a change only if the taxpayer is able to establish a substantial business purpose for the change. There are also a few instances where IRS approval is not required to change an accounting period such as a newly married person changing tax years to match his or her spouse so that a joint return may be filed.
• Returns for periods less than 12 months are acceptable for the following two reasons: When the taxpayer’s first or final return is filed, or when the taxpayer changes accounting periods.

Question 19

The tax year must coincide with the year used to keep the taxpayer’s books and records.
* False
* True

Answer 19

True

The tax year must coincide with the year used to keep the taxpayer’s books and records. Taxpayers who do not have books must use a calendar year.

Question 20

All of the following are acceptable accounting tax years EXCEPT?
* A corporate tax year ending on February 15th.
* A corporate tax year ending on the last Friday in April.
* A partnership tax year ending on December 31 with three equal tax partners whose tax year ends on September 30, October 31, and November 30.
* An S corporation’s tax year ending on December 31.

Answer 20

A corporate tax year ending on February 15th.

A tax year must fall at the end of the month or be specified as a specific day at the end of the month such as the last Friday in April.

Question 21

When preparing a tax return for a short period, the taxpayer should annualize the income if the short return:
* Is the last return for a decedent who died on November 23.
* Is the first return for a corporation created on June 12.
* Is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year.
* Is the last return for a partnership, which is terminated on October 12.

Answer 21

Is a return for June 1 to December 31, for a corporation changing from a fiscal year to a calendar year.

Taxpayers who change from one accounting period to another must annualize their income for the resulting short period. This prevents income earned during the resulting short period from being taxed at lower rates.

Question 22

Section 2 - Accounting Methods

A taxpayer’s method of accounting determines the year in which income is reported and expenses are deducted. Taxable income must be computed using the method of accounting regularly used by the taxpayer in keeping his or her books if that method clearly reflects income. Permissible overall accounting methods are:
* Cash receipts and disbursements method (often called the “cash method of accounting”)
* Accrual method
* A combination of the first two methods often called the hybrid method

Individual taxpayers and small businesses use the cash receipts and disbursements method of accounting. Taxpayers using the accrual method of accounting generally report income in the year it is earned. The hybrid method of accounting really is a combination of the cash and accrual methods. Under the hybrid method, some items of income or expense are reported under the cash basis and others are reported under the accrual method.

While taxpayers have the right to choose a method of accounting, the chosen method still must clearly reflect income as determined by the IRS. The IRS has the power to change the accounting method used by a taxpayer if, in the opinion of the IRS, the method being used does not clearly reflect income.

Answer 22

In order to have an understanding of accounting methods, the following topics will be covered in this lesson:
* Cash Method
* Accrual Method
* Hybrid Method
* Long-term Contract
* Installment Sales

Upon completion of this lesson, you should be able to:
* List the different accounting methods,
* Explain the purpose of having different methods to compute tax,
* Explain the differences among these methods, and
* Determine the taxable ramifications of an installment sale.

Question 23

Cash Method of Accounting Example:

In December of the current year, Troy, who owns an apartment building, collects the first and last months’ rent from the tenant. Troy must report two months’ rent in the current year. The actual expenses associated with the last month’s rental are not incurred until the last month. However, Troy must report two months’ income this year, but may only deduct one month’s expenses.

Reporting prepaid income can have harsh results because it is not offset by related deductions. If the income is taxed before the expenses are incurred, the taxpayer may not have enough cash to pay the expenses when they are incurred.

Answer 23

Most individual taxpayers and most small businesses use the cash receipts and disbursements method of accounting. Under this method, income is reported in the year the taxpayer actually or constructively receives the income rather than in the year the income is earned. The income can be received by the taxpayer or the taxpayer’s agent and be in the form of cash, other property, or services. When received as property or services, the amount included in income is the value of the property or services.

Accounts receivable or other unsupported promises to pay are considered to have no value under the cash method and, as a result, no income is recognized until the receivable is collected. The fact that prepaid income is taxed when received and not when earned often results in mismatching of income and expenses.

Question 24

What is Constructive Receipt?

Answer 24

A cash-basis taxpayer must report income in the year in which it is actually or constructively received. Constructive receipt means that the income is made available to the taxpayer so that it may be drawn upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. This rule prevents taxpayers from deferring income that is otherwise available by merely “turning their backs” on it. A taxpayer cannot defer income recognition by refusing to accept payment until a later taxable year.

Question 25

What are instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received include?

Answer 25

Instances of constructive receipt where taxpayers are required to report taxable income even though no cash is actually received include: * A check received after banking hours * Interest credited to a bank savings account * Bond interest coupons that have matured but have not been redeemed * Salary available to an employee who does not accept payment

Question 26

When is an amount is not constructively received?

Answer 26

An amount is not constructively received if: * It is subject to substantial limitations or restrictions. * The payer does not have the funds necessary to make the payment. * The amount is unavailable to the taxpayer.

Question 27

# Constructive Receipt Example: Beth owns an ordinary life insurance policy with a cash surrender value. She need not report any income as the cash surrender value increases, because the requirement that she cancel the policy in order to collect the cash surrender value constitutes a substantial restriction. **If she cancels the policy, she reports as income the difference between the cash surrender value collected and net premiums paid**.

Question 28

# Exam Tip: Getting to know the CFP Board-provided tax tables and limits is essential to achieving exam success. Listen in to this audio guide to find out tax table-related best practices for your studies & exam preparation. Constructive Receipt - income is recognized and taxes are paid * Good question to ask to determine: **Are there any strings attached still attached to the receipient's ability to have access to the funds?**

Answer 28

* If there's no strings attached, it is constructive receipt * **Common to see on test: Non-qualified deferred compensation - strings attached (period of time, accomplishment of goals). Until that time, there's substanial risk of forfeiture. So, no constructive receipt until it's released.**

Question 29

The term ‘constructive receipt’ means the taxpayer has access to the income at any time. * False * True

Answer 29

True. Constructive receipt means that the income is made available to the taxpayer so that (s)he may draw upon it any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Question 30

What is one of the exceptions to the basic rule that cash-basis taxpayers report income when it is actually or constructively received?

Answer 30

* **The interest on Series E and Series EE U.S. savings bonds need not be reported until the final maturity date, which varies but may be as long as forty years after the date of issue, and can be deferred even longer if the bonds are exchanged within one year of the final maturity date for Series HH U.S. savings bonds**. Many taxpayers purchase bonds with a maturity date that occurs after retirement when the taxpayers expect to be in a lower tax bracket. For example, Tenisha purchased a Series EE U.S. savings bond in the current year for $2,500 that matures in 10 years. The bond will not pay any interest until it matures; at maturity, the bond will be worth $5,000. Tenisha is not required to report any interest income for tax purposes until the bond matures. **At maturity, when Tenisha receives the $5,000, she will report $2,500 of interest income. If she desires to defer the interest further and avoid paying tax on the interest income, she could exchange her Series EE bond for a Series HH bond within one year**.

Question 31

What is the other exception to the basic rule that cash-basis taxpayers report income when it is actually or constructively received?

Answer 31

Special rules also apply to **farmers and ranchers**. **Farmers may report crop insurance proceeds in the year following receipt if the crop would have ordinarily been sold in the following year**. **Ranchers who sell livestock may, on account of drought, flood, or other weather-related conditions delay reporting income until the following year if they can establish that the livestock sale would otherwise have taken place in a later tax year**. These rules help taxpayers avoid bunching income into one year.

Question 32

What are taxpayers who use cash receipts and disbursement methods required to do with fixed assets?

Answer 32

**Taxpayers who use cash receipts and disbursement methods are required to capitalize fixed assets. They must also recover the cost through depreciation or amortization**. The regulations state that **pre-paid expenses must be capitalized and deducted over the life of the asset if the life of the asset extends substantially beyond the end of the tax year**. Typically, capitalization is required only if the life of the asset extends beyond the close of the tax year following the year of payment. Capitalization Example: On July 1, 2023, Acme Corporation, a cash-basis, calendar-year taxpayer, pays an insurance premium of $3,000 for a policy that is effective from July 1, 2023, to June 30, 2024. The full $3,000 is deductible in 2023.

Question 33

What is one notable exception to the one-year rule?

Answer 33

**One notable exception to the one-year rule denies a deduction for prepaid interest**. **Cash-method taxpayers must capitalize such amounts and allocate interest over the prepayment period**. **A special rule allows homeowners to deduct points paid on a mortgage used to buy or improve a personal residence**. The payment must be an established business practice in the area and not exceed amounts generally charged for such home loans.

Question 34

Who is required to use the accrual method of accounting, according to IRC Section 448? Who is exempt from this requirement?

Answer 34

Taxpayers using the accrual method of accounting generally report income in the year it is earned. Income is earned when all the events that fix the right to receive the income have occurred and the amount of income can be easily determined. In the case of a sale of property, income normally accrues when the title passes to the buyer. Income from services accrues as the services are performed. **IRC Section 448 requires C corporations and partnerships with corporate partners, tax shelters, and certain trusts to use the accrual method of accounting**. **Qualified personal service corporations, certain types of farms, and entities with average gross receipts under $29 million (2023) are exempt from the requirement**.

Question 35

What is a major exception to the normal operation of the accrual method?

Answer 35

**A major exception to the normal operation of the accrual method is the rule applicable to the receipt of prepaid income**. **Prepaid income is generally taxable in the year of receipt**. For example, if a lender receives interest for January in the preceding December, it is taxable in the year received, whether the lender uses the cash or accrual method. This treatment, of course, differs from financial accounting, where the interest would be reported as it accrues. **Two important exceptions to the general rule are**: * **Accrual-basis taxpayers may defer recognizing income in the case of certain advance payments for goods and in the case of certain advance payments for services to be rendered**. * **A taxpayer may defer advance payments for goods (inventory) if the taxpayer's method of accounting for the sale is the same for tax and financial accounting purposes**. A taxpayer may defer advance payments for services if the payments are for services to be performed before the end of the tax year following the year of receipt. Such payments may be reported as the services are performed. For example, the taxpayer may allocate the payment received over the current and succeeding years. **The rule is not applicable if a payment covers a time period that extends beyond the end of the tax year following the year of receipt**. This rule can be applied to a variety of services such as **dance lessons, maintenance contracts (but not to warranties included in the sales price of a product), and rent (if services are associated with the rent, as with a hotel or motel)**.

Question 36

What is the all events test?

Answer 36

An accrual-method taxpayer reports an item of income when all events have occurred that fix the taxpayer's right to receive the item of income and the amount can be determined with reasonable accuracy. Similarly, an expense is deductible when all events have occurred that establish the fact of the liability and the amount of the expense can be determined with reasonable accuracy. For deductions, the all-events test is not satisfied until the economic performance has taken place.

Question 37

What is the economic performance test?

Answer 37

**Economic performance (of services or property to be provided to a taxpayer) occurs when the property or services are actually provided by the other party**. Economic Performance Example: The owner of a professional football team provides medical benefits for injured players through insurance coverage. Economic performance occurs over the term of the policy rather than when the team enters into a binding contract with the insurance company or during the season when the player earns the right to medical benefits. Thus, a one-year premium is deductible over the year of the insurance coverage rather than over the term of the player's contract under which the benefit is earned. Similarly, if a taxpayer is obligated to provide property or services, economic performance occurs in the year the taxpayer provides the property or service.

Question 38

What are the five conditions that waives the requirement that economic performance take place before a deduction is allowed?

Answer 38

The requirement that economic performance takes place before a deduction is allowed is waived if all of the following five conditions are met: * The all-events test, without regard to economic performance, is satisfied. * Economic performance occurs within a reasonable period (but in no event more than 8 1/2 months) after the close of the tax year. * The item is recurring in nature, and the taxpayer consistently treats items of the same type as incurred in the tax year in which the all-events test is met. * The taxpayer is not a tax shelter. * Either the amount is not material or the earlier accrual of the item results in a better matching of income and expense. Reserves for items such as product warranty expenses are commonly encountered in financial accounting. **The all-events and economic performance tests prevent the use of such reserves for tax purposes**. This is because the amount of such expense is not usually ascertainable with sufficient accuracy. Under earlier law, taxpayers were permitted to use the allowance method for bad debts, but that method is no longer allowed for tax purposes.

Question 39

Describe the hybrid method of accounting

Answer 39

The hybrid method of accounting is a combination of the cash and accrual methods. In the hybrid method, some items of income or expense are reported under the cash basis and others are reported under the accrual method. The **method is most often encountered in small businesses that maintain inventories and are required to use the accrual method of accounting for purchases and sales of goods. Such businesses often prefer to use the cash method of reporting for other items because the cash method is simpler and may provide greater flexibility for tax planning**. A taxpayer using the hybrid method of accounting would use the accrual method, with respect to purchases and sales of goods. The taxpayer would use the cash method in computing all other items of income and expenses. Finally, **cash basis taxpayers do not have to pay taxes until they receive the money**. Under the accrual method, **income is reported when it is earned even if it has not been received**. As a result, accrual basis taxpayers sometimes have to pay the tax before they actually receive the income they have earned.

Question 40

# Hybrid Method of Accounting Example: Jane begins a new retail business which has sales of $400,000 during the first year. She has no receivables as all sales are for cash. She purchases $240,000 of merchandise during the year. At the end of the year, she has not paid for $30,000 of the merchandise she purchased, and she has $50,000 of inventory on hand. Other expenses of the business were $150,000. As her average gross receipts are less than $1 million she can use either the cash or accrual method. Her business income computed under both methods is as follows:

Answer 40

Accrual. Cash. Sales $400,000 $400,000 Purchases $240,000 $210,000 Inventory $50,000 $50,000 Cost of sales $190,000 (1) $210,000 (2) Gross profit 210,000 190,000 Expenses $150,000 $150,000 Net income $60,000 $40,000 (1) Inventory used ($240,000 - $50,000) (2) Amount actually paid for inventory during the year. **Note that under the accrual method, Jane deducts the cost of the merchandise she sells during the year, while under the cash method she deducts as cost of sales the amount she pays during the year for merchandise. This difference results in a reported income that is $20,000 less under the cash method**.

Question 41

What's considered a long-term contract?

Answer 41

**Long-term contracts include building, installation, construction, or manufacturing contracts that are not completed in the same tax year in which they began**. A manufacturing contract is long-term only if the contract involves the manufacture of either a unique item not normally carried in finished goods inventory or items that normally require more than 12 calendar months to complete. **Contracts for services (architectural, accounting, legal, and so on) do not qualify for long-term contract treatment**. Long-Term Contract Availability Example: The Diamond Corporation manufactures two types of airplanes: * small, general aviation planes that require approximately six months to complete, and * large jet aircraft sold to airlines that require two years to complete. Diamond maintains an inventory of the small planes but manufactures the large planes to contract specification. **Diamond can use long-term contract accounting only for the large planes**. Assume Diamond also offers aircraft design assistance to the government and others who seek such services. In these cases, long-term contract accounting is not available.

Question 42

What methods may be used when accounting for income and expenses associated with long-term contracts?

Answer 42

The accounting method selected by a taxpayer must be used for all long-term contracts in the same trade or business. In general, **the income and expenses associated with long-term contracts may be accounted for by using either the percentage of completion method or the modified percentage of completion method**. In limited instances, taxpayers may use the **completed contract method**. Under the percentage of completion method, income from a project is reported in installments as the work progresses. Under the completed contract method, income from a project is recognized upon completion of the contract. **The modified percentage of completion method is a hybrid that combines two methods**. **Alternatively, taxpayers may use any other accounting method (e.g., the accrual method) that clearly reflects income**.

Question 43

Interest must be capitalized if the property being produced is which of the following? (Select all that apply) * Costing more than $1 million in less than 1 year. * Requiring more than 2 years to produce. * Real. * Long-lived.

Answer 43

Requiring more than 2 years to produce. Real. Long-lived. Interest must be capitalized if the property being produced is: * Requiring more than 2 years to produce, * Real, or * Long-lived.

Question 44

What are the Costs Subject to Long-Term Contract Rules?

Answer 44

Direct contract costs are subject to long-term contract rules. Labor, materials, and overhead costs must be allocated to the contract and accounted for accordingly. Thus, **under the completed contract method, such costs are capitalized and deducted from revenue in the year the contract is completed**. **Selling, marketing, and advertising expenses, expenses for unsuccessful bids and proposals, and research and development costs not associated with a specific contract may be deducted currently**. In general, **administrative overhead must be allocated to long-term contracts**. This is not required if taxpayers (other than homebuilders) are using the completed contract method. The use of the completed contract method is usually limited. **Interest must be capitalized if the property being produced is real property, long-lived property, or property that requires more than two years to produce (one year in the case of property costing more than $1 million)**. Interest costs directly attributable to a contract that can be avoided if contract costs had not been incurred must be allocated to long-term contracts.

Question 45

What are the two limited circumstances that the completed contract method may be used?

Answer 45

**Under the completed contract method of accounting, income from a contract is reported in the taxable year in which the contract is completed**. This is true regardless of whether the contract price is collected in advance, upon completion, or in installments. Costs associated with the contract are accumulated in a work-in-progress account and deducted upon completion. The use of the completed contract method may only be used in two limited circumstances. **First, the method can be used by smaller companies (those with average gross receipts for the three preceding tax years of $10 million or less) for construction contracts that are expected to take two years or less to complete**; and **second, for home construction contracts**. It **cannot be used by larger companies for manufacturing or for other long-term contracts other than home construction**, and it **cannot be used by any size company for construction contracts expected to last longer than two years**.

Question 46

What is the Percentage of Completion Method Formula?

Answer 46

**Current Year Cost ÷ Expected Total Cost = Percentage of Completion** Under the percentage of completion method of reporting income, the taxpayer reports a percentage of the gross income from a long-term contract based on the portion of work that has been completed. The portion of the total contract price reported in a given year is determined by multiplying the total contract price by the percentage of work completed in the year. The percentage is determined by dividing current year costs by the expected total costs.

Question 47

When is the modified percentage of completion method useful?

Answer 47

At the beginning of a contract, it is difficult to estimate total costs. For this reason,** taxpayers may elect to defer reporting any income from a contract until they have incurred at least 10% of the estimated total cost**. This is called the **modified percentage of completion method**. Under this method, if a contract has just been started at the end of the year, the taxpayer does not have to estimate the profit on the contract during that year. **The next year the taxpayer will report a profit on all work that has been completed, including work done during the first year.** This is assuming that at least 10% of the work has been completed as of the end of the taxable year. If more than 10% of the costs are incurred during the first year, the modified percentage of completion method is identical to the regular percentage of completion method.

Question 48

The look-back interest adjustment involves which of the following? * Calculation of gross profit on an installment sale collection. * Calculation of interest on an installment sale. * Calculation of interest on additional tax due if actual cost rather than estimated cost had been used on the percentage of completion method. * Calculation of additional tax due if actual cost rather than estimated cost has been used for the percentage of completion method.

Answer 48

Calculation of interest on additional tax due if actual cost rather than estimated cost had been used on the percentage of completion method. **When a contract is completed, a computation is made to determine whether the tax paid each year during the contract is more or less. The tax that would have been paid is also estimated, if the actual cost of the contract had been used instead of the estimated cost. Interest is paid on any additional tax that would have been paid**.

Question 49

Describe Lookback Interest

Answer 49

**Certain contracts (or portions of a contract) accounted for under either the regular or modified percentage of completion method are subject to a look-back interest adjustment**. **When a contract is completed, a computation is made to determine whether the tax paid each year during the contract is more or less**. The tax that would have been paid if the actual total cost of the contract had been used rather than the estimated cost, is also estimated.** Interest is paid on any additional tax that would have been paid. The taxpayer receives interest on any additional tax that was paid**.

Question 50

When is Look-back interest only applicable?

Answer 50

**Look-back interest is applicable only to contracts that have been completed more than two years after the commencement date**. Furthermore, **look-back interest is applicable only if the contract price equals or exceeds either 1% of the taxpayer's average gross receipts for the three taxable years preceding the taxable year the contract was entered into, or $1 million**. Taxpayers may elect a "de minimis" exception to the "look-back" interest computation. If elected, the exception is applicable to all contracts completed within a year, and the election to use the exception can be revoked only with IRS approval. Under the exception, if income reported each year on a contract is within 10% of the recomputed "look-back income," no interest computation is made for the contract. Whether reported income is within 10% of recomputed income is determined separately for each completed contract.

Question 51

When is an installment sale method applicable? When is an installment sale method not applicable?

Answer 51

An installment sale is any disposition of property where **at least one payment is received after the close of the taxable year in which the disposition occurs**. The installment method is not applicable to sales of: * Inventory, * Personal property by a dealer, or * Marketable securities.

Question 52

What are the key points to remember about installment sales?

Answer 52

* **Gains recaptured as ordinary income under IRC sections 1245 and 1250, must be recognized in the year of the sale** (regardless of when the first payment is to be received), and are not eligible for installment sale treatment. Only section 1231 gain is eligible for installment. * **If property is sold to a related party, and the related party sells property within 2 years from the date of the original sale, the deferred gain must be fully recognized at that time by the original seller**. * **The Gross Profit Percentage (GPP) is used to calculate the gain and is applied to the down payment as well as the principal portion of the loan payments**, which are comprised of principal and interest (P&I).

Question 53

What is the 5-step process to determine the amount and tax character of the income from an installment sale?

Answer 53

* Calculate the **gross profit percentage (GPP)** * Calculate the down payment * Calculate the loan payments, then using the amortization function, calculate the principal and interest (P&I) received the first year * **The interest (from P&I) is taxed as ordinary income** * **The sum of the down payment and the principal (from P&I) times the GPP is the reported capital gain**

Question 54

# Installment Sale Calculation Example: On May 1, 2023, John sold a rare art piece that he had bought several years ago at a cost of $22,000. The sale terms were $56,000, with a 20% down payment on May 1, with the balance to be paid monthly over the next 5 years. The annual interest rate is 8%, compounded monthly. The first payment will be received on May 31st. **What total amounts must John report in 2023 as (1) ordinary income and (2) capital gains?**

Answer 54

* Calculate the gross profit percentage (GPP): The gross profit is $56,000 - $22,000 = $34,000. The GPP is gross profit divided by the sale amount: $34,000 / $56,000 = 0.6071. By multiplying the GPP by the down payment + the principal received on the loan payments, the amount required to be reported as capital gain can be determined. * Calculate the down payment: The down payment is 20% of $56,000 or $11,200. * Calculate the loan payment based on the terms: HP 12C 60 n; 44,800, CHS, PV; 8 ÷ 12 g i; PMT = 908.38* (monthly PMT, end of period) 8, f, AMORT [first 8 months (May 31 - Dec. 31)] = 2,273.99 (interest received for 8 months) X>

Question 55

# Amortization using HP 12C A client would like to know what balance on their mortgage will be due to the bank at the end of 1, 5, and 10 years. They just borrowed $275,000 at a fixed rate of 3.00%, compounded monthly, for 30 years. Following are the keystroke input steps using an HP12C.

Answer 55

Step One – Calculate the monthly mortgage payment [f][CLX] 360 [n] 275,000 [PV] 0 [FV] 3 [g] [12÷] Solve [PMT] -1,159.41 Step Two – Calculate the mortgage loan balance after one year 12 [f] [AMORT] The display reads 8,171.48. This is the interest paid in the first year. Then, press the [x>

Question 56

# Section Two Summary The three main accounting methods are the cash receipts and disbursements method, the accrual method and the hybrid method. While taxpayers have the right to choose a method of accounting, it is important to remember that **the chosen method must reflect income as determined by the IRS**. The IRS has the power to change the accounting method used by a taxpayer if the method being used does not clearly reflect income. It must also be kept in mind that there are certain exceptions to these guidelines. In this lesson we have covered the following: * **Cash method** is used by most individual taxpayers and small businesses. Under this method, income is reported in the year the taxpayer constructively receives the income rather than in the year it is earned. * **Accrual method** is used for** sales and costs of goods sold if inventories are income-producing factors of a business**. Taxpayers report income in the year it is earned. * **Hybrid method** is a combination of the cash and accrual method. Some items of income or expense are reported under a cash basis and others are reported under the accrual method. This method is **often seen in small businesses that maintain inventories**.

Answer 56

* **Long-term contracts**: Contracts include building, installation, construction, or manufacturing contracts that are not completed in the same tax year in which they began. The accounting method selected by a taxpayer must be used for all long-term contracts in the same trade or business. * **Installment Sales**: **Using the gross profit percentage (GPP) determine the percentage of capital gain and return of basis for the down payment, as well as for the principal portion of the loan payments. The interest collected will be taxed as ordinary income**.

Question 57

A taxpayer must use the same accounting method on a personal tax return as the taxpayer's business. * False * True

Answer 57

False An overall accounting method used in one business does not have to be the same method used in another business or for non-business income and deductions.

Question 58

Which type of taxpayers must use the accrual method of accounting? * Taxpayers with inventories * Taxpayers using the completed contract method * Taxpayers who have met the all-events test * Taxpayers who do not use the hybrid method

Answer 58

Taxpayers with inventories The **accrual method must be used for sales and costs of goods sold if inventories are an income producing factor of the business**.

Question 59

When accounting for long-term contracts, all of the following accounting methods are acceptable EXCEPT? * The completed contract method * The percentage of completion method * The modified percentage of completion method * The cash method of accounting

Answer 59

The cash method of accounting Taxpayers must use accounting methods that clearly reflect income, which the cash method does not.

Question 60

# Section 3 - Inventories **Inventories may be valued at either cost, market value, or at the lower of the two**. Taxpayers may determine inventory costs by the following methods: * Specific identification method * First-in, First-out method (FIFO) * Last-in, First-out method (LIFO) * Lower of Cost or Market Method **The costs that must be included in inventory are referred to as the Uniform Capitalization Rules (UNICAP)**.

Answer 60

To ensure you have an understanding of inventories, the following topics will be covered in this lesson: * Determination of Inventory Cost * LIFO method * FIFO method * Lower of Cost or Market Method Upon completion of this lesson, you should be able to: * List the different methods by which inventories may be valued, * Explain the purpose of having different methods to value inventory, and * Explain why the LIFO method is more popular than the FIFO method.

Question 61

# Determination of Inventory Cost Inventories may be valued at cost, market value, or the lower of the two. **Taxpayers who use the last-in, first-out (LIFO) inventory valuation method may not use the lower of cost or market method.** For merchandise purchased, **the cost is the invoice price less trade discounts, plus freight and other handling charges.** **Unlike financial accounting, purchasing costs (e.g., salaries of purchasing agents), warehousing costs, packaging, and administrative costs related to these functions must be allocated between cost of goods sold and inventory**. **The costs that must be included in inventory are referred to as the Uniform Capitalization Rules (UNICAP). This requirement is applicable only to taxpayers whose average gross receipts for the three preceding years exceed $29 million (2023)**. **In the case of goods manufactured by the taxpayer, direct labor and materials along with manufacturing overhead must be included in inventory under UNICAP rules**. Non-manufacturing costs (e.g., advertising, selling, and research, and experimental costs) are not required to be included in inventory. **Interest must be inventoried if the property is real property, long-lived property, or property requiring more than two years to produce (one year in the case of property costing more than $1 million)**.

Answer 61

**The main difference** between the **full absorption cost method** traditionally used for financial accounting purposes and the **UNICAP cost method required for tax purposes** is that **UNICAP expands the list of overhead costs to include certain indirect costs that have not always been included in overhead for financial accounting purposes**. For example, for financial accounting purposes, the costs of operating payroll and personnel departments have sometimes been considered sufficiently indirect or remote to justify omitting them from manufacturing overhead. This is true even though much of the effort of the payroll and personnel departments were directed toward manufacturing operations. For simplicity and other reasons, overhead costs included in inventory for financial purposes are often limited to those incurred in the factory. **UNICAP requires that costs associated with these departments be allocated between manufacturing and non-manufacturing functions (i.e., sales, advertising, research, and experimentation)**.

Question 62

# LIFO Method This method assumes a last-in, first-out (LIFO) flow of costs. **The most recent cost of the inventory (usually the highest costs for inventory) is used to determine the cost of the goods sold (i.e., COGS)**. This method **results in the lowest taxable income during periods of inflation** because it shows the highest cost of goods sold **and, therefore, the lowest profits**. The LIFO method usually **results in the lowest value for the inventory remaining at the end of the tax year** since it is valued at earlier, usually lower purchase costs. **Many taxpayers use the LIFO cost flow assumption because, during inflationary periods, LIFO normally results in the lowest taxable income**. Once LIFO has been elected for tax purposes, the taxpayer's financial reports must also be prepared using LIFO. This requirement to conform to financial reporting often **discourages companies from electing LIFO because lower earnings must be reported to shareholders**. **Also, LIFO cannot be used with the lower of cost or market method**. T**he main deterrent regarding LIFO is that it is more complex, and small businesses prefer to simplify their accounting**.

Answer 62

Record keeping under LIFO can be cumbersome. For this reason, **taxpayers are permitted to determine inventories using “dollar-value” pools and government price indexes rather than by maintaining a record of actual costs**. **Retailers use appropriate categories in the Consumer Price Index; other taxpayers use categories in the Producer Price Index**. Taxpayers using the index method must divide their inventories into one or more pools (groups of similar items). Thus, a department store might create separate pools for automobile parts, appliances, clothing, furniture, and other products. Dividing inventory into pools can be critical because of the different inflation rates associated with various goods and because, if a particular pool is depleted, the taxpayer loses the right to use the lower prices associated with past layers. **An important exception permits taxpayers with average annual gross receipts of $5 million or less for the current and two preceding tax years to use the simplified LIFO method. The simplified LIFO method uses a single LIFO pool, thereby avoiding problems with multiple pools**.

Question 63

What is the method for calculating inventory valuation, where the flow of cost method assumes that the first goods purchased will be the first goods sold?

Answer 63

**The First-in First-Out (FIFO) method** is another method of inventory valuation. This flow of cost method assumes that the first goods purchased will be the first goods sold. **Thus, the ending inventory consists of the last goods purchased**. **In some industries, such as electronics, FIFO may actually provide lower inventory values**.

Question 64

Among the inventory accounting methods, FIFO normally results in the lowest taxable income. * False * True

Answer 64

False. The LIFO method results in the lowest taxable income during periods of inflation because it shows the highest cost of goods sold and, therefore, the lowest profits.

Question 65

# Section Three Summary Inventories may be valued at either cost, at market value, or at the lower of the two. Taxpayers may determine inventory costs by the following methods: * Specific identification method * First-in, First-out method (FIFO) * Last-in, First-out method (LIFO) * Lower of Cost or Market Method In this lesson we have covered the following: * **Determination of Inventory Cost**: **The overhead items included in inventory under UNICAP include factory repairs and maintenance, including the excess of tax depreciation over accounting depreciation, factory administration and officers' salaries related to production, taxes (other than the income tax), quality control, rework, service costs of pension and profit-sharing plans, service support such as purchasing, payroll and warehousing costs**.

Answer 65

* **LIFO method** assumes a last-in, first-out flow of costs. It r**esults in the lowest taxable income during periods of inflation** because it **shows the lowest inventory value**. * **FIFO method** is another method of inventory valuation. This flow of cost method assumes that the first goods purchased will be the first goods sold. * **Lower of Cost or Market Method** is **available to all taxpayers other than those who determine cost using the LIFO method**. The term **"market" refers to replacement cost**. **On the date an inventory is valued, the replacement cost of each item in the inventory is compared with its cost. The lower figure is used as the inventory value**.

Question 66

# Section 4 - Changes in Accounting Methods A change in accounting methods usually results in duplications or omissions of items of income or expense. When this happens the net amount of the change must be taken into account. There are alternative methods that may be used to report the amount of change. But, in general, once an accounting method is chosen, it cannot be changed without IRS approval. There are, however, a few exceptions to the rule. For example, **taxpayers may adopt the LIFO inventory method without prior IRS approval**. Once such methods are adopted, they cannot be changed again without IRS approval. An accounting method helps determine the taxable year in which income and expenses are reported for tax purposes. The term **"accounting method" indicates not only the overall accounting method used by the taxpayer but also the treatment of any item of income or deduction**. A change of accounting methods should not be confused with the correction of an error. Errors include mathematical mistakes, posting errors, deductions of the wrong amount for an expense, omission of an item of taxable income, or incorrect computation of credits.

Answer 66

To ensure that you have an understanding of changes in accounting methods, the following topics will be covered in this lesson: * Amount of Change * Tax Planning Considerations Upon completion of this lesson, you should be able to: * Examine the circumstances under which accounting methods may be changed, * List the IRS stipulations on restrictions in changes in accounting methods, and * List the accounting periods and methods to compute taxable income and tax considerations before choosing or changing to a different accounting method.

Question 67

What must be taken into account when there is a change in accounting methods?

Answer 67

A change in accounting methods usually results in duplications or omissions of items of income or expense. **The net amount of the change must be taken into account**. **A positive adjustment is added to income, whereas a negative adjustment is subtracted from income**. This adjustment can, of course, be made in the year of the change. If the amount is small, recognizing the full amount of the net adjustment in the year of the change is both simple and equitable. Reporting a large positive adjustment in one year could push the taxpayer into a higher marginal tax bracket and result in a significant tax increase. As the extra income is due to changing accounting methods, not increasing cash flows, the taxpayer may not have the ability to pay the additional tax.

Question 68

# Change in Accounting Method Example: Bonnie, a practicing CPA, has been reporting income using the cash method. In the current year, Bonnie obtains permission to change to the accrual method. At the beginning of the current year, Bonnie has $80,000 of receivables that have not been reported earlier because they were not collected. Although the receivables are collected in the current year, they are not taxable because, under the accrual method, Bonnie now reports income as it is earned and the income is not earned in the current year. In this case, the income was earned in prior years.

Answer 68

Consequences of Change in Accounting Method Example: Assume Bonnie has accounts payable of $15,000 at the beginning of the current year. The accounts payable were not deducted in prior years because the expenses had not been paid. Furthermore, the accounts payable are not deductible in the current year even if they are paid. This is because the expenses were incurred in prior years. Obviously, the IRS expects to collect the tax on the $80,000 of receivables, and Bonnie is entitled to deduct the $15,000 of payables. In the absence of any special provision, both amounts would be omitted from the computation of taxable income. If the change is from the accrual method to the cash method, both amounts would be reported twice (in the year prior to the change because they had accrued and in the year of the change because they are collected or paid). Thus, a special provision is also needed for duplications.

Question 69

A positive adjustment is subtracted from income and a negative adjustment is added to income. * False * True

Answer 69

False. A positive adjustment is added to income and a negative adjustment is subtracted from income.

Question 70

# Reporting the Amount of Change Example: Diana obtains permission to change from the accrual to the cash method of reporting income. The change results in a $30,000 negative adjustment to income. The IRS requires Diana to spread the adjustment over four years. As a result, she may deduct $7,500 per year for four years. Note that because the amount of the adjustment is spread over the current and future years, the tax savings associated with the deduction are deferred.

Answer 70

There are alternative methods that may be used to report the amount of change. T**he methods that are available depend on whether the change is voluntary (a change that is initiated by the taxpayer) or involuntary (a change from an unacceptable to an acceptable method that is required by the IRS)**. In the case of an **involuntary change, several alternative methods are available to the IRS**. In the case of **voluntary changes, taxpayers must agree to report the adjustment over a period not to exceed four years. When the amount of the adjustment is $25,000 or less, taxpayers may elect to include the full amount in the current year**. In the case of a change spread out over four years, equal portions of the change are reported in each of the four years beginning with the year of the change. In general, the amount of the adjustment cannot be spread over a period longer than the method being changed has been used. A taxpayer who amends the original income tax return within six months of its due date may request a change of accounting methods with the amended return. In general, taxpayers initiating a change in accounting methods from an incorrect to correct method are exempt from penalty and from retroactive application of the new reporting method.

Question 71

When is Obtaining IRS Consent important?

Answer 71

**Most changes in accounting methods require the approval of the IRS, which states that a taxpayer changing the method of accounting "on the basis of which he regularly computes his income in keeping his books" must obtain consent before computing taxable income under the new method**. This **implies that a taxpayer who has been computing taxable income, on a method other than that used in computing book income, does not need approval to conform the computation of taxable income to the method regularly used on the taxpayer's books**. This conclusion is supported by **IRC Section 441(a), which requires that the same method of accounting used in keeping the books be used in computing taxable income**. The alternative might be to require the taxpayer to align his or her book accounting method to the tax accounting method. The IRS has ruled that a reconciliation of taxable income with accounting income was a part of the taxpayer's auxiliary records. Hence, the taxpayer was using the same accounting method for book and tax reporting. As a result, a taxpayer who changes the method of accounting used for financial reporting may not be required to change the method of accounting used for tax reporting as long as financial income and book income are reconciled.

Question 72

New businesses should consider the tax implications of electing an accounting method. * True * False

Answer 72

New businesses should consider the tax implications of electing an accounting method. **Choosing an accounting method requires an understanding not only of the available accounting methods but also of the nature of the taxpayer's business**. **Will a specific election be to the advantage of the taxpayer?** As a financial planner, you will need to be able to understand the issues in determining the election that best meets your client's needs.

Question 73

What else should new corporations consider?

Answer 73

New corporations often routinely adopt a calendar year. **Consideration should be given, however, to adopting a tax year for the initial reporting period that ends before the amount of taxable income exceeds the amount that is taxed at the lowest tax rates (i.e., if the state in which the corporation is based has taxable income thresholds). This is less critical for a corporation suffering losses because the NOLs may be carried forward for an indefinite amount of time**. In the past, taxpayers were able to defer income by selecting different tax years for partners and partnerships or S corporations and shareholders. Current law limits this opportunity. **Nevertheless, partnerships and S corporations may adopt a tax year that differs from that of their owners if that year qualifies as a natural business year (e.g., at least 25% of revenues occur during the last two months of the year)**. Furthermore, **deferral is possible in the case of estates, because they are not subject to similar restrictions on the choice of tax years**.

Question 74

How do taxpayers may benefit from the LIFO inventory method? Which method do service companies usually choose?

Answer 74

New businesses should consider the tax implications of electing an accounting method. **For example, taxpayers may benefit from the LIFO inventory method because LIFO typically reduces gross profit and defers the payment of taxes during inflationary periods**. Similarly, **service companies usually choose the cash method of reporting income because it permits receivables to be reported when collected** rather than when the income is earned. **LIFO inventory is often recommended because, during inflationary periods, it tends to reduce inventory values and increase the cost of goods sold**. **In certain industries, such as the computer industry, however, costs are declining, and LIFO actually may result in a higher inventory value**.

Question 75

In other industries, **inventories may fluctuate widely from one year to the next because of changing demand, shortages of materials, strikes, or other causes**. LIFO layers may have to be depleted to continue business operations. Because of this, what two things can happen?

Answer 75

This can cause one of two things to happen: * Incurring extra record-keeping costs of LIFO for little or no benefit because the inventories are depleted before they produce significant tax deferrals, or * Depleting low-cost layers from years past, resulting in a substantial increase in taxable income in the year of occurrence.

Question 76

# Comparison of Accounting Methods in Different Environments: Rising Prices FIFO LIFO Profit Higher Lower Tax Liability Higher Lower Inventory Value Realistic Understated

Answer 76

Falling Prices FIFO LIFO Profit Lower Higher Tax Liability Lower Higher Inventory Value Realistic Overstated

Question 77

What are the procedures for changing to LIFO?

Answer 77

The LIFO method may be adopted in the initial year that inventories are maintained by merely using the method in that year. In addition, advance approval (e.g., within 180 days following the start of the year) from the IRS is not required for adoption of the LIFO method in the initial year that inventories are maintained on the LIFO method. However, Form 970 (Application to Use LIFO Inventory Method) should be filed along with the taxpayer's tax return for the year of the change. The application must include an analysis of the beginning and ending inventories. Further, if a taxpayer is changing to the LIFO method from another method, advance approval from the IRS is also not required. Form 970 must be filed with the return and the beginning inventory for LIFO purposes is the same as under the former inventory method. If the former inventory is valued based on the lower of cost or market (LCM) method, an adjustment is required to restate the beginning inventory to cost because the LCM method cannot be used under LIFO. Generally, the beginning LIFO inventory is the same as the closing inventory for the prior year, except for the required restatement of previous writedowns to market. This adjustment to the beginning inventory can be spread ratably over the year of the change and the next two years.

Question 78

# Change to LIFO Method Example: Delaware Corporation elects to change to the LIFO inventory method for 2023. In 2022 Delaware's inventories are valued using the LCM method based on the FIFO cost-flow assumption. **The FIFO cost for the ending inventory in 2022 is $50,000, and its LCM amount is $35,000**.

Answer 78

**The initial inventory for 2023 under LIFO must be restated to its cost, or $50,000**. **The $15,000 ($50,000 cost - $35,000 LCM value) difference can be included in taxable income over the current year and next two years**. $5,000 is added to taxable income in 2023, 2024, and 2025.

Question 79

# Section Four Summary **The accounting method for any organization is the deciding factor in determining the taxable year in which income and expenses are reported.** A change in accounting methods usually results in duplications or omissions of items of income or expense. A change can be either voluntary or involuntary. **When a change happens, the net amount of the change must be taken into account**. There are alternative methods that may be used to report the amount of change. But in general, once an accounting method is chosen, it cannot be changed without IRS approval. There are, however, a few exceptions to the rule. For example, **taxpayers may adopt the LIFO inventory method without prior IRS approval.** But once such methods are adopted, they cannot be changed for the second time without IRS approval.

Answer 79

In this lesson, we have covered the following: * **Amount of Change** may result in duplications or omissions of items of income or expense. **A positive adjustment is added to income, whereas a negative adjustment is subtracted from income**. * **Tax Planning Considerations:** New businesses should consider the tax implications before opting for an accounting method. * **Procedures for Changing LIFO**: The LIFO method **can be adopted in the initial year when inventories are maintained by simply using that method in that year**. **Form 970** must be complete and sent with the return.

Question 80

How is the LIFO method adopted in the initial year that inventories are maintained? * With IRS approval * By using the LIFO method * By filing Form 970 * By filing Form 3115

Answer 80

By using the LIFO method The LIFO method may be adopted in the initial year that inventories are maintained by merely using the method in that year.

Question 81

Why is LIFO inventory recommended during inflationary periods? * It tends to reduce inventory values and increase the cost of goods sold * It tends to reduce inventory values and decrease the cost of goods sold * It tends to increase inventory values and decrease the cost of goods sold * It tends to increase inventory values and increase the cost of goods sold

Answer 81

It tends to reduce inventory values and increase the cost of goods sold **LIFO inventory is often recommended because, during inflationary periods, it tends to reduce inventory values and increase the cost of goods sold. This will reduce taxable income**. **In certain industries, such as the computer industry, however, costs are declining, and LIFO actually may result in a higher inventory value**.

Question 82

# Module Summary There are different types of accounting periods for different situations. All of them are subject to specific IRS guidelines. There are **three main kinds of accounting methods, namely, the cash receipts and disbursements method, the accrual method and the hybrid method**. There are **different methods to determine inventory costs**. The **basic ones are LIFO and FIFO**. There are certain circumstances under which accounting methods can be changed. But a taxpayer must keep in mind the tax considerations before choosing or changing to a different accounting method. As a financial planner you will need to be aware of the tax implications of all theses accounting methods, so you will be able to direct your client to the most advantageous method for their individual situation.

Answer 82

The key concepts to remember are: * **Accounting Periods**: **Taxable income is computed on the basis of the taxpayer's annual accounting period**. A taxpayer's annual accounting period will be the 12 months ending on December 31st. **If a taxpayer is using a fiscal year, the annual accounting period will be a 12-month period that ends on the last day of any month other than December**. * **Accounting Methods**: There are three main kinds of accounting methods: The cash receipts and disbursements method, the accrual method, and the hybrid method. * **Inventories**: The two most common methods to determine inventory costs are LIFO and FIFO. The LIFO method assumes a last-in, first-out flow of costs. It results in the lowest taxable income during periods of inflation because it shows the lowest inventory value. FIFO assumes that the first goods purchased will be the first goods sold. * **Changes in Accounting Methods**: In general, once an accounting method has been selected, it cannot be changed without IRS approval. There are a few exceptions. For example, **taxpayers may adopt the LIFO inventory method without prior IRS approval**. Once such methods are adopted, however, they cannot be changed without IRS approval.

Question 83

Match the installment sale income with the correct tax treatment. Gross profit Original basis Interest * Tax-free * Ordinary income * Capital Gains

Answer 83

* Tax-free - Original basis * Ordinary income - Interest * Capital Gains - Gross profit

Question 84

On August 1st of the current year, Carmen sold a piece of historical memorabilia that she had bought several years ago at a cost of $70,000. The terms of the sale were a price of $125,000, with a 25% down payment on August 1, with the balance to be paid monthly over the next 8 years. The annual interest rate is 7.5%, compounded monthly. The first payment will be received on August 31st. Calculate the total amount that Carmen must report in the current year as ordinary income (rounded). * $3,623 * $9,529 * $6,508 * $2,885

Answer 84

$2,885 1. Calculate the gross profit percentage (GPP) = $55,000 ÷ $125,000 = 0.44 2. Calculate the down payment = 0.25 x $125,000 = $31,250 3. Calculate the loan payments, then using the amortization function, calculate the principal and interest (P&I) received the first year HP 12C 96 n; 93,750, CHS, PV; 7.5 ÷ 12 g i; PMT = 1,301.61 (monthly PMT, end of period) 5, f, AMORT [first 5 months (Aug 31 - Dec. 31)] = 2,884.68 (interest received for 5 months) X>

Question 85

Identify items that would NOT be considered constructively received. (Select all that apply) * Salary available to an employee who does not accept payment * It is subject to substantial limitations or restrictions. * Interest credited to a bank savings account. * The amount is unavailable to the taxpayer. * The payer does not have the funds necessary to make payment.

Answer 85

It is subject to substantial limitations or restrictions. The amount is unavailable to the taxpayer. The payer does not have the funds necessary to make payment. An amount is not constructively received if: * It is subject to substantial limitations or restrictions. * The payer does not have the funds necessary to make payment. * The amount is unavailable to the taxpayer.

Question 86

Taxpayers using the ____________ generally report income in the year it is earned. * cash method * hybrid method * constructive receipt method * accrual method

Answer 86

accrual method Taxpayers using the accrual method of accounting generally report income in the year it is earned.

Question 87

On March 1, Johanna sold mint condition comic books that she had bought several years ago at a cost of $200. The terms of the sale were a price of $5,000, with a 15% down payment on March 1, with the balance to be paid monthly over the next 10 years. The annual interest rate is 4%, compounded monthly. The first payment will be received on March 31st. Calculate the gross profit percentage associated with Johanna’s installment sale arrangements. * 0.75 * 0.15 * 0.40 * 0.96

Answer 87

0.96 The gross profit is $5,000 - $200 = $4,800. The GPP is gross profit divided by the sale amount: $4,800 ÷ $5,000 = 0.96. By multiplying the GPP by the down payment + the principal received on the loan payments, the amount required to be reported as capital gain can be determined.

Question 88

During inflationary periods, LIFO normally results in __ ____??____ __ taxable income. * prorated * the lowest * deferred * the highest

Answer 88

the lowest During inflationary periods, LIFO normally results in the lowest taxable income.

Question 89

The installment method is NOT applicable to sales of: (Select all that apply) * Marketable securities * Personal property by a dealer * Section 1231 property * Inventory

Answer 89

The installment method is not applicable to sales of: * Inventory, * Personal property by a dealer, or * Marketable securities.

Question 90

Application for permission to change accounting periods is made on __ ____??____ __. * Form 3115 * Form 1128 * Form 2553 * Form 8716

Answer 90

Form 1128 Application for permission to change accounting periods is made on Form 1128. The application must be sent to the Commissioner of the IRS, Washington, D.C.

Question 91

DEF Partnership begins operations on May 1, 2023, and elects a September 30 year-end under Section 444. The partnership's net income for the fiscal year ended September 30, 2023, is $250,000. Calculate DEF Partnership’s required payment. * $95,000 * $19,000 * $104,167 * $39,583

Answer 91

$39,583 DEF must make a required payment of $39,583 ($250,000 x 38% x 5/12) on or before April 15, 2024.

Question 92

Generally, S corporations and personal service corporations are required to adopt a __ ____??____ __ for tax purposes. * calendar year * modified tax year * fiscal year * short tax year

Answer 92

calendar year Generally, S corporations and personal service corporations are required to adopt a calendar year.

Angel’s CFP Brain 😇🧠💵🗓️ (87 decks)

• Bryant - Course 1. Introduction to Financial Planning - Module 14. Monetary Settlements and Special Circumstances
• Bryant - Course 1. Introduction to Financial Planning - Module 12. Life Cycle Planning
• Bryant - Course 1. Introduction to Financial Planning - Module 11. Credit and Debt Management
• Bryant - Course 1. Introduction to Financial Planning - Module 8. CFP Board's Procedural Rules
• Bryant - Course 4. Tax Planning. Module 1. Income Tax Law Fundamentals
• Bryant - Course 4. Tax Planning. Module 2. Gross Income
• Bryant - Course 4. Tax Planning. 3. Income Tax Calculations
• Bryant - Course 4. Tax Planning. 4. Tax Characteristics of Entities
• Bryant - Course 4. Tax Planning. 5. Basis
• Bryant - Course 4. Tax Planning. 6. Cost Recovery Concepts
• Bryant - Course 4. Tax Planning. 7. Tax Consequences on Sale of Assets
• Bryant - Course 4. Tax Planning. 8. Like-Kind Exchanges and Involuntary Conversions
• Bryant - Course 4. Tax Planning. 9. Income Taxation of Trusts and Estates
• Bryant - Course 4. Tax Planning. 10. Passive Activity
• Bryant - Course 4. Tax Planning. 11. Charitable Contributions and Deductions
• Bryant - Course 4. Tax Planning. 12. Tax Implications of Changing Circumstances
• Bryant - Course 4. Tax Planning. 13. Tax Accounting Methods
• Bryant - Course 4. Tax Planning. 14. Tax Compliance
• Bryant - Course 4. Tax Planning. 15. Alternative Minimum Tax
• Bryant - Course 4. Tax Planning. 16. Tax Management Techniques
• Bryant - Course 4. Tax Planning. Comprehensive Course Exam for Tax Planning
• Bryant - Course 6. Estate Planning. 1. Overview of Estate Planning
• Bryant - Course 6. Estate Planning. 2. Forms of Property Ownership
• Bryant - Course 6. Estate Planning. 3. Gifting
• Bryant - Course 6. Estate Planning. 4. Gross Estate
• Bryant - Course 6. Estate Planning. 5. Estate Tax Calculations
• Bryant - Course 6. Estate Planning. 6. Generation-Skipping Transfer Tax
• Bryant - Course 6. Estate Planning. 7. Estate Planning Documents
• Bryant - Course 6. Estate Planning. 8. Probate Process
• Bryant - Course 6. Estate Planning. 9. Trusts
• Bryant - Course 6. Estate Planning. 10. Charitable Gifting
• Bryant - Course 6. Estate Planning. 11. Business Planning
• Bryant - Course 6. Estate Planning. 12. Miscellaneous Planning
• Bryant - Course 6. Estate Planning. 13. Estate Planning Process
• Bryant - Course 6. Estate Planning. Comprehensive Course Exam for Estate Planning
• Bryant - Course 5. Retirement Planning & Employee Benefits. 1. Retirement Needs Analysis
• Bryant - Course 5. Retirement Planning & Employee Benefits. 2. Qualified Retirement Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 3. Non-Qualified Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 4. Government 457 Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 5. Other Tax-Advantaged Retirement Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 6. Investment Considerations for Retirement Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 7. Lesson 7. Distribution Rules, Alternatives and Taxation
• Bryant - Course 5. Retirement Planning & Employee Benefits. 8. Plan Selection for Businesses
• Bryant - Course 5. Retirement Planning & Employee Benefits. 9. Employee Benefit Plans
• Bryant - Course 5. Retirement Planning & Employee Benefits. 10. Employer/Employee Insurance Arrangements
• Bryant - Course 5. Retirement Planning & Employee Benefits. 11. Social Security, Medicare and Medicaid
• Bryant - Course 5. Retirement Planning & Employee Benefits. 12. Regulatory Considerations
• 5. Retirement Planning & Employee Benefits. All questions and Comprehensive Course Exam for Retirement Planning and Employee Benefits
• 5. Retirement Planning - All Exam Tips and Practitioner's Advice
• 3. Investment Planning - All Questions and Comprehensive Course Exam
• 3. Investment Planning - All Exam Tips and Practitioner's Advice
• 3. Investment Planning. 1. Fixed Income Securities
• 3. Investment Planning. 2. Equities
• 3. Investment Planning. 3. Pooled Investments
• 3. Investment Planning. 4. Derivatives, Insurance Securities, and Other Investments
• 3. Investment Planning. 5. Investment Risks
• 3. Investment Planning. 6. Measures of Investment Returns
• 3. Investment Planning. 7. Time Influence on Valuation
• 3. Investment Planning. 8. Valuation of Bonds and Stocks
• 3. Investment Planning. 9. Portfolio Management and Measurements
• 3. Investment Planning. 10. Formula Investing & Invest. Strategies
• 3. Investment Planning. 11. Asset Allocation & Portf. Diversification
• 3. Investment Planning. 12. Efficient Market Theory
• 3. Investment Planning. 13. Asset Pricing Models
• 3. Investment Planning. 14. Buying and Selling Securities
• 3. Investment Planning. 15. Hedging and Option Strategies
• 3. Investment Planning. 16. Tax Efficient Investing
• 3. Investment Planning. 17. Taxation of Investment Vehicles
• BIF Review Practice Quiz - All Questions
• 2. Insurance Planning. 1. Principles of Insurance
• 2. Insurance Planning. 2. Evaluation and Analysis of Risk Expos.
• 2. Insurance Planning. 3. Legal Aspects of Insurance
• 2. Insurance Planning. 4. Property and Casualty Insurance
• 2. Insurance Planning. 5. General Business Liability
• 2. Insurance Planning. 6. Health Insurance
• 2. Insurance Planning. 7. Disability Income Insurance
• 2. Insurance Planning. 8. Long-Term Care Insurance
• 2. Insurance Planning. 9. Life Insurance
• 2. Insurance Planning. 10. Viatical Settlements
• 2. Insurance Planning. 11. Insurance Needs
• 2. Insurance Planning. 12. Taxation of Insurance
• 2. Insurance Planning. 13. Insurance Policy Selection
• 2. Insurance Planning. 14. Insurance Company Selection
• 2. Insurance Planning. - All Questions and Comprehensive Course Exam
• 2. Insurance Planning. - All Exam Tips and Practitioner's Advice
• BIF Bites
• CFP Exam