Page 65 - DCOM301_INCOME_TAX_LAWS_I

Income Tax Laws – I

Notes The amount of income a taxpayer is to receive can be reasonably ascertained.
An expense is incurred when the following conditions are met:
All the events that establish a taxpayer’s obligation to pay it have occurred;
and
The amount of the expense to be paid can be reasonably ascertained.
The cash method of accounting lends itself to more planning opportunities because the
taxpayer himself has control over when he pays his expenses and how fast he gets paid for
his work.
Planning is more difficult under the accrual method because it’s more difficult to change
the objective fact of when a transaction is or is not complete. Regardless of whether you
use the accrual or cash method of accounting, in November or December of every year
you should consult with your tax planner to discuss options for deferring taxable income
to a subsequent tax year and accelerating deductions to the current year.

Example: If you use the cash basis method of accounting your tax planner might suggest
that you prepay certain expenses that you anticipate will come due early in the following tax
year. Likewise, your tax advisor might suggest that you delay the issuance of invoices in order
to defer income to the following tax year.
Since the recognition of revenues and expenses under the cash method depends upon the timing
of various cash receipts and disbursements, however, it can sometimes provide a misleading
picture of a company’s financial situation. In contrast, the accrual basis makes a greater effort to
recognize income and expenses in the period to which they apply, regardless of whether or not
money has changed hands. Under this system, revenue is recorded when it is earned, rather than
when payment is received, and expenses recorded when they are incurred, rather than when
payment is made.

Example: Say that a contractor performs all of the work required by a contract during the
month of May, and presents his client with an invoice on June 1. The contractor would still
recognize the income from the contract in May, because that is when it was earned, even though
the payment will not be received for some time.

The main advantage of the accrual method is that it provides a more accurate picture of
how a business is performing over the long-term than the cash method. The main
disadvantages are that it is more complex than the cash basis, and that income taxes may
be owed on revenue before payment is actually received.

Notes Under generally accepted accounting principles (GAAP), the accrual basis of
accounting is required for all businesses that handle inventory, from small retailers to
large manufacturers. It is also required for corporations and partnerships that have gross
sales over $5 million per year, though there are exceptions for farming businesses and
qualified personal service corporations-such as doctors, lawyers, accountants, and
consultants. A business that chooses to use the accrual basis must use it consistently for all
financial reporting and for credit purposes. For anyone who runs two or more businesses,
however, it is permissible to use different accounting methods for each.

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