Question

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You are currently working at a mid-sized certified public accounting firm. Your client is Bob Jones. Bob, age 60 and single, has recently retired from IBM. He has $690,000 available in his 401(k) fund and he is thinking of using that money to open a used car business that will be located at 210 Ocean View Drive in Pensacola, Florida. Bob has estimated that the business might make $300,000 in taxable income. Bob’s personal wealth including investments in land, stocks, and bonds is about $14,000,000. He reported an interest income of $20,000 and dividend income of $6,000 last year. The $14,000,000 includes land worth $9,000,000 that Bob bought in 1966 for $450,000. Bob has hired your firm for professional advice regarding whether he should operate as a sole proprietor, a partnership, an S corporation, or a C corporation. He is also considering transferring a possible 40% interest in his new business to his daughter Mandy, age 23 and single.

Required:

A. Differentiate between accrual accounting and cash basis. Based on the type of business and the client’s accounting system, what is the impact when revenue is recognized?

B. Based on the decision of accrual vs. cash basis, describe when revenue would be recognized on the sale of inventory, and how the accrual reporting differs from cash basis.

C. Determine the economic impact on the client’s financial situation. Based on your decision, determine the potential tax liability, keeping in mind

D. Summarize, using moral reasoning, cash or accrual basis accounting systems in relation to the selected business entity. Consider how the accounting system impacts revenue recognition, consistent with Internal Revenue Code and Treasury regulations.

Answer 1

A.) Differentiate between accrual accounting and cash basis. Based on the type of business and the client’s accounting system, what is the impact when revenue is recognized?

Comparison Chart

BASIS FOR COMPARISON	CASH ACCOUNTING	ACCRUAL ACCOUNTING
Meaning	The accounting method in which the income or expense is recognized only when there is actual inflow or outflow of cash.	The accounting method in which the income or expense is recognized on mercantile basis.
Nature	Simple	Complex
Method	Not recognized method as per companies act.	Recognized method as per companies act.
Income statement	Income statement shows lower income.	Income statement will show a comparatively higher income.
Applicability of matching concept	No	Yes
Recognition of revenue	Cash is received	Revenue is earned
Recognition of expense	Cash is paid	Expense is incurred
Degree of Accuracy	Low	Comparatively high

Conclusion

Cash Basis And Accrual Basis Of Accounting

Cash basis and accrual basis are accounting methods that differ based on the timing of when revenues and expenses are recognized. When a company uses cash basis accounting, it recognizes revenues when cash is actually received and expenses at the time they are actually paid. With accrual accounting, income is recognized at the time revenue is earned (which may not be when it is received) and expenses are recorded when liabilities are incurred (which may not be when they are paid). The benefit of accrual accounting is a more accurate measure of a company's profitability. To comply with GAAP, businesses are required to use the accrual basis. The cash basis is often used by small companies and individuals because it is simpler and less costly.

B.) Based on the decision of accrual vs. cash basis, describe when revenue would be recognized on the sale of inventory, and how the accrual reporting differs from cash basis.

Recognition of Sales of inventory

It may be confusing to identify the point when a sale occurs. Do we recognize sale when the goods are dispatched to customers, when the customer receives those goods, or when we receive the payment in respect of those goods? In case of sale of goods, sale is generally said to occur when the seller transfers the risks and rewards pertaining to the asset sold to the buyer. This generally happens when buyer has received the asset. The receipt of payment from the customer is not relevant to the recognition of sale since income is recorded under the accruals basis.

Difference

The difference between the cash and accrual methods is essentially a matter of timing. Companies that use the cash-basis method recognize revenue as customers pay invoices and expenses as they pay bills.

Conversely, the more complex accrual-basis method conforms to the matching principle under GAAP. That is, revenue (and expenses) are ‘matched’ to the periods in which they are earned (or incurred).

C. ) Determine the economic impact on the client’s financial situation. Based on your decision, determine the potential tax liability, keeping in mind

Depending upon the structure of of Bob's used car business the economic impact on financial situation could vary greatly .For example if Bob's chooses his business as a C corporation rather than S corporation or partnership or sole proprietorship the business will be considered a separate entity from Bob .But if the business was choosen as a partnership or s corporation or sole proprietorship the financial situation would flow along with the business since he would be able to claim all income as well as loss on his as personal income tax return as defined in IRC Section 1366

D.) Summarize, using moral reasoning, cash or accrual basis accounting systems in relation to the selected business entity. Consider how the accounting system impacts revenue recognition, consistent with Internal Revenue Code and Treasury regulations.

For Bob forming s corporation is recommendable . S corporation provides benefits of tax & it protects the liability of corporation .It avoids double taxation .The IRS code permits S corporation to file the tax return on accrual as well as cash basis but Bob has to choose accrual method since inventory is the main income for Bob & it is beneficial for tax purposes also as double taxation is avoided under S corporation .The main purpose of accrual accounting is to match income & expenses( IRS pub 538)

Hence it is advisable to Bob to choose s corporation & accrual method of accounting as inventories is his main income