Free «Taxation» Essay
The governments of every sovereign nation or country raise revenues to gear their operation and expenditures through either taxation or public borrowing. These are accounted for through fund accounting, cash basis accounting and or accrual/matching basis. These methods determine the amount of tax that a resident in the particular country is supposed to pay.
Most businesses use either cash based accounting method or accrual basis to keep following their business transactions. These accounting techniques are composed of rules used to find out the timing and the way revenues and expenses are reported. This paper seeks to explain the differences between the two methods, narrate the circumstances when the cash basis is used, recommend on its use, give the highlight of pros and cons of using cash basis and prepare the taxable income report on the business of Andrew Moore basing on the information extracted by him using the two approaches later recommend whether he should use the cash based accounting system or adopt the accrual basis.
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The accrual and cash techniques of business accounting are the two major known methods of running business income and expenses. These accounting methods give businesses diverse merits depending on the nature and size of the business and the quantity of wealth it brings in (Van 2009). The cash method is the easier accounting approach and paves way for use in small scale businesses. Contrary, the accrual method is more flexible in expense and income reporting for common tax purposes (Ruiz del Portal 2009).
By means of the accrual basis approaches as used commonly by all freely traded companies and in most large firms, revenues are recorded when they are earned and expenses recorded when incurred. Amid of the cash basis, as majorly used by small scale businesses, revenues are recorded when they are received and expenses recorded when paid. Individuals usually use the cash based method when to meet their returns on income tax (Rumpf 2001). The most fundamental differences between the two techniques include:
- The cash based method balance sheet lacks receivables and payables.
- For small sized businesses within definite income tax limits, inventory may not be recorded in the balance sheet using the cash basis.
- In the cash basis reports, only the cash amounts collected from sales and other income generating activities are shown as revenue. On the other hand, accrual basis reports proceeds includes both the collected and uncollected values.
- The amount paid to the suppliers and other individuals in the cash based reports are treated as expenses contrary to the accrual basis reports where expenses are composed of both the paid and unpaid amounts.
To use an accrual basis of accounting, the following are the circumstances when one may opt for it: when revenue is predictable before cash is established, a situation described as accrued revenue, it is categorized as a non-fixed asset. The main example is the accounts receivables arising from credit sales to customers. Secondly, when cash comes before the revenue is received, a situation described as deferred revenue; it is categorized as a current liability .an example is when a customer pays a deposit for a service rendered (Olmert 2006). Nevertheless, you will not recognize the revenue until the service is rendered. Another example can be the rental income paid in advance where a tenant might opt to pay rent on a quarterly basis, but only each month’s rent is recognized when it occurs (Logue 2009). Thirdly, when an expense is recognized before cash is paid, the situation is known as accrued expense. Accounts payables, resulting from credit purchases from the vendors, is the most common example. Another example is paying interest on a bank loan on a quarterly basis, but when it comes to recording the accrued interest, it is done on a monthly basis. Lastly, if cash is paid before the expense is incurred, it is known as deferred or prepaid expense or expenses paid in advance. This is categorized as a current asset. As an example, anyone may decide to meet an insurance payment twice a year but only record the expenditure on a monthly basis.
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The value of cash discounts given to customers and the value of bad debts to close up with in the accounts both reduces the amount of cash to be got from turnover. Also the discounts received from suppliers declines the value of remittances on purchases. The way of reporting these events in both the turnover and tax returns on income differs from one country to another. As shown by the accounts of Andrew moore, his cash based report shows these values. It is allowed that one is restricted to the legal requirement of his or her nation on the values to include or exclude.
If Andrew collects sales tax, he wants to beat the payment deadline. Just like income tax, if he makes his payments late, he will have to face interest payments and penalties. In Texas, for example, one pays on a, monthly, quarterly or yearly, depending on the size of the payment, and the nation will never grant extensions (Pritchard, 2002). The amount to be paid on a particular period is different depending on the method the business adopts either on cash basis or accrual based.
Remember, as stated earlier, many small businesses use cash accounting where the entity records income when the customer pays for a purchase and records an expense when the company pays out money. Accrual-based reporting business records income as soon as the sale is made, even if the customer is not going to make payment for six months, and treats expenses the same way. If the business gets greater than $5 million in sales a year, the Internal Revenue Service (IRS) recommends it to adopt an accrual accounting system, even if it was used to cash basis (The Business of coal: economics and operations, accounting and taxation, business information systems 2001).
The report of sales tax should be in a way that complies with the regular accounting system. If cash accounting is used, the tax on a $500 sale is due in the month, quarter or year that the business made the sale. If accrual method is used, the tax would be due when the customer actually makes the payment. If a mix of both systems is used, the sales tax should be reported the way sales are reported: If the sales are recorded on a cash basis, so are the sales taxes, even if other business accounts are accrual-based.
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Contrasting the cash method, accrual accounting has to deal with the risk of bad debt. If the company makes a credit sale and can't collect some or all of the debt, Texas law recommends, as an example, to decline the sales tax payment for the business to reflect the loss because one can only write off the losses that were subject to tax. Also, there's no sales-tax deduction for any finance charged or the legal costs incurred in an event of collecting the debt (Taxation 2000).
If there are a lot of credit sales, the choice of accounting method to be used won't affect how much tax you owe in the long run, but it could cause a huge disparity on how much to report in a given quarter or year. One cannot, nonetheless, adjust the accounting back and onward to maximize on profits or minimize on payments.
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The cash method of accounting does not count income towards the firm until cash is actually received for purchases of goods or services. Cash means any method of immediate payment and it may include cheques, debit cards or physical currency. Credit card payments are not included because money received from credit card companies is not immediately available in the business accounts. The company does not include expenses until it actually incurs the cost and pay out the associated prices and fees. According to me, the cash method is the most common practice of accounting to be used in small business.
The Internal Revenue Service (IRS) allows one to claim business expenses only for the period actually made payments for the associated debts. According to IRS Publication 538, it includes expenses where one contest liability. For example, one can deduct uncertain contracts with vendors only for the year in which he/she paid the expenses. The cash method does not allow the business to deduct prepaid expenses for future services (Paul 2010). The IRS requires the business to benefit from these expenses using the Uniform Capitalization Rules. This means one needs to recoup capital expenses over a number of years as an alternative subtracting the expenses all at once.
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The accrual method of accounting allows the business to include transactions starting from when customers place orders, delivery of the products or when the company performs services. One can include these transactions regardless of when the business actually received cash for goods or services. The company records income only on the completion of services or on the receipt of products by the customer. This also applies to the business expenses and costs in that the company does not record expenses until service providers complete rendering the services or venders complete the delivery of the goods or products. Completion dates should be the major significant sources of information when using the accrual method of accounting (Bailey, 2001).
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For tax purposes, the accrual method permits the business equate the expenses to the correct tax year. Different from the cash method, the accrual method permits the company to claim expenses for a given tax period when expenses meet any one of these four criterions: the business gets payment, a party claims the business money, the company receives income or a title changes hands with the business. According to IRS 538, the accrual approach lets the business to carry forward payment of taxes on prepayments for future goods or services until the next tax period (Schanz 2011).
Either method used by a firm is acceptable for recording the financial transactions for any business operation. Owners of the business basically should choose the accounting method to be used based on their company size and their routine operations. They may also choose the method with which they feel most comfortable, as they are often responsible for recording financial transactions. The accrual and cash basis accounting approaches possess different merits and demerits for managing any financial information. These advantages and disadvantages are discussed in the following paragraphs.
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Accrual accounting records financial transactions as they occur which create an accurate record of all the business activities. The owners of the business can adopt the accrual accounting information to determine sales trends related to definite economic environment in the business. Banks and lenders carries out analysis on the business trends and deduce an accounting data when carrying out capital structure decisions using the accrual based methods.
Generally accepted accounting principles (GAAP) actually recommends entities to adopt accrual accounting method under specific circumstances. Generally, small businesses with $5 million in annual sales or $1 million from stock sales should adopt accrual basis. Owners of the business can select the accrual accounting method if they expect momentous growth to occur in their business. This may cause a change from one period to another in the course of carrying out the business from one method to another (Williams, 2008).
Accrual method usually requires owners of the business to use a lot of time managing their financial information. Since accrual basis records financial transactions as they occur, more journal entries are needed to post financial transactions into the company routine operations and general ledger. Closing out accounting year also necessitates the use of journal entries (Keen 2010).
The accrual accounting method is infamous for its failure to keep an accurate record of cash. Owners of the business usually provide cash flow statements to trace cash flows from business operations. Using these cash flow statements also needs owners of the business to spend more time in preparing and reviewing accounting information (Keen 2010).
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Cash accounting technique is usually easy to adopt if compared with the accrual method. Owners of the small scaled businesses adopt this method to recognize events only when cash are received. This generally avoids a lot of journal entries from being kept in the books of the owner (Kaplow, 2006).
Owners of the business frequently use the cash-basis since it traces cash flows much easier than accrual accounting. Smaller or home-based businesses, like that of Moore, regularly rely on accurate cash flows for managing their business operations. Cash flow management can also help owners of the business grow their business gradually through operational profits (Avi-Yonah 2002).
Cash flow accounting does not produce an accurate chronological trend of business operations. Because cash basis accounting records transactions only when cash are received, it does not, as a canon, represent date of sale for goods and services. Stock purchases or other asset acquisitions can also be exaggerated by the cash basis technique.
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Owners of the business might be unable to use cash-basis accounting for certain industries for example construction, manufacturing and retail firms. These industries frequently depend on comprehensive accounting information to make good business decisions.