Apply Cash And Accrual Accounting Methods
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CPA Tax Compliance & Planning (TCP) › Apply Cash And Accrual Accounting Methods
The constructive receipt doctrine requires a cash-basis taxpayer to report income when:
The taxpayer is legally entitled to the income under a contract.
The payor has deposited funds into an account accessible to the taxpayer.
The taxpayer could have received the income but chose not to for personal reasons.
The income is set apart for the taxpayer without substantial limitations or conditions, even if not actually received.
Explanation
Constructive receipt occurs when income is set apart for the taxpayer and available without substantial limitation - the taxpayer cannot defer income by simply refusing to accept it. Answer A is correct. Mere legal entitlement (D) or ability to receive (B) alone is insufficient if there are substantial conditions. A deposit accessible to the taxpayer (C) is close but incomplete without the 'without substantial limitation' element.
A cash-basis law firm receives a check for legal services on December 31. The firm does not deposit or cash the check until January 3. In which year is the income recognized?
January, because the check was not deposited until that date.
January, because constructive receipt requires actual ability to access the funds.
December, because a check received before year-end is constructively received when it is delivered to the payee.
The year the legal services were performed.
Explanation
Under the constructive receipt doctrine, a check received before year-end is income in that year - the taxpayer has control over it regardless of when it is deposited. Answer C is correct. The deposit date doesn't determine recognition under cash method (A, B). The year of service is the accrual method (D).
A calendar-year accrual-basis taxpayer receives advance payment in December for services to be performed over the following 18 months. Under Rev. Proc. 2004-34, the taxpayer may:
Defer the recognition of income to the year the services are performed, but only to the extent the income is deferred for financial accounting purposes and included in the next tax year.
Elect to spread the income evenly over 18 months.
Recognize all of the advance payment in December when received.
Defer all of the advance payment until all services are completed.
Explanation
Rev. Proc. 2004-34 allows a one-year deferral for advance payments - the portion allocable to the next year can be deferred, but amounts not earned by year-end of the following year must be recognized. Answer A is correct. Deferral beyond the next tax year is not permitted (B). Full recognition in the year received (C) is the default without Rev. Proc. 2004-34. Straight-line 18-month spreading (D) is not the rule.
Under the accrual method, a deduction is allowed when:
The taxpayer records the expense on their books regardless of payment.
The taxpayer pays the expense in cash during the tax year.
The taxpayer receives the invoice for the expense.
All events have occurred establishing the fact of liability, the amount can be determined with reasonable accuracy, and economic performance has occurred.
Explanation
Accrual method deductions require the all-events test (liability fixed, amount determinable) plus economic performance (the activity giving rise to the liability has occurred). Answer C is correct. Cash payment (A) is the cash method. Book recording (B) and invoice receipt (D) alone do not satisfy the all-events plus economic performance requirement.
The 'economic performance' requirement for accrual method deductions means that:
The deduction is allowed when the expense is approved by management.
The deduction generally requires the provider to actually perform the services or deliver the property giving rise to the liability.
The deduction is allowed when the liability is reasonably certain to occur in the future.
The taxpayer must have the financial resources to pay the liability before a deduction is allowed.
Explanation
Economic performance requires the underlying activity to have actually occurred - services must be performed, goods delivered, or use of property provided. Answer D is correct. Financial resources (A) are irrelevant. Future certainty (B) does not satisfy economic performance. Management approval (C) is not the standard.
A cash-basis attorney pays for office supplies in December. The supplies are used in the following January. Under the cash method, the deduction is taken in:
Either year, at the taxpayer's election.
January, when the supplies are actually used.
December, when the cash payment is made.
The year the expense provides a tax benefit.
Explanation
Under the cash method, deductions are generally taken when payment is made - the December payment creates a December deduction, regardless of when the supplies are consumed. Answer B is correct. Consumption timing (A) is the accrual matching principle. Tax benefit (C) and election (D) are not the cash method rules.
An accrual-basis taxpayer contests a liability and the amount is genuinely disputed. Under the tax benefit rule and all-events test, a deduction for the contested liability:
Cannot be taken until the dispute is resolved and the liability becomes fixed.
Is allowed in the year the taxpayer first receives notice of the claim.
Is allowed when the taxpayer sets aside funds to pay the potential liability.
May be taken in the year the liability is claimed, even if disputed.
Explanation
The all-events test requires the liability to be fixed - a genuinely contested liability is not fixed until resolution. Answer A is correct. Disputed liabilities are not fixed (B). Notice alone (C) and setting aside funds (D) do not satisfy the all-events test.
A business taxpayer using the accrual method has accounts receivable that have become uncollectible. The proper tax treatment is:
To recognize a loss only when the debt has been unpaid for more than 90 days.
To deduct the bad debt in the year it becomes wholly or partially worthless and was previously included in income.
To deduct the bad debt in the year the debt first became overdue.
To take a deduction for bad debts using the reserve method, recognizing the estimated future bad debts.
Explanation
For accrual-basis taxpayers, bad debts are deductible in the year they become worthless, but only to the extent the income was previously recognized. Answer D is correct. The reserve method (A) is only allowed for certain financial institutions. The 90-day rule (B) is not the standard. Overdue date (C) is not when worthlessness is determined.
A cash-basis taxpayer borrows $50,000 and deposits it in their bank account. Which of the following correctly states the tax treatment of the borrowed funds?
The $50,000 is includible in income only if the loan is forgiven.
The $50,000 is includible in income because it was received and deposited.
The $50,000 is not includible in income because borrowed funds create a corresponding obligation to repay, resulting in no accession to wealth.
The $50,000 is includible in income but an equal deduction is allowed in the same year.
Explanation
Borrowed funds are not income because they are offset by the repayment obligation - there is no accession to wealth. Answer B is correct. Constructive receipt doesn't apply to loan proceeds (A). No income is recognized (C). Loan forgiveness (D) would create cancellation of debt income but the original borrowing is not income.
Which of the following is the primary advantage of the cash method over the accrual method for a service business?
The cash method allows deductions for estimated future expenses.
The cash method results in lower overall tax liability over the life of the business.
The cash method allows the taxpayer to defer income by delaying billing or collection and accelerate deductions by prepaying expenses within limits.
The cash method requires less sophisticated accounting systems.
Explanation
The primary tax planning advantage of the cash method is the ability to manage the timing of income and deductions - deferring income until cash is received and accelerating deductions by early payment. Answer D is correct. There is no systematic lower tax over time (A). Estimated future deductions are not allowed on cash basis (B). Administrative simplicity (C) is a practical, not tax, advantage.