Accrual basis

[Gretel]

I never had an accrual basis client, only one I help with QB. Is there any summary info available of what expenses need to be considered if a taxpayer is on accrual basis? I have been through my accounting books but it just has left me confused.
AR and AP is easy but then...

[BHoffman]

Gretel - if you understand the concept of AP and AR, then you are most of the way there.

AP - you record expenses as they are incurred, regardless of when the bill gets paid. The phone bill for December doesn't get paid until January. You recognize the expense in December on accrual.

AR - you record revenues as they are earned, regardless of when the payment is received. An invoice is dated in December but payment isn't received until January. You recognize the revenue in December.

Is there something specific you're wondering about?

[Nashville]

"Most of the Way There"

Hoffman is correct...the bulk of accrual amounts is involved in Payables (bills for costs which occurred prior to year end) and Receivables (billings for revenue whose performance occurred prior to year end).

One easy way to determine this: If your client pays his bills promptly, look at the checks he wrote during the 1st 15 days of January. You will discover most of the bills are for costs incurred prior to December 31. These costs are deductible (unless inventory) for the year ended (December) instead of the year they were paid (January). You might do the same for your client's sales if they are billed to customers, except this becomes "revenue" in the year ended. Accrual accounting thus results in a net difference of sales and expenses, which can either raise or lower taxable income for the client. In most cases, the accrual effect "levelizes" income over the years when compared to the cash method, and I normally prefer it, as does the financial community at large (Banks, insurance companies, CPAs, etc)

You should have very little problem grasping the concepts described above. If you understand that it is the time of the EVENT rather than the time of PAYMENT, you are well on your way to understanding accrual concept.

There are more sophisticated applications that we don't have the time to address. One example is the Insurance Policy that is paid at the beginning of October for $10,000, but the insurance policy covers the client until Sep 30 of the next year. You should have no problem understanding that only $2500 of this amount is a deduction under the accrual basis, as $7500 is really an expense in the next year. In such a case, make sure that you deduct the amount left over from the PREVIOUS year, so you don't miss a deduction.

There are complex applications of the accrual concept, but if you can deal just with the payables and receivables as Ms Hoffman indicated, you will usually pick up 90-95% of the dollar effect.

[Gretel]

Yes, I am wondering about about payroll. Looks like the only item allowed to be accrued is vacation pay (and of course direct payroll costs) if paid within 21/2 months. Work.comp. is not allowed? Doesn't make much sense. Clients accrues for job costing.

[Gretel]

Thanks, Snag. The "recurring item exception" would cover your insurance example, wouldn't it? Does this mean all expenses paid in year 1 that don't cover more than 12 months can be deducted in year 1? Is the recurring item exception election made by filing something with the first tax return or just by using it the first year? Is it an item by item election, or all or nothing?

[Nashville]

General Response

Thanks, Snag. The "recurring item exception" would cover your insurance example, wouldn't it? Does this mean all expenses paid in year 1 that don't cover more than 12 months can be deducted in year 1? Is the recurring item exception election made by filing something with the first tax return or just by using it the first year? Is it an item by item election, or all or nothing?

Not sure I can immerse myself into all of this and give you a timely response. Not sure what the term "recurring item exception" attaches to. We might best answer your accrual questions on a situation-by-situation basis, as everything thus far from myself and Hoffman have been very broad discussion.

I can answer one of them, for example, that if an item is paid in year 1, and nothing covered by the payment extends into the next year, then the entire payment is deductible in year 1 (assuming it is deductible at all).

I appreciate your confidence.

[BHoffman]

Hi Gretel - I googled "recurring item exception" to get an idea of what you are looking at.

This might be confusing your issue.

Insurance. How much per month should be allocated? I know some premiums are paid annually, but perhaps cover from May to April. You need to just do the math and make a journal entry. The offset is "Prepaid Expense", a current asset.

Customer deposits received. This can be tricky. If I charge a client a retainer of $1000 in December, but don't complete the work until January and I'm an accrual basis TP, then I'd recognize the revenue in January and record the amount received in December as a liability. Why? Because if I actually owe that back to the customer until I perform the service.

Warranty obligations. Some companies sell warranties. They have performed no services yet, so no revenue is recognized. This would debit cash and credit a liability. As the services are performed, you would debit the liability and credit revenues.

It's all in the timing. If you overthink these things, you will go nuts. Please feel free to post specifics, as Nash suggested, and we can help you better.

[Gretel]

Snags and BHoffman, thanks for all your effort and support.

Yes, I probably over-think, and yes again, I am going nuts. I thoroughly dislike the feeling of not getting a handle on a situation. Well, actually I am not even having the situation yet, but the taxpayer I am dealing with will probably bring this situation into my life and we will need to make a decision. If I don't understand most of it, how can I even suggest something?

Of course I would like to have him on cash basis, but if his planning works out he might need to use the accrual method of accounting and converting from cash to accrual seems to be an even more daunting task. OK, I am calming down.

I am perfectly fine with all the examples both of you have given. All of this follows common sense. All of this is the common thing to do.

The info I found at the IRS website and other websites states that TP can elect to use the recurring item exception, which basically means that f.e. insurance paid in July for 12 months can be all expensed in year paid if election is made. At least this is the way I understand it. BHoffman, you didn't arrive at the same conclusion than I did so maybe I am wrong.

Also, to my suprise, the IRS instructions say that work.comp. is an expense in year paid and not when accrued. Again, my understanding.

After writing all this I am almost at a point to say, not matter what, I will put this TP on cash basis and deal with everything else when the time comes. And maybe, by then, I will have been able to find some good reference materials. I have tried for years, since it always bothered me that I thought I didn't have a good enough understanding of accrual accounting.

[Snaggletooth]

Cannot Change

I will put this TP on cash basis and deal with everything else when the time comes.

Gretel, this makes us think you are going to put client on cash basis and then change later when you understand accrual issues better.

I need to advise that once you start on an accounting basis, you cannot change unless you get consent from the IRS. Applying for a change requires a user fee, last time I checked it was $1200.

Wish we had time to walk you through the issues.

[geekgirldany]

Recurring Item Exception refers to:

A liability incurred for the first time can qualify as a recurring item if it is reasonable to expect that the same item will be incurred on a recurring basis in the future.

To make the election:
S corporations that incur the types of liabilities eligible for the recurring item exception should make the election in the first tax year they experience such liabilities. The election is made by using the recurring item exception to account for applicable items in a timely filed return.
======
There is more to recurring item exception but I found it in other research material. You want to start out the right way so do accrual is that is appropriate like Snag said. You don't want to go back later and change. Take the items one at a time and you will be okay. Accrual is really more correct than cash basis. Well... not correct but is preferred.

[Gretel]

Thank you so much for all your help. My intentions are to do the best for my clients. My thinking was, that if this client will reach the limit soon (some years down the road) and not be eligible any longer to use the cash method of accounting than it would be better to start off with the accrual method right away.

Actually nothing anyone of you said was new to me besides the way the election is done. I probably just need to trust myself a little more.

From a business stand point the accrual method just makes more sense. Long years ago when I used to work for corporations they all used the accrual method. Unfortunately I was not in a position to be involved in the year end procedures.

[TaxLadyinPA]

my two cents on QB

Everyone likes to use their QB to do bookkeeping. I have several clients who do and bring me their files saved on their little jump drive.

All of these clients mainly because they don't understand how to do accounting but some just because they want to …. They all do "after the fact" bookkeeping in their QB meaning they don't enter the bill when they receive it .. they enter when they pay it.. They are accrual tax payers.

What I have learned …. Be it right or wrong …. I tell them if they want to do 'after the fact' then when they enter it into QB even though they pay the bill on Jan. 15 of the new year they need to enter it in QB as being paid Dec. 31 of the year the bill pertains to. That way it gets credited to the year it pertains to… and stays separate from the bills that pertain to Jan 10 of the new year and is put into QB on Jan 10 of the new year.
That way when I pull it up from Jan. to Dec. I get all the correct info for expenses.

Not that this really has much to do with the original question. It just seemed to be a good time to put my foot into my mouth and see if someone thinks I should not be telling my clients to do this. (There is never any hope of training them to actually use QB the way the program intended accrual payers to keep records. )

[Gretel]

What I have learned …. Be it right or wrong …. I tell them if they want to do 'after the fact' then when they enter it into QB even though they pay the bill on Jan. 15 of the new year they need to enter it in QB as being paid Dec. 31 of the year the bill pertains to. That way it gets credited to the year it pertains to… and stays separate from the bills that pertain to Jan 10 of the new year and is put into QB on Jan 10 of the new year.
That way when I pull it up from Jan. to Dec. I get all the correct info for expenses.

I don't think there is really anything wrong with this approach. The only possible problem I see is that he cannot pay invoices that belong to two different years with one check. I was thinking about this and that it would be better to use the bill function. With this particular client it actually would work. In a sense he is a dream client who just started out, wants to do everything correctly and is eager to learn and follows my advise. Almost too good to be true. Never had anything close to it.