You are currently working at a mid-sized certified public accounting firm. Your

Question

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. Specifically, the following critical elements must be addressed: 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? Which option would you recommend for the client? 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 appropriate IRS code and regulations. D. Summarize, using moral reasoning, the cash or accrual accounting method in relation to the selected business entity

Explanation / Answer

Under Cash accounting system, the expenses and incomes are accounted in books only when they are actually paid or received in cash respectively. Under Accrual accounting method, the expenses and incomes are accounted as and when they are incurred. Cash accounting system is more simpler to use than accrual accounting and suits for small proprietors and businessmen. However, if a business has inventory then accrual accounting method is recommended compared to cash basis due to the fact that cash method may result in wide discrepancies between sales and purchases reported and the inventory accounting . In cash method, inventories are valued both at the start and end of the year without taking sales and purchases of goods. If we opt accrual method, then the taxable income is arrived at based on the accrued sales and expenses irrespective of its actual cash outflow. If we opt cash method, the taxable income is arrived at on the net cash inflow (income received less expenses spent). Accordingly, tax will have to be paid. As the business is involved in used cars ie., maintaining inventory, it is suggested to opt for accrual accounting system.

It is suggested to opt for sole proprietorship model compared to partnership or company. Reason: tax rates are based on marginal taxable incomes based on slab under sole proprietorship as compared to flat 20% tax rates in partnership firms. Also, under sole proprietorship, he can claim some eligible deductions including contributions to 401(f) fund.

Considering moral reasoning, he can opt a hybrid accounting method ie., cash basis method for accounting expenses and revenue and accrual accounting method only for recording inventories. This will ensure both simplicity in maintaining books and also good control over inventory tracking.

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