Death and Taxes! Well, OK, just the taxes part

Handling Accrual Basis and Tax Basis Accounting in the same set of Books

Dynamics 365 Financials

The number of rules and regulations facing American businesses is unprecedented in American history. Each year the Federal Register publishes something like 78,000 pages of new rules and regulations. The US tax code, all by itself, is approximately 75,000 pages. I would argue that, in its entirety, it is incomprehensible. Lawyers and CPA’s can have in depth knowledge of parts of it, but virtually no one knows it all. It is little wonder than ordinary taxpayers are frustrated and intimidated by taxes.

“Amazingly, in the first 26 years of the federal income tax, the tax code only grew from 400 to 504 pages. Even through President Franklin Roosevelt’s New Deal, the tax code was well under 1,000 pages. Changes during World War II made the length of the tax code balloon to 8,200 pages.

Most of the growth in the tax code came in the past 30 years, growing from 26,300 pages in 1984 to nearly three times that length today.” by JASON RUSSELL • 4/15/16

So what’s a body to do? Most of us view the prospect of an audit as akin to {you fill in the blank for your particular version of horror}.

If you are of a certain kind of business, the IRS allows you to file your tax return using what is known as “cash basis”. That is generally contrasted with the alternate “accrual basis”.

In very simple terms, cash basis taxpayers pay taxes based on cash monies received in their businesses less the actual cash expended on deductible expenses. How is that different from an accrual basis taxpayer? Suppose you are a lawyer and you submit a large invoice to one of your customers in mid-December. If you are a calendar year taxpayer and that invoice gets paid before year end, as a cash basis taxpayer you pay taxes on that. If unpaid, you do not. An accrual basis tax payer triggers tax liability when the invoice is billed, not when it is collected.

You should understand two things here:

1. Your tax situation should be determined by consultation with a tax professional. Nothing in this article is intended to provide tax advice.

2. In the long run, both cash basis and accrual basis provide the same net income. The only thing that differs is the period in which it is deemed to be earned.

As an example, think about this. At the end of my first year in business I have a $10,000 invoice open and unpaid. As a cash basis taxpayer, I do not pay taxes on that money in year one. But if I collect that money in January, I will owe taxes on it in year two because that’s when I collected the money (converted it into CASH). So in any given year, the net tax effect of receivables is the difference between what I was owed at the end of the prior year compared to the same at the end of the current year.

So why all the twisting of hands and gnashing of teeth if both methods in the long run produce the same result. The answer is that even if both produce the same long term net income, they both probably will not produce the same tax bill!

The reason is because tax law changes “all the time”. If you’ve been in business for twenty years, you have twenty individual slices of aggregate net income. Chances are, some of your years have been better than others. If you have high income in an individual year with high net tax rates and low income in years with low net tax rates you pay more total tax than if that situation was reversed.

One of the central tenants of tax planning is to, within the confines of the law, defer income and accelerate expenses, both of which create timing advantages in a world with increasing tax rates end decreasing deductions. Until we get to a simpler tax code…

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How does Dynamics 365 Financials Help?

Many systems imply or require that you can only keep books using their software by selecting one of the two prevailing methods – cash or accrual. The ideal situation for a cash based taxpayer entity would be the ability to use one system for both tax and book. That gives the user the ability to use accrual based accounting to stay on top of things like open invoices for receivables and for payables, tools for actually managing your business activities, and preserving the ability to use the generally more favorable cash basis for calculating and paying your taxes.

How does this occur? The differences between cash and accrual basis books are few and identifiable. While not a comprehensive review, three general areas of difference are sales, payables and accruals. Let’s examine each of these in turn.

SALES: In accrual accounting, invoicing for services typically generates an entry similar to the following:DebitCreditAccounts Receivable$1,050.00Sales$1,000.00Sales Tax Payable    $ 50.00

PAYABLES: As vendor invoices are processed for payment, they first are entered to the system as liabilities. Payment is a separate, second operation. Timing for cutting the checks is normally based on the vendor terms. Entering the invoices into payables as received and approved lets you use the payables portion of the system to manage dues dates and payments. This example will be simple, just accruing a phone bill but it is illustrative of the concept.DebitCreditTelephone Expense$500.00Accounts Payable$ 500.00

Please consult a tax professional regarding expenses. All of them are not deductible for tax purposes or otherwise may have limitations established regarding their deductibility.

ACCRUALS: One of the main ideas behind accrual accounting is the concept of matching. The notion is to match the costs incurred to produce revenues with the revenues so generated. Unless you pay your bills when they are incurred, cash basis accounting does not properly match expenses and revenues. You use electricity all month long and get a bill. The power company gives you 30 days to pay for it. Consequently, you pay for it in a period after the actual usage. In accrual based accounting you might make a monthly entry like this.DebitCreditElectrical Power Expense$750.00Accrued Expenses$ 750.00

Granted, these three examples are very simple but they are illustrative of the concepts and principle involved.

Here’s where Dynamics 365 for Financials comes into play. Using the Account Schedules, you create two sets of financial statements (Income Statement & Balance Sheet), one using accrual accounting and the other cash basis. The cash basis statements basically “close” things like Sales by using A/R to offset what shows as sales (functionally Debit Sales, Credit Accounts Receivable – reversing the receivables back against revenue – but only in the financial statement, no actual G/L Entry is required. When you do the same for payables and accruals, you in substance wind up with a set of cash basis financial statements but produced from an accrual set of books.

Once a year at tax time, you will “tweak” the individual accounts to file the return. But this way, you get the best of both worlds, running your business using accrual accounting but paying taxes on a cash basis.

#TaxBasisAccounting #tax #FinancialStatements #ConvertAccrualBasis #AccountSchedules #AccrualBasisAccounting

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