Tax Periods and Methods - Roland Service Company - Case Study Example

Tax Periods and Methods The start-up company under the and style of The Roland Service Company is in the business of repairing and refurbishing private homes, especially after natural calamities such as hurricanes, floods, earthquakes, and hailstorms. The company also provides carpet and home cleaning services to the discerning clients who wants their homes free of mold and termite. At least, 25% of the revenue is generated from the supply of a variety of building materials and the remaining revenue is generated from servicing activities such as carpet and home cleaning. The company also provides consultancy in the field of mold and termite control for improving air quality in home. The business owns some sophisticated equipments necessary for providing cleaning services and revamping the dilapidated houses using minimum manual labor. The regular business operations require storing some inventory items necessary for building and cleaning activities. With 10 employees on payroll, others can be contracted on temporary basis as and when requirement arises depending upon the workload. Usually, payments for cleaning services are made within 30 days and all consulting services are paid in 15 days. Business is highly competitive and buyers usually dictate the terms while awarding the contract. Business has some seasonal effect too. Cleaning services are at its peak in the month of December due to Christmas festival and again in the months of May-June, with the onset of summer. As in any business, bad debt is possible in this kind of business too. My key business philosophy is ethical dealings providing full customer satisfaction to gain repeat business. With a small set up and relying more on word-of-mouth publicity, my objective is to win more and more customers through innovation. Moreover, to keep costs minimum and be effective, my areas of operations usually do not go beyond the periphery of 25 miles. It is equally important that I follow proper accounting methods to keep my tax liability minimum as much as possible by applying proper accounting treatments with regard to several important business transactions. My understanding regarding accounting methods, accounting periods and accounting treatments in relation to specific transactions is likely to play a crucial role in survival and growth of my business. Accordingly, the paper attempts to address these issues involved in the following pages. Accounting Periods – A Calendar or Fiscal Year A firm must choose a tax year to determine its taxable income from business transactions. The tax year, also known as the accounting period of the firm, could be a calendar year, or a fiscal year. The calendar year of 12 consecutive months has its beginning on January 1 and ending on December 31. One needs to choose a calendar year as per the provisions made in the Internal Revenue Code. Those who do not keep books or records need to adopt the calendar year as their tax year. A fiscal year as an accounting period can be chosen when one does not want to choose calendar year as its accounting year. A fiscal year is also made of 12 consecutive months that will end on the last day of any month except December 31st (Rupert et al, 2015). 52-53-Week Tax Year A firm can also elect a 52-53-week tax year provided the firm keeps books and records and calculates its income and expenses during the period. When the firm begins on some intermediate date of the month (for example, March 10 and adopts a tax year that ends on March 9 ascertaining 12 months), this would be construed as an improper tax year. In such situations the firm needs to change to a proper tax year. Form 1128 is needed to file with IRS for approval to change in tax year. All partnerships, personal service corporations (PSCs) or S corporations are needed to elect a tax year. A partnership firm must align its tax year with its partners unless approval from IRS is taken (Rupert et al, 2015). My business being a partnership company needs to use calendar year as its tax year so as to match with the tax year of its owners – to comply with IRC regulations. Accounting Methods As far as accounting methods are concerned, they are essentially of two kinds: accrual accounting and cash-basis of accounting. Accrual-basis of Accounting When the firm uses accrual accounting method of book keeping, it takes into account the actual occurrence of transaction regardless of the fact when it receives its payments or pays its dues. The firm may receive its payments several weeks or months later from the sale transaction; however, the firm is considered to have generated income from the transaction. Similarly, the firm records its expenses as and when they incur regardless of when it pays to its providers. All incorporated companies need to use accrual accounting method; however, unincorporated firms may elect cash-basis of accounting. In a business where bad debts are high, accrual accounting method may create a distorted picture of revenue and profits earned. Cash-basis of Accounting In cash-basis of accounting, accounting is done only when the cash is actually paid out to providers. In the same way, revenue is earned only when they actually receive cash for the goods or services sold. For example, when a service is rendered in the last week of December and the payment is received in January (in next calendar year) then the earnings will be taken into account only in the next financial year. In cash-basis of accounting method, revenues and expenses often do not match on month-to-month basis. It may happen that expenses and income both may have occurred in the previous month; however, cash-basis of accounting may report the transactions in books of accounts in the following month if money transactions have taken in that month. The advantage of cash-basis of accounting is that it is a sure way of tracking the cash available. Negative aspect is that cash-accounting method does not take into account the liability until it is paid. This may give a distorted picture of the business in real sense, especially when legal liabilities are huge enough to put the entire business in jeopardy. Having understood the difference between these two accounting methods, I began with accrual accounting method as it can provide me a true picture of my business. Two Specific Transactions Treatment to Depreciation The Roland Home Service Company decides to change from the straight line method to double-declining balance (DDB) depreciation method under the accrual accounting method. The asset was purchased on January 1, 2012 for $50,000 with an estimated life of five years and no residual value. After three years the company decided to apply double-declining balance method due to technological obsolescence. The following table represents how the depreciation treatment will be applied in the current year. Depreciation applied in accounting year 2012 Depreciation applied in accounting year 2013 Depreciation applied in accounting year 2014 Depreciation applied in accounting year 2015 $10,000 $10,000 $10,000 $ 20,000 The asset had a book value of $20,000 in the beginning of 2015 and a remaining life of two years; however, changed depreciation method will reduce the book value of the machine to zero and the profit tax before tax by $10,000. This will result into a lesser tax liability. Treatment to Inventory valuations Inventory valuation is another important parameter that may play a pivotal role in deciding profit before tax. The firm uses FIFO (first-in-first-out) method in inventory valuation in past years. When inventory is valued at weighted average, the following impact was noticed. Inventory Valuation Year 2013-14 $ Year 2014-15 $ FIFO – Ending Inventory 40,500 43,500 Weighted Average–Ending Inventory 39,600 42,,200 When inventory is valued on the basis of weighted average cost for entire year the cost of goods sold will increase resulting into the lesser profit in a given year. Reduced profit will attract less tax. This is so because the inventory items have rising costs year after year. Unlike FIFO, weighted average method of inventory valuation takes into account all purchases made in the accounting year. The cost of carry-forward inventory, thus, gets reduced but the cost of goods sold increases assuming the cost of consumables keep on rising in the market. Opposite will happen if the costs of consumables keep on declining (Accounting Inventory Methods, 2015). Rules to Follow While Changing the Accounting Method While accrual method is being adopted for the last three year, switching to the cash method of accounting would not only need justification but must follow certain rules. Commissioners consent is mandatory while making changes to a method of accounting. While changing method of accounting it is likely that certain income is either omitted or duplicated in relation to business transactions. As per IRC section 481 (a), certain adjustments are necessary to prevent such income anomaly. Accordingly, income for the taxable year before the change must be calculated and adjustments need to be made for the cumulative differences that arise out of these changes. IRS approval is needed for change in treatment of any material item. Automatic change in method is granted if the firm complies with the procedures necessary for such changes; however, Form 3115 must be filed with the authorities (Internal Revenue Service, 2014). Changing Accounting Method from Accrual to Cash The last three years’ workings reveal that switching from accrual to cash accounting can reduce my tax liability. This is essentially due to nature of my business having following characteristics. All consumables purchased are paid within one week. Customers pay for cleaning services within one month of services. Consulting services provided by the company are paid within 15 days. Three business transactions that can either reduce my business revenue and increase expenses are mentioned in the following table. Year 2014 ($) Estimated Growth in year 2015 ($) Impact due to change from accrual to cash accounting method ($) Gross Revenue 2,850,000 2,992,500 Reduced by 73,490 Gross expense 2,255,000 2,375,000 Increased by 61,800 Cleaning Services done in month of December of the accounting year for payments to be received within 30 days 57,500 60,375 (+5%) Revenue reduced by (60,375) Invoicing regarding consulting services raised in last 15 days of December. Payments received in 1st week of January 12,200 13,115 (+7%) Revenue reduced by (13,115) Consumables purchased in the last week of December that will be used in January; however, paid on 31st December. 60,000 61,800 (+3%) Expense increased by -61,800 IRC permits cash accounting method to small businesses provided their yearly revenue does not exceed $5 million. Since the firm’s total revenue is less than $5 million, it is possible to switch to cash accounting for year 2015. Cash accounting will reduce profit before tax of the firm by 60,375+13,115 +61,800 =135,290. Thus, tax liability at 30% tax rate would save close to $40,600 in accounting year 2015. It is important to note that change in accounting method does not change a long-term tax liability except that it makes changes to current year’s tax liability (Bran, 2014). Letter to IRC for Change in Accounting Method from Accrual to Cash Basis The Commissioner, IRC Dear Sir/Madam, The Roland Home Servicing Company is registered as a small business partnership firm to providing home repairing and cleaning services within the periphery of Dallas, TX. The firm’s registered address is Golden Mansion, 6576 Academic School Road, Dallas, TX. The firm began its operations in 2012 completing three years since then. The company has adopted accrual method of accounting and calendar year as its tax year to reflect its business transactions following all IRS regulations. However, the experience of last three years’ business operations of the firm has necessitated that accounting method be changed to cash basis in the current 2015 calendar year for the following reasons. The Rolland Home Servicing Company is a small business with gross revenue earnings of 2,850,000 in year 2014. Maintaining positive cash flows is a business necessity to survive in the fiercely competitive industry; however, accrual method of accounting impairs this aspect of business because customers in the industry availing home and carpet cleaning services pay only after 30 days. Moreover, it has been found that in at least 25% of the orders customers have paid between 40-65 days putting additional pressure on cash flows. The firm has always paid its legal dues, employees’ salaries on time and has never defaulted on that during last three years. Moreover, the company has paid to its suppliers on time to build a mutually supportive long-term business relationship to serve our customers better and the company will continue to do so in future also. Bad debt is another aspect that is not in control of the firm. The last two years’ annual reporting reveals that 1.25% of the revenue was not recoverable putting additional pressure on cash flows for which even taxes were also paid to IRC. Revenue of the company is likely to remain less than $5 million for the next couple of years. It is requested that IRS allows the company to change its accounting method from accrual to cash basis. Form 3115, as required by IRS, is being attached herewith for your consideration to grant us the permission to make change in our accounting method from accrual to cash. This change in accounting method will help us not only to manage our cash flows but serve our customers in a much better way. Hoping to receive a favorable reply from your office and meanwhile thanking you, Sincerely, Robert Murdock (Managing Partner) The Rolland Home Servicing Company Dallas References Rupert, T. J., Pope, T. R., Anderson, K. E. (2015). Prentice Halls Federal Taxation Individuals. Pearson. Internal Revenue Service (2014). irs.gov. Retrieved January 31, 2015 from http://www.irs.gov/publications/p538/ar02.html Accounting Inventory Methods (2015). Accounting Tools. Retrieved January 31, 2015 from http://www.accountingtools.com/accounting-inventory-methods Bran, T. (2014). Cash vs. Accrual and Why Accounting Matters for Taxes. Retrieved January 31, 2015 from https://www.americanexpress.com/us/small-business/openforum/articles/cash-vs-accrual- and-why-accounting-matters-for-taxes-1/ Read More