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@074 CHAP ZZ
┌─────────────────────────────────────────────┐
│ TAX ACCOUNTING METHODS │
└─────────────────────────────────────────────┘
"Never trust a naked certified public accountant. Or
one with clothes on." -- Jenkins' Fifth Law of Business
Survival (by Michael D. Jenkins, CPA & Attorney)
The primary accounting methods businesses are allowed to use for income
tax purposes are the cash receipts and disbursements method ("CASH
BASIS") and the accrual method ("ACCRUAL BASIS"). However, certain
taxpayers may be allowed to use some hybrid combination of the two,
such as reporting inventory-related sales and purchases on an accrual
basis while reporting service income and miscellaneous other expenses
on the cash basis. There are also special methods of accounting, such
as percentage-of-completion or completed contract accounting for
certain long-term contractors, such as companies engaged in heavy con-
struction on long-term contracts. However, the Revenue Reconciliation
Act of 1989 has completely eliminated the benefits of completed con-
tract accounting for most firms whose average annual gross receipts for
the 3 preceding years exceed $10 million, except for certain qualified
ship contracts and certain home or residential construction contracts.
Such firms are generally required to use the less desirable percentage-
of-completion method for their long-term contracts.
Also, small contractors (with under $10 million or less in average
annual gross receipts) are not subject to these new restrictions on use
of the completed contract method, but only for construction contracts
which are estimated to be completed within two years of the contract
commencement date.
INVENTORY ACCOUNTING METHODS. In addition to overall tax accounting
methods, there are various tax accounting methods that are permissible
for tax purposes. While most businesses with inventories use the sim-
pler FIFO (first-in-first-out) method of accounting for the value of
such inventories, a company may instead elect the complex "LIFO"
(last-in-first-out) method. In times of inflation, LIFO is attractive
since it assumes that items remaining in inventory at year-end are the
oldest such items, generally those you bought or manufactured a long
time ago, which have a lower cost. By reducing the value of your end-
ing inventory, LIFO reduces your current taxable income, and thus gives
you significant tax deferral, particularly in times of high inflation.
While using the LIFO method is quite complex and may require a lot of
expensive accounting talent, a simplified version of LIFO may be used
by companies with under $5 million a year in sales, as permitted by the
Tax Reform Act of 1986.
UNIFORM CAPITALIZATION RULES. However, the '86 Act also adopted tough
new uniform capitalization rules that require all manner of indirect
expenses to be capitalized and included in the cost of inventory (for
both FIFO and LIFO taxpayers). Fortunately, small retailers and
wholesalers (with $10 million or less of average annual sales) are
exempted from this new requirement with regard to their inventories.
These capitalization rules also apply to expenses incurred in construc-
tion and development activities.
With regard to inventory, the new rules require businesses to capital-
ize not only direct costs of acquiring or producing inventory, but also
a number of kinds of indirect costs that were previously allowed as
deductions, before the Tax Reform Act of 1986. The new law (as amended
by the Revenue Act of 1987) requires some interest expense to be al-
located to inventory, and generally requires taxes, contributions to
pension and profit sharing plans (including past service costs) and
storage costs incurred by manufacturers following completion of the
manufacturing of a product to be allocated as indirect costs. Whole-
salers and retailers (other than small firms exempt from the uniform
capitalization rules) are now required to allocate costs incident to
purchasing inventory (such as wages of employees who do purchasing),
repackaging, assembly and other costs incurred in processing goods
while in the taxpayer's possession; costs of storing goods (rent, in-
surance premiums, taxes attributable to a warehouse, etc.); and the
portion of general and administrative costs allocable to these func-
tions. In short, the new Uniform Capitalization rules are an account-
ing nightmare for those subject to them, as well as a way of raising
your tax burden by deferring the time at which you can take a deduction
for expenses incurred in your business. Welcome to the world of "tax
simplification."
@CODE: LS
Then, in @STATE, there is the "consistent fraud" method of
inventory accounting, which is widely used.
@CODE:OF