Question

Oliver is the sole shareholder, director and employee of Northrop Consulting Engineers. Oliver's company owns and operates a spraying aircraft for spraying crops and pastures with either fertilizers or pesticides. The business charges farmers on an hourly basis for the use of the aircraft and for Oliver’s time in flying the aircraft. Oliver charges $400 per hour of which around $50 per hour would be for his labour. The business also charges farmers for the spray being used. The only way a farmer can engage the aircraft is together with Oliver as the pilot as he lets no one else fly because the aircraft is his major asset. The company maintains simple books of account and records income when it is received. Most clients pay cash on completion of a job. Oliver rarely extends credit to his clients and only in special circumstances. Oliver keeps virtually no supplies of fertiliser or pesticides on hand and orders them for specific jobs. He does have a small amount of fuel and oil in his hanger.

With reference to relevant cases and legislation, critically discuss whether Oliver returns his income for tax purposes on a “cash” or on an “accruals” basis?

Answer 1

There are two methods of accounting :

1) Cash method

2) Accrual method

Selection of method depends on type and size of the business. A sole proprietor is someone who owns an unincorporated business by himself or herself. According to IRS Publication 334, most of the small business owners e.g. sole proprietors use the cash method of accounting as it is easier to use in daily practice.

As per the Cash Accounting method, the entity report their income when they receive the money in real and report most of the expenses when it get paid in actual. Let us understand another way - entity report/account the income and expenditure based on real cash inflows and outflows.

On the other hand, Accrual Accounting method says count/record it if the obligation has arrived. It does not really matter if you have received or paid cash for the transactions. For example, bill raised but yet to be paid or received.

In terms of Income Tax Returns, we have option to choose the method of accounting. But as per the rules, we can't simply change the method once it has chosen. Same method must be continued year after year; after first filing of income tax return. As per rules one must apply with Form 3115 and have the IRS approval to switch the method.

Changes include not only an overall switch, like going from the cash method to the accrual method, but also changes in how you treat significant items, such as when you consider revenue from large projects due under the accrual method.