Carol owns and operates a retail appliance store with annual sales of approximately $12 million. The store has an extensive selection of appliances. Approximately 80% of her sales are with extended credit terms. What method of tax accounting is most appropriate for Carol’s business?
A) The cash method, because it provides flexibility in the timing of income and expenses
B) The installment sale method, to spread the gain over a longer time frame
C) The accrual method, because inventory is such a large component of the business
D) The hybrid method, because the business involves both inventory and service
The correct answer and explanation is:
The correct answer is C) The accrual method, because inventory is such a large component of the business.
Explanation:
The accrual method of accounting is typically the most appropriate for businesses with significant inventories, like Carol’s retail appliance store. Under the accrual method, income and expenses are recorded when they are earned or incurred, regardless of when cash is actually received or paid. For Carol’s business, the accrual method ensures that sales are recognized when they occur, and expenses are matched with the revenues they help generate, giving a more accurate picture of the business’s financial position and performance over time.
Given that Carol’s store deals with a large volume of inventory (appliances), the accrual method is particularly relevant because it accurately reflects the costs associated with purchasing and selling inventory. Under this method, the store would account for inventory purchases and sales immediately upon receipt and sale, not waiting until payment is made or received. This allows Carol to track her inventory levels, calculate the cost of goods sold, and match it with the corresponding revenues in the same period.
Additionally, businesses with over $25 million in annual sales (as in Carol’s case) are generally required by the IRS to use the accrual method if they carry inventory. This requirement helps businesses avoid the complexities of trying to match revenues and expenses under the cash method, which would be inappropriate when inventory is involved.
Although the other methods (cash, installment, and hybrid) might seem to offer certain benefits in different circumstances, the accrual method is the most accurate and suitable for businesses with substantial inventories like Carol’s. It ensures that Carol’s financial statements reflect true financial performance and comply with tax regulations.