EA2 Study Unit 01 - Entity Types, Methods, and Periods

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Questions and Answers

Which of the following statements is NOT true regarding the sole proprietorship?

The owner has unlimited liability, meaning their personal assets are at risk for business debts.

Sole proprietorships are considered separate legal entities from their owners. (correct)

Sole proprietorships are generally easy to establish and require no special forms.

Income or loss from a sole proprietorship is reported on Schedule C of Form 1040.

If a sole proprietorship is sold, how is the sale treated by the Internal Revenue Service (IRS)?

The sale is treated as a business asset sale, taxed at a reduced rate.

The sale is treated as a simple asset transfer, with each asset individually reported. (correct)

The sale is treated like a partnership dissolution, with profits and losses shared among partners.

The sale is treated as a corporate transaction, with tax implications based on the corporation's structure.

What does the term 'unlimited liability' mean in the context of a sole proprietorship?

The owner is only liable for business debts up to the value of the business assets.

The owner is only liable for business debts related to specific transactions, not general business operations.

The owner is personally responsible for all business debts, even if those debts exceed the value of the business assets. (correct)

The owner is not liable for any business debts, as the business is a separate legal entity.

What is the main benefit of a sole proprietorship over other business structures?

It provides the owner with greater control over business decisions and operations. (C) Signup and view all the answers

Which of the following is NOT a common characteristic of a sole proprietorship?

It is considered a separate legal entity from the owner. (A) Signup and view all the answers

If spouses file a joint tax return and want to operate a business together as a sole proprietorship, which of the following options is available to them?

They can elect out of partnership treatment and be considered a qualified joint venture. (A) Signup and view all the answers

What is the main purpose of reporting income and expenses on Schedule C?

To determine the overall profit or loss of the business for the year. (A) Signup and view all the answers

What is the significance of the business being able to receive Social Security benefits in the context of a qualified joint venture?

It allows each spouse to receive Social Security benefits based on their individual business income. (A) Signup and view all the answers

Which of the following is NOT a requirement for a taxpayer to use the nonaccrual-experience method to report bad debts?

The taxpayer must charge interest or penalties for late payments. (D) Signup and view all the answers

When does economic performance occur for a liability?

When the taxpayer provides the service or property related to the liability. (C) Signup and view all the answers

Which of the following is NOT an example of a liability for which economic performance occurs as the taxpayer makes payments?

Interest expense on a loan. (C) Signup and view all the answers

A corporation using the accrual method of accounting has accrued 2% of gross sales as bad debt expense. How is this justified based on the given text?

The corporation is using the nonaccrual-experience method, as the accrued amount is based on historical patterns. (C) Signup and view all the answers

A taxpayer using the accrual method of accounting has a disputed liability. What can they deduct under these circumstances?

The portion of the disputed liability that is actually paid. (A) Signup and view all the answers

What is the key principle behind the concept of "hybrid methods" in accounting?

Taxpayers can use different accounting methods for different aspects of their business as long as it reflects income accurately. (A) Signup and view all the answers

A taxpayer using the cash method for all transactions except for inventory would be considered to be using what type of accounting method?

Hybrid method (B) Signup and view all the answers

How does the text relate the deductibility of expenses to the accrual method?

The accrual method allows for the deduction of expenses when they are incurred, rather than when paid. (D) Signup and view all the answers

What is the requirement for a taxpayer to use the rolling-average cost method to value inventory?

The taxpayer must recompute the rolling average cost of an inventory item either on a regular basis or when purchasing or producing additional units. (D) Signup and view all the answers

What is the variance percentage threshold for using the rolling-average cost method?

The variance percentage must not exceed 1%. (B) Signup and view all the answers

What is the inventory turnover requirement for using the rolling-average cost method?

The taxpayer's inventory must turn at least four times per year. (B) Signup and view all the answers

Which of the following is NOT a condition that must be met to use the retail inventory method?

The taxpayer must use the retail inventory method instead of valuing inventory at cost or LCM. (A) Signup and view all the answers

What is the formula for calculating the inventory turnover ratio?

Cost of Goods Sold ÷ Average Inventory (C) Signup and view all the answers

What is the formula for calculating the variance percentage in the context of the rolling-average cost method?

(Rolling average cost – Actual cost) ÷ Rolling average cost (D) Signup and view all the answers

When does the ownership of goods transfer under FOB shipping point?

When the goods are loaded onto the carrier (C) Signup and view all the answers

Which of the following is the best way to determine the correct valuation method for inventory?

Choose the method that best aligns with the taxpayer's business practices and industry standards (B) Signup and view all the answers

Which of the following statements accurately describes the liability of shareholders in a C corporation?

Shareholders are liable for the corporation's debts only to the extent of their investment. (D) Signup and view all the answers

What is the primary distinction between the cash method and the accrual method of accounting?

The accrual method recognizes expenses when they are incurred, while the cash method recognizes expenses when they are paid. (A) Signup and view all the answers

Which of the following statements regarding accounting methods is NOT true?

The taxpayer can change their accounting method at any time, as long as they notify the IRS. (D) Signup and view all the answers

Which of the following is NOT a characteristic of an S corporation?

Income is taxed at the corporate level. (C) Signup and view all the answers

Which of the following actions is typically undertaken by a board of directors in a C corporation?

Electing the officers of the corporation. (A) Signup and view all the answers

Which statement BEST describes the relationship between shareholders and the daily operations of a C corporation?

Shareholders typically delegate the management of daily operations to a board of directors. (D) Signup and view all the answers

What is the key difference between the legal existence of an S corporation and a C corporation?

An S corporation is a separate legal entity, while a C corporation is not. (A) Signup and view all the answers

Which of the following terms is NOT directly associated with a typical corporate structure?

Sole Proprietorship. (D) Signup and view all the answers

Under what circumstances is a bonus considered taxable income?

When the bonus is partially payable, even if contingent on future events. (C) Signup and view all the answers

When does the 'all-events test' apply to consignment sales?

When the consignee makes a sale to a third party. (A) Signup and view all the answers

What is the IRS's stance on holding a transaction open when neither the fair market value (FMV) received nor the FMV given can be determined?

The IRS only respects holding a transaction open in rare and unusual circumstances. (B) Signup and view all the answers

When is income recognized from proceeds from a lawsuit settlement?

When the settlement is received. (D) Signup and view all the answers

When is prepaid income for services generally included in income?

When the payment is received. (D) Signup and view all the answers

In what scenario would prepaid income for services be included in the year following receipt?

When the services are not completed within the next tax year. (B) Signup and view all the answers

How is prepaid income for merchandise sales treated for accounting purposes?

It is included in income when reported for accounting purposes, even if earlier than when earned. (C) Signup and view all the answers

What is the determining factor for recognizing income from merchandise sales?

Shipment of goods. (A) Signup and view all the answers

Which of the following is NOT an example of an unacceptable method of valuing inventory?

Segregating indirect production costs into fixed and variable production cost classifications and allocating only the variable costs to cost of goods produced, while treating fixed costs as period costs that are currently deductible (the direct cost method). (B) Signup and view all the answers

Which of the following is an example of how a taxpayer using the cash method treats inventory?

The inventory is treated as non-incidental materials and supplies. (A) Signup and view all the answers

Which of the following is NOT a characteristic of non-incidental materials and supplies?

They are typically held for resale. (D) Signup and view all the answers

What is the main factor that determines whether a taxpayer can utilize the cash method of accounting?

The taxpayer's average annual gross receipts. (B) Signup and view all the answers

Which of the following is NOT an accurate statement about the concept of a 'tax year'?

It's determined based on a specific date when a taxpayer's business began. (C) Signup and view all the answers

In the context of inventory valuation, what does "nominal price" refer to?

A price that is significantly lower than the actual cost of the inventory. (D) Signup and view all the answers

Which of the following is a key distinction between the 'direct cost method' and the 'prime cost method' in inventory valuation?

The direct cost method accounts for variable costs while the prime cost method accounts for fixed costs. (A) Signup and view all the answers

Study Notes

Business Entities

Several business forms exist, each with tax and liability implications
Sole Proprietorship: a common form; no separate legal entity from the owner; owner reports income/loss on Schedule C of Form 1040; unlimited liability (owner's personal assets at risk); easy establishment; non-transferable; sale treated as individual asset sales
Spouses filing jointly can elect out of partnership treatment, each filing Schedule C and receiving Social Security benefits

Corporations

Corporations offer limited liability, protecting owner's personal assets from creditors
C-Corporations: income taxed at corporate level and again when distributed as dividends (double taxation)
S-Corporations: income taxed only to the shareholders; S-corporations have ownership restrictions
Partnerships: income taxed only once; the owners are liable for the partnership's debts

Limited Liability Companies (LLCs):

An LLC combines limited liability with the tax advantages of a partnership
LLCs are classified as a partnership (multiple owners), or as a disregarded entity by a single owner (for Federal tax purposes)
LLCs can elect to be treated as a corporation

Single-Member Limited Liability Companies (SMLLCs):

Treated as disregarded entities unless electing corporate taxation

Trusts and Estates:

Separate entities from their owners
Trusts hold assets for beneficiaries; beneficiaries pay tax on distributed income
Trusts only pay tax on income not required to be distributed

Accounting Methods

Accounting methods are rules for determining the tax year an item is includible or deductible
Taxpayers must choose a method that clearly reflects income and consistently applied.
Common methods include the cash method and the accrual method

Inventory Valuation

Specific identification: matching each item cost with its acquisition
First-in, First-out (FIFO): items first acquired are first sold
Last-in, First-out (LIFO): latest acquired are first sold
Cost Method: includes all direct and indirect costs associated with inventory

Accounting Periods

Tax year: period for which a tax return is filed, commonly a calendar or fiscal year
Calendar Year: 12 months ending December 31
Fiscal Year: 12 months ending on the last day of any month other than December, or a 52- or 53-week period
Short Tax Year: less than 12 months; annualized income calculation needed for taxation

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Description

One of the most important decisions a business can make is its choice of entity type. Each type of business form has advantages and disadvantages from both tax and liability perspectives. Each taxpayer must figure taxable income on an annual accounting period called a tax year. The calendar year is the most common tax year. Each taxpayer must also use a consistent accounting method, which is a set of rules for determining how and when to report income and expenses. The most commonly used accounting methods are the cash method and the accrual method.