Understanding Financial Statements in Light of Wildfire Relief and IRS Audits

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A historic wildfire has devastated Los Angeles. In response, the federal government, the state of California, and LA County authorities have announced relief measures, including extended tax deadlines for affected individuals. According to the IRS, tax filing and payment deadlines for residents impacted by the wildfire have been extended to October 15. This is part of a broader effort to alleviate financial burdens for those affected by the disaster.

The IRS extension covers 2023 individual income tax returns normally due by April 15, as well as contributions to Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs). Additionally, quarterly estimated tax payments originally due on January 15, April 15, June 15, and September 15 are also included in the relief. Businesses with tax deadlines during this period will likewise benefit from these extensions.

IRS Audits: How Methods Vary by Business Type and Accounting Approach

IRS audits differ depending on a business’s structure, industry, and accounting method. The two primary accounting methods are cash basis and accrual basis. The choice of method affects how income and expenses are recognized, and ultimately, how taxable net income is calculated.

1. Overview

Businesses generate revenue by providing goods or services to customers. In doing so, they incur various expenses. However, when artificially dividing the fiscal year into reporting periods, it may be difficult to objectively match revenue and expenses to the appropriate period. Thus, two major accounting methods are used to recognize revenue and expenses: cash basis and accrual basis.

(1) Cash Basis Accounting

Revenue is recognized when cash is received, and expenses are recognized when cash is paid. In other words, income and expenses are reported in the period in which actual cash transactions occur. This method is commonly used by small service-based businesses but can distort a company’s financial performance and position.

(2) Accrual Basis Accounting

Accrual accounting recognizes income and expenses when they are earned or incurred, regardless of when cash is received or paid. Revenue is recorded when it is earned and realized, while expenses are recognized in the same period as the related revenue. This method provides a more accurate reflection of financial performance.

2. Cash Flow Statement

(1) Definition and Purpose

While the income statement and balance sheet show a company’s profitability and financial position, they do not fully explain changes in cash flow—an essential indicator of financial health. The cash flow statement explains the movement of cash and cash equivalents during a period. Cash, in this context, includes currency, checks, and demand deposits such as checking and savings accounts.

(2) Components

The cash flow statement consists of three sections: operating activities, investing activities, and financing activities. It shows how cash is generated and used in each area:

• 1) Cash Flow from Operating Activities:Includes cash transactions related to the company’s primary revenue-generating operations, such as production, sales, and services. Under accounting standards, any transactions not classified as investing or financing activities are generally considered part of operating activities. These are closely linked to net income as shown on the income statement.

• 2) Cash Flow from Investing Activities:Represents cash flows from buying or selling long-term assets and investments. Inflows may include proceeds from sales of property, equipment, or marketable securities. Outflows include expenditures for acquiring investments, property, equipment, or intangible assets.

• 3) Cash Flow from Financing Activities:Covers cash movements related to borrowing, repaying debt, issuing equity, or distributing dividends. Inflows include proceeds from loans, bond issuances, or stock sales. Outflows include loan repayments and dividend payments.
  

Understanding how financial statements reflect tax obligations is especially critical in times of natural disaster or IRS scrutiny. Accurate accounting and timely reporting not only fulfill legal responsibilities but also enable access to vital relief measures when needed.

Contact: Phone: (213) 384-1189 / Email: dwcracpa15@gmail.com

By Douglas Chong, CPA / Former IRS Revenue Agent