Question

Q1-A. Earlier this year, Wally Wizard, whose regular job is as a manager of a video arcade, started a new part-time business, purchasing, reconditioning, and selling used pinball machines, operating out of his basement. During the year, Wally purchased twenty machines for $1,000 each, spent $1500 for parts and labor to recondition each machine, and delivered twelve of the machines to customers at a price of $5,000 each. As of December 31, he had been paid for eight of the machines. Wally, who is a calendar-year, cash method taxpayer, has requested your advice regarding how he should report the receipts and expenses incurred in his pinball machine business on his tax return.

Please advise Wally and explain how his tax consequences will differ depending on whether he continues to use the cash method and if he should change to the accrual method.

B. How would your advice be different if Wally had paid $500 for five of the pinball machines in January, $1,000 for 10 of the pinball machines in July, and $1,500 for five of the pinball machines in September, incurred the same $1,500 expense per machine for reconditioning, and used FIFO inventory method? Assume Wally is using the accrual method of accounting.

C. How would your answer be to part to be different if Wally used LIFO?

D. Is there any other method other than LIFO or FIFO available to Wally?

Answer 1

Sub Part (A)

Taxable income under Cash Method = ($5000*8) - (20*$1000) - (20*1500) = Loss of $10000

Taxable Income under Accrual Method = $(5000-1000-1500)*12 = Gain of $30000

It is advised to follow accrual method

Sub Part (B)

Using FIFO Method,

Taxable Income under Accrual Method = (12*5000) - (5*500) - (7*1000) - (12*1500) = Gain of $32500

Sub Part (C)

Using LIFO Method,

Taxable Income under Accrual Method = (12*5000) - (5*1500) - (7*1000) - (12*1500) = Gain of $27500

Sub Part (D)

Yes, it is Weighted Average cost method wherein cost is averaged among all units.