Posted by JHyre in Ohio on October 01, 2001 at 20:38:02:
is less accrual vs. cash accounting and more GAAP vs. tax accounting. Jim described cash method for tax purposes. Frank described GAAP (Generally Accepted Accounting Principles) accrual. Which is correct depends upon the context…Jim is answering the tax question, Frank the literal Acoounting 101 question.
Point of trivia: The portion of the return where GAAP books are reconciled with tax accounting is “Schedule M”…the translation of Frank’s “book” entries into Jim’s “tax accounting” is known as “the M-1 adjustment” or just “M adjustment” in tax geek parlance. Most small investors keep their books according to tax, and not GAAP, principles…there are no public investors to report to, so why pay guys like me extra to make the “M adjustments”? I like the money, but the adjustments themselves are quite tedious.
Accounting 101 - don’t laugh. - Posted by Marc Donovan
Posted by Marc Donovan on September 29, 2001 at 19:53:46:
How do I account for option premiums?
Its an asset right?
If someone gives me a check for an option premimium, I debit my checking account (increasing the balance since its an asset) and then credit the option premium account. But this reduces the assets. So that’s not right…
Or is it a liabilty until the option is exercised?
Im really confused. I hate this part of the business. I need to hire a fuill time CPA.
Posted by Frank Chin on September 30, 2001 at 07:00:58:
Hi Marc:
I assume you’re talking about a L/O where you collected an option premium and the lessee has a period in which he can excercise the option.
After the lease is signed, you have earned the option premium. You don’t refund it whether he excercises the option or not. So its not a liability. In this case:
Debit “Cash”
Credit “Premium Income”
Rent credits on the other hand are different. That’s a liablity due the lessee upon excercise of the option. When receiving the monthly payment, you got:
Posted by JPiper on September 30, 2001 at 11:36:16:
Frank:
I?d have to disagree with some of this.
The ?option premium? or option consideration is actually an ?unearned revenue?. It?s not ?earned? until the option is either exercised or expires, the point at which the income is realized. Even the IRS acknowledges that ?option consideration? is not taxable until the option either expires or is exercised. The fact that it is non-refundable (a legal concept) should be distinguished from when it is earned (an accounting concept).
Therefore, the proper accounting treatment (as is the case with all unearned revenues) is to set a liability account up called ?unearned option consideration?, or perhaps ?unearned option revenue?. The entry then would be?..debit cash, credit unearned option consideration (a liability account).
If the option expires the entry would be?.debit unearned option consideration, credit option revenue (or some other income account).
If the option is exercised it would be an adjustment to your cost basis?.debit unearned option consideration, credit property (the property asset account).
Posted by Frank Chin on September 30, 2001 at 18:32:24:
Hi Jim:
Thanks, you raised a good point.
Are we talking “Cash Accounting” or “Accrual Accounting” here?
I do most of my business under “Cash Accounting”, and recognize income when cash is received.
I agree with you here if the “Accrual Method” is used. In this case, I wonder if the “unearned revenue” is recognized monthly, and not just goes from unearned to earned at the point of expiration?
In other words, for a two year option, would 1/24th of the unearned premium be recognized as earned per month?
Posted by JPiper on September 30, 2001 at 19:59:48:
I’m a cash basis taxpayer as well. And, I have taken Accounting 102…35 years ago. LOL.
I can’t think of any conflict with accounting for option consideration in the manner I described. The IRS doesn’t require taxes to be paid until the option is exercised or expires…so therefore they don’t require it to be recognized as income…even if you’re a cash basis taxpayer.
I think this is comparable in some ways to a security deposit. I debit cash, credit security deposits…a liability account. According to my lease, a tenant would lose the security deposit if he left prior to the end of a lease. If that were the case, I would debit security deposit, credit rental income at that time. Certainly I don’t do it before hand though, because I don’t know how to account for it.
Same thing with option consideration. It’s a liability to me when I receive it…not income. I might eventually “earn” it if it expires. On the other hand, it may become an adjustment to cost basis if it is exercised. This isn’t “income” per se…it just lowers the cost basis which is then subtracted from the gross sales proceeds. It all comes out in the wash, but again it’s not income, but rather an adjustment to cost basis.
Besides, that’s how my CPA told me to do it! LOL.
You wouldn’t prorate the option consideration either. It isn’t earned until it expires.