Chapter 6Chapter 6

Taxable Income from Taxable Income from Business OperationsBusiness Operations

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

ObjectivesObjectives

• Describe the relationship between business operating cycle and taxable year

• Identify the permissible methods of accounting for tax purposes

• Explain why tax policy objectives affect the taxable income computation

• Apply the cash method of accounting to compute taxable income

• Contrast the principles of conservatism reflected by GAAP and by the tax law

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Objectives (continued)Objectives (continued)

• Differentiate between a permanent and a temporary book/tax difference

• Explain the difference between tax expense per books and tax payable

• Apply the tax accounting rules for prepaid income and accrued expenses

• Explain how the NOL deduction smooths taxable income over time

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Taxable IncomeTaxable Income

• Taxable income = gross income less allowable deductions• Gross income “means all income from whatever source

derived”

• Deductions are allowed by legislative grace and include “all ordinary and necessary expenses … in carrying on any trade or business”

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Taxable IncomeTaxable Income

• Good rule of thumb: • Receipts are taxable unless a specific rule states that the

receipt is nontaxable • Expenses are deductible only if a specific rule states that

the expense is deductible

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Taxable YearTaxable Year

• A taxable year is generally the 12-month period corresponding to a firm’s fiscal year • Individuals generally use a calendar year• Firms generally choose a tax year that reflects

their annual operating cycle

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Taxable Year ExamplesTaxable Year Examples

• Discuss the choice of a taxable year for the following businesses:

• Retail plant and garden center

• French bakery

• Chimney cleaning business

• Moving and transport business

• Software consulting business

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• A new business establishes its taxable year by filing an initial tax return based on such year

• Changing tax years requires IRS permission • The first return after the change may reflect a short period

of less than 12 months• The taxable income reported on the short-period return

must be annualized – mathematically inflated to reflect 12 months of business operations

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Taxable YearTaxable Year

• Example:Acme had a fiscal year ending on June 30. It changed to a year ending September 30. For the three months ended 9/30, Acme earned $25,000 income

• Annualized income = $100,000 [($25,000/3) × 12]

• Tax on $100,000 = $22,250

• Tax for 3-month short period = $5,563 [($22,250/12) × 3]

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Tax Methods of Accounting Tax Methods of Accounting

• A overall tax accounting method determines the year in which a taxpayer recognizes items of income, gain, deduction, and loss

• The Internal Revenue Code (IRC) permits firms to use the following accounting methods:• Cash• Accrual• Combined (hybrid)

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Tax Methods of AccountingTax Methods of Accounting

• Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to clearly reflect the income of each • Huge issue in international taxation• More discussion in Chapter 13

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Methods of Accounting: Policy ObjectivesMethods of Accounting: Policy Objectives

• Public policy• No deduction for fines, political contributions

• Why?• Congress doesn’t want to subsidize bad

behavior with a tax deduction or finance the lobbying efforts of special interest groups

• Only 50% of meal and entertainment expense is deductible• Why?• Lavish meals and entertainment involve more pleasure than

business and should not be subsidized with federal tax dollars

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Methods of Accounting: Policy ObjectivesMethods of Accounting: Policy Objectives

• Economic incentives• State and local bond interest income is tax-exempt (and

related expenses are nondeductible)• Why?• To help local governments raise funds by lowering the cost of

capital

• Businesses can write-off equipment faster for tax purposes than GAAP useful life• Why?• To encourage firms to make capital investments

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Cash MethodCash Method

• Under the cash method, gross income includes cash or property actually received during the tax year – regardless of when the sale occurred or services were provided

• Deductions are usually taken in the year cash or property is paid – regardless of when the expense was incurred

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Cash MethodCash Method

• A CPA receives free automobile repair work in exchange for preparing the mechanic’s tax return

• Does the CPA recognize income under the accrual method of accounting?• Yes – services have been provided and income has been

earned

• What if the CPA uses the cash method of accounting?• Yes – cash method income includes the receipt of non-

cash goods or services

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Cash Method IncomeCash Method Income

• Constructive receipt of income• Occurs when taxpayer has unrestricted access to and

control of the income – even if not in the taxpayer’s actual possession

• No constructive receipt exists if the income is available only on surrender of a valuable right or if there are substantial barriers to receipt

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Cash Method IncomeCash Method Income

• A calendar year, cash basis firm wants to defer income from this year to next year. Can it defer income recognition if:• It holds the checks received from customers in December

in its vault and does not cash them until January?• No – the income has been constructively received

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Cash Method DeductionsCash Method Deductions

• Cash method - deduct expenses when paid. A check is paid on the date it is mailed

• When does it make sense for a cash basis firm to pay an expense early?• When the tax savings from the deduction are greater than

the opportunity cost of the early payment

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Capital ExpendituresCapital Expenditures

• If an expenditure results in a benefit that extends beyond 12 months, the expenditure is capitalized to an asset account • The cost of the asset may be recovered over time

(through depreciation, amortization, or cost of goods sold)

• Major repairs may result in a dispute with the IRS concerning deduction versus capitalization

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Cash Method Deductions - InventoryCash Method Deductions - Inventory

• Inventory must be accounted for on the accrual method, even for cash basis taxpayers

• Hybrid method of accounting• Purchases and sales of inventories are accounted for

under the accrual method and all other transactions are accounted for under the cash method

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Limitations on Corporations Using Cash MethodLimitations on Corporations Using Cash Method

• Corporations that average more than $5 million in annual gross receipts can’t use the cash method• Prohibition applies to partnerships with a corporate

partner

• Personal service corporations(providing professional services such medical, legal, and accounting services) may use the cash method

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Accrual Method of AccountingAccrual Method of Accounting

• Under the accrual method, taxpayers recognize income when the right to the income is fixed and the amount of income can be determined with reasonable accuracy

• Taxpayers deduct expenses when all events have occurred that establish the fact of the liability for the expense and the amount of the liability can be determined with reasonable accuracy

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Book-Tax DifferencesBook-Tax Differences

• Financial accounting (GAAP) and tax accounting reflect contrasting principles of conservatism• GAAP seeks to protect shareholders and creditors: Don’t

overstate book income• Tax law seeks to protect government revenues: Don’t

understate taxable income

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Permanent Book-Tax DifferencesPermanent Book-Tax Differences

• Permanent differences between book income and taxable income do not reverse in future years

• Examples • Tax-exempt interest on state and local bonds• Key-person life insurance premiums and proceeds• 50% nondeductible meals and entertainment• Political contributions• Fines and penalties• Domestic production activities deduction

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Temporary Book-Tax DifferencesTemporary Book-Tax Differences

• Temporary differences occur when an item of income or expense is taken into account in a different year (or years) for book purposes than for tax purposes

• Examples• Depreciation and amortization• Receipt of prepaid income• Accrued expenses that fail the all-events test• Net capital losses• Bad debts (allowance vs. direct write-off)

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Favorable or Unfavorable DifferencesFavorable or Unfavorable Differences

• A permanent or temporary difference that causes an excess of book income over taxable income is described as favorable

• A permanent or temporary difference that causes an excess of taxable income over book income is described as unfavorable

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Tax Expense per Books Versus Tax PayableTax Expense per Books Versus Tax Payable

• Tax expense per books is based on book income adjusted for all permanent book/tax differences

• Tax payable is based on taxable income• Temporary differences increase or decrease the

firm’s deferred tax assets and liabilities• Favorable differences increase deferred tax liabilities (or

decrease deferred tax assets)• Unfavorable differences increase deferred tax assets (or

decrease deferred tax liabilities)

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ExampleExample

• ABC Company earned $100,000 operating income and $2,000 municipal bond interest this year. ABC purchased an asset for $20,000 which it expensed and deducted for tax purposes but capitalized for book purposes. Book depreciation was $5,000. ABC’s tax rate is 35%

• Compute ABC’s book and tax income

• Compute ABC’s tax expense per books and tax payable

• Determine the change in ABC’s deferred tax accounts for the year

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SolutionSolution

• Book income = $97,000 ($100,000 operating income + $2,000 interest - $5,000 depreciation)

• Taxable income = $80,000 ($100,000 operating income - $20,000 deduction)

• Tax expense per books = $33,250 (35% × $95,000 (book income - $2,000 favorable permanent difference for tax-exempt interest))

• Tax payable = $28,000 (35% × taxable income)

• $5,250 excess of tax expense over tax payable = increase in deferred tax liability

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Temporary Differences: Prepaid IncomeTemporary Differences: Prepaid Income

• Prepaid income may be taxed when received even though it has not been earned• Prepaid (unearned) income is not included in book income• Common examples are prepaid rent and prepaid interest

• Creates an unfavorable temporary book/tax difference resulting in a deferred tax asset

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Prepaid Income ExamplePrepaid Income Example

• Acme, an accrual basis, calendar year taxpayer, received a $12,000 prepayment of four months’ rent from a tenant. The rent was for December of this year and January through March of the next year.

• How much book income does Acme report this year?

• Acme reports $3,000 rent income (December rent)

• How much taxable income does Acme report this year?

• Acme reports $12,000 taxable income

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One-Year Rule for Prepaid Service IncomeOne-Year Rule for Prepaid Service Income

• Prepayments for future services to be rendered to clients or customers are accounted for under a special one-year deferral method• The prepayment for services rendered in the year of

receipt is taxable in that year• The remaining payment is taxable in the following year

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Temporary Differences: Accrued ExpensesTemporary Differences: Accrued Expenses

• An accrued expense is deductible only if it passes the all events test:• All events that establish the liability have occurred• The amount must be determinable with reasonable

accuracy• Economic performance with respect to the liability has

occurred

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Economic PerformanceEconomic Performance

• Liability relating to the provision of services, property or the use of property to the taxpayer by another party:• Economic performance occurs when the other party

provides the services, property, or use of property

• Liability relating to the provision of services or property by the taxpayer to another party:• Economic performance occurs when the taxpayer

provides the services or property

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Economic Performance – Payment Liabilities Economic Performance – Payment Liabilities

• The economic performance requirement defers the deduction until payment is made for accrued:• Legal settlements for workers compensation, tort, breach

of contract• Customer rebates/refunds • Awards, prizes, jackpots• Taxes imposed by a governmental authority

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Recurring Item Exception Recurring Item Exception

• Taxpayers may adopt the recurring item exception as a method of accounting for:• Liabilities routinely incurred from year to year and properly

accrued under GAAP• Economic performance occurs within 8½ months after

year-end

• Taxpayer may deduct the corresponding expense in the year of accrual

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Accrued Expense ExampleAccrued Expense Example

• ABC Company has two accrued expenses at year end• December’s utility bill to be paid in 30 days• Estimated legal settlement under workers compensation

claim

• Which accrual can be deducted on the current year tax return?• Accrued utility expense

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Special Accrual RulesSpecial Accrual Rules

• Compensation accruals• Employer cannot deduct expense unless compensation

paid within 2½ months after the close of year

• Related party accruals• The payer can’t deduct an accrued expense until the year

that the recipient recognizes income

• Bad debt expense• GAAP requires the allowance method• For tax purposes, the direct write-off method is required

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Net Operating Loss (NOL)Net Operating Loss (NOL)

• An excess of deductible business expenses over gross income is a net operating loss (NOL)

• An NOL yields no current tax savings but may be deductible in an earlier or later tax year• NOLs can be carried back two years

• Carryback deduction generates tax savings in the form of a refund of prior year tax

• Taxpayers can elect to give up this carryback

• NOLs can be carried forward 20 years• Carryforward generates only future tax savings

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Accounting for NOLsAccounting for NOLs

• An NOL results in a negative tax expense (tax benefit) for book purposes but no current tax refund• This book/tax difference results in a deferred tax asset

equal to the expected future tax savings from the NOL carryforward

• The deferred tax asset will reverse in future years when taxable income (but not book income) is reduced by the NOL carryforward deduction

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