tax chp 1
TRANSCRIPT
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Chapter 01 - Business Income, Deductions, and Accounting Methods
Chapter 1
Business Income, Deductions, and Accounting Methods
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] hat is an !ordinar" and necessar"# $usiness e%penditure&
Ordinary and necessary imply that an expense must be customary and helpful,
respectively. Because these terms are subjective, the tests are ambiguous. However,
ordinary is interpreted by the courts as including expenses which may be unusual for a
specific taxpayer but not for that type of business! and necessary is not interpreted as
only essential expenses. "hese limits can be contrasted with the reasonable limit on
amounts and the bona fide re#uirement for profit motivation.
'. [LO 1] Is cost o( goods so)d deducti$)e as a $usiness e%pense (or a $usiness se))ing
in*entor"& +%p)ain.
$o. %nder the return of capital principal, cost of goods sold represents a reduction in
gross income rather than a business expense. &or example, if a taxpayer sells
inventory for '()),))) and reports a cost of goods sold of '*),))), the business+s
gross income is '),))) '()),))) - *),)))! not '()),))).
. [LO 1] om is an attorne" ho o(ten represents indi*idua)s in/ured hi)e oring
orer )ia$i)it" c)aims2. his "ear -om spent 340 on a $oo entit)edlumbing &or
/ummiesand paid 3400 to tae a course on p)um$ing residences and renta) housing.
Can "ou imagine circumstances in hich these e%penditures ou)d $e deducti$)e as
!ordinar" and necessar"# (or an attorne". +%p)ain.
Ordinary and necessary imply that an expense must be customary and helpful,
respectively. Because these terms are subjective, the tests are ambiguous. However,
ordinary is interpreted by the courts as including expenses which may be unusual for a
specific taxpayer but not for that type of business! and necessary is not interpreted as
only essential expenses. "om may represent a plumber and incurred this expenditure
so he can better understand and explain how his client was injured on the job. 0n this
case, the expenses would be both ordinary and necessary to "om+s practice as an
attorney, and therefore deductible.
5. [LO 1] 6ae is a pro(essiona) dog trainer ho purchases and trains dogs (or use $" )aen(orcement agencies. Last "ear 6ae purchased 400 $ags o( dog (ood (rom a )arge pet
(ood compan" at an a*erage cost o( 30 per $ag. his "ear, hoe*er, 6ae purchased
400 $ags o( dog (ood (rom a )oca) pet (ood compan" at an a*erage cost o( 354 per $ag.
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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Chapter 01 - Business Income, Deductions, and Accounting Methods
)ie)" cha))enge the cost 6ae?s dog (ood as
unreasona$)e&
1easonableness is an issue of fact and circumstance, and extravagance is difficult to
determine definitely. However, a common test for reasonableness is whether the
expenditure is comparable to an arm2s length amount - a price charged by objective
unrelated! individuals who do not receive any incidental personal benefits.
1easonableness is most li3ely to be an issue when a payment is made to a related
individual or the taxpayer enjoys some personal benefit incidental to the expenditure.
Hence, the 014 is most li3ely to challenge the cost of the dog food if 5a3e or his family
controlled the local pet food company.
4. [LO '] hat inds o( deductions are prohi$ited as a matter o( pu$)ic po)ic"& h"
might Congress deem it important to disa))o deductions (or e%penditures against
pu$)ic po)ic"&
"he 016 lists bribes, 3ic3bac3s, and other illegal payments as nondeductible.6ongress didn+t want the tax benefits associated with deductions to benefit or subsidi7e
wrongdoing. Of course, this rationale doesn+t really explain the prohibition against
deducting political contributions which is probably better explained by the potential
perception that political efforts are being subsidi7ed by taxpayers.
@. [LO '] ro*ide an e%amp)e o( an e%pense associated ith the production o( ta%-e%empt
income, and e%p)ain hat might happen i( Congress repea)ed the prohi$ition against
deducting e%penses incurred to produce ta%-e%empt income.
"wo common examples are interest expense associated with debt used to purchase
municipal bonds and life insurance premiums paid on 3ey man insurance. 0f thisprohibition were repealed, then taxpayers would have an incentive to borrow to invest
in municipal bonds or borrow to invest in employee life insurance. "his former
practice would lead to higher demand for municipal bonds less yield! and less
revenue for the government. "he latter practice would lead to higher demand for
insurance higher premiums8! and less revenue for the government. Both practices
could lead to a perception of ine#uity between those taxpayers able to utili7e the tax
arbitrage to reduce taxes and those who could not use the practice.
. [LO '] =esearch 6err" is a se)(-emp)o"ed roc star and this "ear he e%pended 31,000
on specia) !()ash"# c)othes and out(its. 6err" ou)d )ie to deduct the cost o( these
c)othes as or-re)ated $ecause the c)othes are not accepta$)e to 6err"?s sense o((ashion.
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Chapter 01 - Business Income, Deductions, and Accounting Methods
uniforms or protective garments and could be deductible. 4ee /. "echner, "6 9emo
(::;rhard 4eminar "raining, "6 9emo (:=
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purposes plus depreciation on the business portion ?? percent! of the vehicle+s tax
basis. lternatively, in lieu of deducting these costs, 5enny may simply deduct a
standard amount for each business mile she drives. "he standard mileage rate
represents the per
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15. [LO ] +%p)ain h" the domestic production acti*ities deduction is sometimes
descri$ed as an !arti(icia)# e%pense and the apparent rationa)e (or this deduction. 9o
might a $usiness $egin to determine the domestic portion o( re*enues and e%penses (or
products that are assem$)ed in the tates (rom parts made o*erseas&
"he // is designed to reduce the tax burden on domestic manufacturers to ma3e
investments in domestic manufacturing facilities more attractive. 0t is artificial
because it does not represent an expenditure per se, but merely serves to reduce the
income taxes the business must pay and thereby increase the after
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total amount of start
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depends on whether the business is a sole proprietorship, a flow
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based upon the same matching principle, expenditures should be recogni7ed in the
period that revenues are generated. "he proposition to expense all business
expenditures is usually defended on the grounds of simplification, encouraging capital
investment, and lac3 of bias at least over the long run! and critici7ed on the grounds
of potential economic bias at least in the short run! and revenue loss by thegovernment.
'4. [LO 4] Descri$e the 1'-month ru)e (or determining hether and to hat e%tent
$usinesses shou)d capita)i:e or immediate)" deduct prepaid e%penses such as insurance
or securit" contracts. +%p)ain the apparent rationa)e (or this ru)e.
business expenditure or business liability may be immediately deducted rather than
capitali7ed! if the expenditure or liability relates to a business expense where the
contract period (! does not last more than a year and @! does not extend beyond the
end of the taxable year following the tax year in which the taxpayer ma3es the
payment. "he rule could be rationali7ed as an attempt to simplify the deduction forexpenditures that merely span tax years and would not li3ely result in material
differences in taxable income should the expenditure be capitali7ed across both
periods.
'@. [LO 4] +%p)ain h" Congress sometimes mandates that $usinesses use particu)ar
accounting methods hi)e other times Congress is content to reHuire $usinesses to use
the same accounting methods (or ta% purposes that the" use (or (inancia) accounting
purposes.
"he natural tension between financial reporting incentives and tax reporting incentives
may be the reason the tax laws indicate that as a general rule businesses must use the
same accounting methods for tax purposes that they use for financial accounting
purposes. "hat is, businesses want to accelerate boo3 income or delay taxable
income! are also re#uired to accelerate taxable income or delay financial income !.
"hus, using the same method for both tends to neutrali7e incentives to stretch numbers
in one direction or the other. 6ongress specifies that businesses are re#uired to use
other, presumably more appropriate, accounting methods for tax purposes when
financial accounting methods do not clearly reflect income for tax purposes or when
dictated by policy or administrative concerns.
'. [LO 4] h" is it not surprising that speci(ic ru)es di((er $eteen ta% accounting and
(inancia) accounting&
"ax policy objectives often differ from the objectives motivating financial accounting
rules. "ax accounting attempts to maximi7e revenue for the government while financial
accounting attempts to minimi7e overstatements that might mislead investors and
creditors. Hence, for policy and administrative reasons, the tax laws identify several
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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circumstances when businesses must use specific tax accounting methods to determine
taxable income no matter what accounting method they use for financial reporting
purposes.
'E. [LO 4] Gred is considering using the accrua) method (or his ne%t $usiness *enture.
+%p)ain to Gred the conditions (or recogni:ing income (or ta% purposes under the
accrua) method.
taxpayer must recogni7e income if (! all the events have occurred that are
necessary to fix the right to receive a payment and @! the amount of the payment can
be determined with reasonable accuracy.
'F. [LO 4] Descri$e the a))-e*ents test (or determining income and descri$e ho to
determine the date on hich the a))-e*ents test has $een met.
"he all events test re#uires a taxpayer to recogni7e income if the taxpayer has a fixed
right to receive a payment and the amount of the payment can be determined with
reasonable accuracy. "he all events test is typically met on the earliest of the
following three datesG (! the date the business provides the service or transfers goods,
@! the date payment is due, or ! the date payment is received.
0. [LO 4] Compare and contrast the ta% treatment (or renta) income recei*ed in ad*ance
and ad*ance pa"ments (or ser*ices.
&or tax purposes, businesses must immediately recogni7e prepaid rental or interest
income it is recogni7ed before it is earned!. "he all
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end of the year of receipt, if the prepayment was included in financial reporting
income, or if the prepayment was for interest or rent taxpayers must recogni7e
prepaid interest and rental income on receipt!. Fhen an accrual basis business
receives an advance payment for goods it will provide to customers in the future, the
business may account for the prepayment for tax purposes under the full
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6ongress enacted these rules primarily for two reasons. &irst, the rules accelerate tax
revenues for the government by deferring deductions for the capitali7ed costs until the
business sells the associated inventory. 4econd, 6ongress enacted these uniform
rules to reduce variation in the costs businesses include in inventory.
5. [LO 4] Compare and contrast (inancia) accounting ru)es ith the ta% ru)es under
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. [LO 4] Descri$e hen economic per(ormance occurs (or the (o))oing e%pensesJ
orer?s compensation,
=e$ates and re(unds
Insurance, arranties, and ser*ice contracts pro*ided tothe $usiness
a%es
For3er+s compensation, rebates, refunds, and service contracts are payment liabilities
and economic performance occurs upon payment regardless of actual performance.
"axes are also payment liabilities, but under 4ection *( accrual
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n accrual
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Problems
54. [LO 1] Mann" hired his $rother?s (irm to pro*ide accounting ser*ices to his $usiness.
During the current "ear, Mann" paid his $rother?s (irm 3E',000 (or ser*ices e*en
though other (irms ere i))ing to pro*ide the same ser*ices (or 350,000. 9o much
o( this e%penditure, i( an", is deducti$)e as an ordinar" and necessar" $usiness
e%penditure&
Only reasonable amounts of compensation are deductible '*),)))!, and the
remainder would be reclassified probably as a gift to his brother.
5@. [LO 1, '] Indicate the amount i( an"2 that Michae) can deduct as ordinar" and
necessar" $usiness deductions in each o( the (o))oing situations and e%p)ain "our
so)ution.
a. Grom time to time, Michae) rents a dump truc (or his $usiness. hi)e hau)ing
gra*e) to a /o$ site, Michae) as stopped (or speeding. 9e paid a (ine o( 31'4 (or
speeding and a (ine o( 3E0 (or carr"ing an o*ereight )oad.
$. Michae) paid a part-time emp)o"ee 340 to dri*e his rented dump truc. Michae)
reim$ursed the emp)o"ee 34 (or gaso)ine (or the truc.
c. Michae) ga*e a mem$er o( the cit" counci) a ne atch, hich cost 3'00. 9e
hopes that the cit" counci)man i)) !thro# some contracts to his $usiness.
a. $o deduction for fines.b. ';=? deduction.
c. $o deduction for bribes against public policy!.
5. [LO 1, '] Indicate the amount i( an"2 that 6osh can deduct as ordinar" and necessar"
$usiness deductions in each o( the (o))oing e%penditures and e%p)ain "our so)ution.
a. 6osh $orroed 340,000 (rom the Girst >tate Ban using his $usiness assets as
co))atera). 9e used the mone" to $u" Cit" o( B)ans*i))e $onds. O*er the course
o( a "ear, 6osh paid interest o( 35,'00 on the $orroed (unds, $ut he recei*ed
3,400 o( interest on the $onds.
$. 6osh purchased a piece o( )and (or 354,000 in order to get a )ocation to e%pand
his $usiness. 9e a)so paid 3,'00 to construct a ne dri*ea" (or access to the
propert".
c. his "ear 6osh paid 314,000 to emp)o" the ma"or?s son in the $usiness. 6osh
ou)d t"pica))" pa" an emp)o"ee ith these responsi$i)ities a$out 310,000 $ut
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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the ma"or assured 6osh that a(ter his son as hired, some cit" $usiness ou)d $e
coming his a".
d. 6osh paid his $rother, a mechanic, 3,000 to insta)) a ro$otic machine (or 6osh?s
$usiness. he amount he paid to his $rother is compara$)e to hat he ou)d
ha*e paid to an unre)ated part" to do the same or. Once the insta))ation as
comp)eted $" his $rother, 6osh $egan ca)i$rating the machine (or operation.
9oe*er, $" the end o( the "ear, he had not started using the machine in his
$usiness.
a. '). "he interest expense is not deductible expense associated with tax
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c. ') is deductible. "he cost of entertainment that occurs in a setting with little
possibility of conducting a business discussion, such as a theater or sports venue,
will only be deductible if the entertainment directly precedes or follows a
substantive business discussion. 0n this situation, they did not have any business
discussions so 1alph is not allowed to deduct any of the costs.
d. '@? is deductible ?)A of dinner and theatre!. Business associates are
individuals who the taxpayer reasonably expects to do business with such as
customers, suppliers, employees, or advisors.
5F. [LO '] Me)issa recent)" paid 3500 (or round-trip air(are to >an Grancisco to attend a
$usiness con(erence (or three da"s. Me)issa a)so paid the (o))oing e%pensesJ
3'40 (ee to register (or the con(erence,300 per night (or three night?s )odging,
3'00 (or mea)s, and
3140 (or ca$ (are.
a. hat amount o( the tra*e) costs can Me)issa deduct as $usiness e%penses&
$. >uppose that hi)e Me)issa as on the coast, she a)so spent to da"s sightseeing
the nationa) pars in the area. o do the sightseeing, she paid 31,000 (or
transportation, 3E00 (or )odging, and 3540 (or mea)s during this part o( her trip,
hich she considers persona) in nature. hat amount o( the tra*e) costs can
Me)issa deduct as $usiness e%penses&
c. >uppose that Me)issa made the trip to >an Grancisco primari)" to *isit the
nationa) pars and on)" attended the $usiness con(erence as an incidenta) $ene(it
o( $eing present on the coast at that time. hat amount o( the air(are can
Me)issa deduct as a $usiness e%pense&
d. >uppose that Me)issa?s permanent residence and $usiness as )ocated in >an
Grancisco. >he attended the con(erence in >an Grancisco and paid 3'40 (or the
registration (ee. >he dro*e 100 mi)es o*er the course o( three da"s and paid 3F0
(or paring at the con(erence hote). In addition, she spent 3140 (or $rea(ast and
dinner o*er the three da"s o( the con(erence. >he $ought $rea(ast on the a" to
the con(erence hote) and she $ought dinner on her a" home each night (rom thecon(erence. hat amount o( these costs can Me)issa deduct as $usiness
e%penses&
a. 4ince business was the primary reason for the trip, 9elissa can deduct '(,=)) of
travel costs L'@?) registration M '*)) M ':)) M ?)AN'@))! M '(?)
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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b. $one of the costs of sightseeing is deductible. However, because her primary
purpose for the trip appears to be business days business vs. @ days personal!
she is allowed to deduct her airfare to 4an &rancisco and her other expenses in
part a. relating to the business portion of the trip.
c. 0f the purpose of the trip is primarily personal, then none of the air fare is
deductible and only those direct costs associated with the conference '(,*))!
can be deducted the registration, lodging, ?) percent of the meals, and cab
fare!.
d. 9elissa would be allowed to deduct the registration fee for the conference of
'@?) and she could deduct ?.? cents per mile for the ()) miles she drove to and
from the conference '?.?! and the par3ing fee of ':). However, because her
travel did not re#uire her to be away from home overnight, she is not allowed to
deduct the cost of her meals going to and coming from the conference each day.
40. [LO '] Kim$er)" is a se)(-emp)o"ed ta%pa"er. >he recent)" spent 31,000 (or air(are to
tra*e) to Ita)". hat amount o( the air(are is deducti$)e in each o( the (o))oing
a)ternati*e scenarios&
a. 9er trip as entire)" (or persona) purposes.
$. On the trip, she spent eight da"s on persona) acti*ities and to da"s on $usiness
acti*ities.
c. On the trip, she spent se*en da"s on $usiness acti*ities and three da"s on
persona) acti*ities.
d. 9er trip as entire)" (or $usiness purposes.
a. ') since the sole purpose of the trip was for personal purposes.
b. ') since the primary purpose of the trip appears to be personal.
c. ';)) '(,))) x ;C()!. 4ince the primary purpose of the trip appears to be
business, she may deduct the portion of the airfare allocated to the business trip
prorated because this is foreign travel!. %sing the number of days of business
activities to total days of travel, she may deduct ;) percent ;C()ths! of the costconversely, she may not deduct ) percent C()ths! of the cost.
d. '(,))) since the sole purpose of the trip is business, she may deduct the entire
airfare.
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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41. [LO '] ="an is se)(-emp)o"ed. his "ear ="an used his persona) auto (or se*era) )ong
$usiness trips. ="an paid 31,400 (or gaso)ine on these trips. 9is depreciation on the
car i( he as using it (u))" (or $usiness purposes ou)d $e 3,000. During the "ear, he
dro*e his car a tota) o( 1',000 mi)es com$ination o( $usiness and persona) tra*e)2.
a. ="an can pro*ide ritten documentation o( the $usiness purpose (or trips tota)ing
,000 mi)es. hat $usiness e%pense amount can ="an deduct i( an"2 (or these
trips&
$. ="an estimates that he dro*e appro%imate)" 1,00 mi)es on $usiness trips, $ut he
can on)" pro*ide ritten documentation o( the $usiness purpose (or trips tota)ing
E'0 mi)es. hat $usiness e%pense amount can ="an deduct i( an"2 (or these
trips&
a. 1yan can claim the direct cost of these trips, including gas '(,?))! anddepreciation on the auto. However, the deduction for auto use is limited todirect costs such as gas and oil! and the pro
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c. 3@00 (or o((ice supp)ies in Ma" o( this "ear. 9e used ha)( o( the supp)ies this
"ear and he i)) use the remaining ha)( $" Ge$ruar" o( ne%t "ear.
d. 3540 (or se*era) pair o( or $oots. Christopher e%pects to use the $oots a$outE0 percent o( the time in his $usiness and the remainder o( the time (or hiing.
Consider the $oots to $e a (orm o( c)othing.
a. '?)) - not deductible.
b. '@)* Q'@*)NL(
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b. ';)) Q '=))NL(
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/escriptionmount
Eualified domestic gross receipts ' @?,)))
llocable costs and expenses < (?,)))Eualified production activity income ' (),)))
9odified D0 ' ?,)))
4tatutory percentage x :A
// ' *?)
1enee+s '*?) deduction is less than ?)A of wages paid in the activity (C@ of
'@,))) Q '(,)))!.
c. 1enee+s tentative '@,@?) deduction is more than ?)A of wages paid in the
activity so the // is limited to '(,))).
. /escriptionmount
Eualified domestic gross receipts ' *),)))
llocable costs and expenses < (?,)))
Eualified production activity income ' @?,)))
4tatutory percentage x :A
"entative // ' @,@?)
?)A of wage limitation // ' (,)))
4@. [LO ] )anning Andre is considering starting a $usiness o( constructing andse))ing pre(a$ricated greenhouses. here are three *er" di((erent methods to
constructing these greenhouses, and each method resu)ts in di((erent re*enue and cost
pro/ections. Be)o, Andre has pro/ected the Hua)i("ing re*enue and costs (or each
method. he se))ing price inc)udes Hua)i("ing receipts. he a))oca$)e e%penses inc)ude
ages and a))oca$)e e%penses are inc)uded in tota) costs.
>e))ing ua)i("ing ota) A))oca$)e A))oca$)eMethod rice =eceipts Cost +%penses ages
1 31,000 3 F,000 3 @,400 3 ',400 3 ',000' 15,000 F,000 ,500 4,400 1,400
14,000 15,000 E,@00 ',000 1,000
a. +stimate the ta% $ene(it (rom the domestic production acti*ities deduction (or
each construction techniHue. Nou ma" assume that Andre has su((icient A8I to
uti)i:e the deduction and that his margina) ta% rate is 0 percent.
$. hich construction techniHue shou)d Andre use i( his margina) ta% rate is 0
percent&
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7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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a. 9ethod ( 9ethod @ 9ethod
Eualified domestic receipts ' :,))) ' :,))) ' (*,)))
llocable expenses < @,?)) < ?,?)) < @,)))E0 ' ,?)) ' ,?)) ' (@,)))
4tatutory percentage x :A x :A x :A
0nitial // ' ?=? ' (? ' (,)=)
?)A wage limit ' (,))) ' ;?) ' ?))
// limit ' ?=? ' (? ' ?))
9"1 x )A x )A x )A
"ax benefit of // ' (; ' :? ' (?)
b. 9ethod ( 9ethod @ 9ethod
4elling price ' (,))) ' (*,))) ' (?,)))
"otal costs < ,?)) < ;,*)) < =,))
retax income ' ,?)) ' ,)) ' ,*))
(
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$oteG 4ince the machine was not placed in service, my cannot claim any cost
recovery.
a. &or the complete destruction of a business asset, my can claim a casualty lossdeduction for the tax basis of the machine less any recovery. Hence, my can
claim a casualty deduction for '(,;)) '@,)))tephen isn?t sure hich $i))s i))
e*entua))" $e paid, he e%pects to co))ect a)) $ut a$out 31,F00 o( these re*enues ne%t
"ear.
+C= has made the (o))oing e%pendituresJ
Interest e%pense 3 1,'40
>hop rent 31,400 per month2 ',000
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;o*em$er 1 o( this "ear >tephen purchased a 1'-month term-)i(e po)ic" that insures the
)i(e o( this !e"# emp)o"ee. >tephen paid 8eco Insurance Compan" 31,E00, and in
return 8eco promises to pa" >tephen a 350,000 death $ene(it i( this emp)o"ee dies
an" time during the ne%t 1' months.
%nder the cash method, revenues are recorded as value is received whether therevenues are earned or not. 1evenues are not, however, recorded for accounts receivable.Hence, >61 will only recogni7e '=*,@)) of revenue in the first six months of this year.
1egarding deductions, >61 can only deduct '@? of the interest expense the portion of theloan proceeds used for business purposes!. Ki3ewise, >61 can only deduct ':,))) of theshop rent relating to this year because the lease extends over @* months it does not #ualifyfor the (@
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1-'4
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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4F. [LO 4] )anning ;ico)e is a ca)endar-"ear ta%pa"er ho accounts (or her $usiness
using the cash method. On a*erage, ;ico)e sends out $i))s (or a$out 31',000 o( her
ser*ices at the (irst o( each month. he $i))s are due $" the end o( the month, and
t"pica))" 0 percent o( the $i))s are paid on time and FE percent are paid ithin @0
da"s.
a. >uppose that ;ico)e is e%pecting a ' percent reduction in her margina) ta% rate
ne%t "ear. Ignoring the time *a)ue o( mone", estimate the ta% sa*ings (or ;ico)e
i( she postpones mai)ing o( $i))s (or Decem$er unti) 6anuar" 1 o( ne%t "ear.
$. Descri$e ho the time *a)ue o( mone" a((ects "our ca)cu)ations.
c. ou)d this ta% sa*ings strateg" create an" additiona) $usiness riss& +%p)ain.
a. On average $icole would delay '=,*)) ;) percent of the average monthly
billings of '(@,)))! of collections thereby shifting this income into the next yearassuming that the accounts remained collectible and that clients didn+t pay in
advance!. Hence, if her business is profitable, $icole+s tax savings would be
'(= '=,*)) N .)@!.
b. "he time value of money impacts the calculation in two opposite ways. &irst,
$icole would be saving the time value on the estimated taxes on the /ecember
income because they would be postponed until 5anuary. 4econd, $icole would
lose the time value of the /ecember collections because the clients would not
pay until 5anuary. On the whole, the effect of the time value of money would be
negative because the tax savings are a fraction of the total collections.
c. "here are two business ris3s created with this strategy. &irst, the strategy
assumes that clients will be e#ually willing and able! to pay if $icole delays
sending bills. 0f this is not true, then $icole+s uncollectible accounts could rise.
4econd, if the tax reduction applies to the clients as well as to $icole and if the
payments are deductible for the clients two big ifs! , it+s possible that clients
might be more willing to pay in /ecember in order to deduct the payments under
the higher tax rate this year. Hence, delaying the collections could ris3
alienating clients and perhaps losing an opportunity to reduce uncollectible
accounts this year.
@0. [LO 4] 6erem" is a ca)endar-"ear ta%pa"er ho sometimes )eases his $usiness
eHuipment to )oca) organi:ations. 9e recorded the (o))oing receipts this "ear.
Indicate the e%tent to hich these pa"ments are ta%a$)e income to 6erem" this "ear i(
6erem" is 12 a cash-method ta%pa"er and '2 he is an accrua)-method ta%pa"er.
1-'@
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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a. 31,000 deposit (rom the Ladies? C)u$ ho ant to )ease a trai)er. he c)u$ i))
recei*e the entire deposit $ac hen the trai)er is returned undamaged.
$. 3E00 (rom the Ladies? C)u$ (or )easing the trai)er (rom Decem$er o( this "earthrough March o( ne%t "ear 3'00 per month2.
c. 300 )ease pa"ment recei*ed (rom the Men?s C)u$ this "ear (or renting 6erem"?s
trai)er )ast "ear. 6erem" $i))ed them )ast "ear $ut recent)" he determined that the
Men?s C)u$ ou)d ne*er pa" him so he as surprised hen he recei*ed the
chec.
a. ') income under both cash method and accrual method. deposit is not taxable
income unless it can be applied toward rent!.
b. '=)) of income under both the cash method and the accrual method advance
payments of rent and interest are always taxable when received!.
c. ')) of income under the cash method. %nder the accrual basis, the income
would have been recogni7ed in the prior year. "he writeeptem$er, Bron hum$ negotiated a 315,000 contract (or ser*ices it ou)d pro*ide
to the cit" in ;o*em$er o( the current "ear. he contract speci(ies that Bron hum$
i)) recei*e 35,000 in Octo$er as a don pa"ment (or these ser*ices and it i)) recei*e
the remaining 310,000 in 6anuar" o( ne%t "ear.
a. 9o much income (rom this 315,000 contract i)) Bron hum$ recogni:e in
the current "ear& +%p)ain.
$. 9o much income (rom this 315,000 contract i)) Bron hum$ recogni:e in
the current "ear i( it uses the cash method o( accounting&
c. >uppose that the tota) amount to $e paid under the contract ith the cit" is
estimated at 315,000 $ut ma" $e ad/usted to 31',000 ne%t "ear during the re*ie
o( the cit" $udget. hat amount (rom the contract, i( an", shou)d Bron hum$
recogni:e as income this "ear& +%p)ain.
d. >uppose that in addition to the $asic contract, Bron hum$ i)) $e paid an
additiona) 3,000 i( its cit" )andscape design ins the annua) designer
competition ne%t "ear. >hou)d Bron hum$ accrue 3,000 re*enue this "ear&
h" or h" not&
1-'
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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a. ccrual
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b. $o deduction this year. >ven though the contract period is (@ months or fewer,
5ustin is re#uired to capitali7e the cost of the prepayment for the insurance
policy because the contract period extends beyond the end of next year.
c. Because the length of the insurance coverage lasts longer than (@ months, 5ustin
may only deduct the portion of the premium pertaining to this year. 5ustin can
deduct '@,@?) of the ',))) insurance premium payment : months C @* months
times ',)))!.
d. /educt '*,=)) rent. "he (@J
his "ear B> $i))ed c)ients (or 3E@,00 and co))ected 3@1,000 in cash (or go)( )essons
comp)eted during the "ear. In addition, B> co))ected an additiona) 315,400 in cash
(or )essons that i)) commence a(ter "ear end. Ben hopes to co))ect a$out ha)( o( the
outstanding $i))ings ne%t "ear $ut the rest i)) )ie)" $e ritten o((.
Besides pro*iding pri*ate go)( )essons, B> a)so contracted ith the countr" c)u$ tosta(( the dri*ing range. his "ear B>$i))ed the countr" c)u$ 3','00 (or the ser*ice. he
c)u$ paid 31,000 o( the amount $ut disputed the remainder. B" "ear end the dispute had not
$een reso)*ed, and hi)e Ben $e)ie*es he is entit)ed to the mone", he has sti)) not co))ected the
remaining 310,'00.
B> has accrued the (o))oing e%penses e%p)ained $e)o2J
Ad*ertising in the c)u$house2 3 1,140
ro 8o)( eachers Mem$ership Gees E@0
>upp)ies go)( tees, $a))s, etc.2 5,'0
C)u$ =enta) @,E00
Ma)practice Insurance ',500Accounting Gees E,E'0
he e%penditures ere a)) paid (or this ca)endar "ear ith se*era) e%ceptions. Girst, Ben
initiated his go)(er?s ma)practice insurance on 6une 1sto( this "ear. he 3',500 insurance $i))
co*ers the )ast si% months o( this ca)endar "ear and the (irst si% months o( ne%t "ear. At "ear
1-'F
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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end Ben had on)" paid 3@00, $ut he has assured the insurance agent he ou)d pa" the
remaining 31,E00 ear)" ne%t "ear. >econd, the amount paid (or c)u$ renta) 3100 per ee2
represents renta) charges (or the )ast si% ees o( the pre*ious "ear, (or the 4' ees in this
ca)endar "ear, and the (irst 10 ees o( ne%t "ear. Ben has a)so mentioned that B> on)" pa"s
(or supp)ies that are used at the c)u$. A)though B> cou)d $u" the supp)ies (or ha)( the coste)sehere, Ben )ies to !thro some $usiness# to the go)( pro shop $ecause it is operated $"
his $rother.
Gi)) out a dra(t o( the (ront page o( a >chedu)e C (or B>.
%nder the accrual method, revenues are generally recorded under the all
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@5. [LO 4] On Apri) 1 o( "ear 0 >tephanie recei*ed a 3F,000 pa"ment (or (u)) pa"ment on a
three-"ear ser*ice contract under the contract >tephanie is o$)igated to pro*ide
ad*isor" ser*ices (or the ne%t three "ears2.
a. hat amount o( income shou)d >tephanie recogni:e in "ear 0 i( she uses the
accrua) method o( accounting she recogni:ed 3','40 (or (inancia) accounting
purposes2&
$. hat amount o( income i)) >tephanie recogni:e in "ear 1 i( she uses the accrua)
method o( accounting&
c. hat amount o( income i)) >tephanie recogni:e in "ear ', i( she uses the
accrua) method o( accounting&
d. hat amount o( income i)) >tephanie recogni:e in "ear 0 i( she recogni:es
34,000 o( income (rom the contract (or (inancia) statement purposes&
a. 4tephanie will recogni7e '@,@?) in year ). "his is the amount of the income she
earned in year ).
b. 4tephanie will recogni7e the remaining ',;?) in year ( because under 1ev.
roc. @))*
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income (rom ad*ance pa"ments& Gor (inancia) accounting purposes, she reports
the income hen the in*entor" is de)i*ered.
d. >uppose that instead o( ser*ices, 6anine recei*ed the pa"ment (or the de)i*er" o(
in*entor" to $e de)i*ered ne%t "ear. hen ou)d 6anine recogni:e the income
(rom the ad*ance pa"ment (or sa)e o( goods i( she uses the accrua) method o(
accounting and she uses the (u))-inc)usion method (or ad*ance pa"ments&
a. 5anine must recogni7e the entire ',))) as income this year because she
received it this year.
b. 5anine must recogni7e the '*=) she earns in year ) @ months x '@*)! and she
must recogni7e the remaining '?,?@) in year ( she is allowed to defer the
prepaid income for only one year!.
c. 0f 5anine uses the deferral method, then she would recogni7e the entire
prepayment of ',))) in year @ when she delivers the goods.
d. 0f 5anine uses the full inclusion method, she would recogni7e the entire
prepayment of ',))) as income in year ).
@@. [LO 4] ;ico)e?s $usiness uses the accrua) method o( accounting and accounts (or
in*entor" ith speci(ic identi(ication. In "ear 0, ;ico)e recei*ed a 35,400 pa"ment
ith an order (or in*entor" to $e de)i*ered to the c)ient ear)" ne%t "ear. ;ico)e has the
in*entor" read" (or de)i*er" at the end o( "ear 0 she purchased the in*entor" in "ear 0
(or 3',002.
a. hen does ;ico)e recogni:e the 3','00 o( gross pro(it 35,400 re*enue minus
3',00 cost o( the in*entor"2 i( she uses the (u))-inc)usion method&
$. hen does ;ico)e recogni:e the 3','00 o( gross pro(it (rom the in*entor" sa)e i(
she uses the de(erra) method&
c. 9o ou)d ;ico)e account (or the in*entor"-re)ated transactions i( she uses the
cash method o( accounting and her annua) sa)es are usua))" )ess than 3100,000&
d. 9o ou)d ;ico)e account (or the in*entor"-re)ated transactions i( she uses the
cash method o( accounting and her annua) sa)es are usua))" o*er 3',000,000 per
"ear&
a. 0f $icole is an accrual method taxpayer using specific identification for the
goods, she can elect either the full inclusion or deferral method to account for
prepayment for goods. %nder the full inclusion method, $icole would recogni7e
the entire '@,@)) of gross profit in year ).
1-'
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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b. $icole can elect to use the deferral method which allows her to wait until spring
of year ( when she delivers the inventory to recogni7e the '@,@)) income from
advance payment because that is when she would have recogni7ed the income if
she had not received a prepayment.
c. Because $icole+s average annual gross receipts are less than '( million, she
may deduct the cost of the inventory when she purchases it as supplies!.
6onse#uently, she would report the '*,?)) as income when she received it and
she would deduct the '@,)) cost of inventory as supplies! in year ) when she
paid for it. "his '@,@)) net increase to income is the same effect on income as if
she was using the accrual method.
d. 0n this case, even though she uses the cash method for nona)ariesJ Gactor" )a$or 1',000 &
>a)es ad*ertising ,400 &Administration 4,'00 &
ropert" ta%esJ Gactor" 5,@00 &O((ices ',00 &
DepreciationJ Gactor" E,000 &O((ices 1,400 &
a. At the end o( the "ear, Am$er?s accountant indicated that the $usiness hadprocessed 10,000 $ags o( mu)ch $ut on)" 1,000 $ags remained in the ending
in*entor". hat is Am$er?s ta% $asis in her ending in*entor" a(ter app)"ing the
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a))ocated to in*entor" according to the )e*e) o( ending in*entor". In contrast,
indirect costs are (irst a))ocated $" time spent and then according to )e*e) o(
ending in*entor".2
$. uppose that Da*id adopted the )ast-in (irst-out LIGO2 in*entor"-()o method
(or his $usiness in*entor" o( idgets purchase prices $e)o2.
idget urchase Date Direct Cost Other Costs ota) Cost1 August 14 3 ',100 3 100 3 ','00' Octo$er 0 3 ','00 3 140 3 ',40 ;o*em$er 10 3 ',00 3 100 3 ',500
In )ate Decem$er, Da*id so)d idget ' and ne%t "ear Da*id e%pects to purchase three
more idgets at the (o))oing estimated pricesJ
1-5
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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idget urchase Date +stimated Cost5 +ar)" spring 3 ',@004 >ummer 3 ','@0
@ Ga)) 3 ',500
a. hat cost o( goods so)d and ending in*entor" ou)d Da*id record i( he e)ects to
use the LIGO method this "ear&
$. I( Da*id se))s to idgets ne%t "ear, hat i)) $e his cost o( goods so)d and
ending in*entor" ne%t "ear under the LIGO method&
c. 9o ou)d "ou anser a2 and $2 i( Da*id had initia))" se)ected the (irst-in,
(irst-out GIGO2 method instead o( LIGO&
d. >uppose that Da*id initia))" adopted the LIGO method, $ut ants to app)" (or a
change to GIGO ne%t "ear. hat ou)d $e his 5E1 ad/ustment (or this change,
and in hat "ears2 ou)d he mae the ad/ustment&
a. %nder the K0&O method, this year /avid should record a cost of goods sold of '
@,*)) and an ending inventory of ' *,??).
b. %nder K0&O, /avid would be deemed to sell widgets R ? and R so his cost of
goods sold next year would be '*,) and his ending inventory would consist of
widgets R (, R@, and R* for a total ending inventory of ';,(?).
c. %nder the &0&O method, for part a, /avid+s cost of goods sold this year would
be '@,@)) and his ending inventory would be ' *,;?). %nder &0&O for part b,
/avid would be deemed to sell widgets R @ and R so his cost of goods sold next
year would be '*,;?) and his ending inventory would consist of widgets R *, R?,
and R for a total ending inventory of ';,@).
d. "he *=( adjustment will re#uire /avid to recogni7e income or expense as though
he initially had adopted the &0&O method. %nder the &0&O method, his cost of
goods sold in the first year would have been '@,@)) instead of '@,*)). Hence,
/avid+s *=( adjustment will be M'@)) effectively increasing his beginning
inventory for the next year from '*,??) under K0&O to '*,;?) under &0&O. "he
adjustment would be spread over four years.
@F. [LO 4] On ;o*em$er 1 o( "ear 0, 6a%on $orroed 340,000 (rom Bucsnort >a*ings
and Loan (or use in his $usiness. In Decem$er, 6a%on paid interest o( 35,400 re)ating
to the 1'-month period (rom ;o*em$er o( "ear 0 through Octo$er o( "ear 1.
1-4
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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1. [LO 4] Circuit Corporation CC2 is a ca)endar-"ear, accrua)-method ta%pa"er. CC
manu(actures and se))s e)ectronic circuitr". On ;o*em$er 14, "ear 0, CC enters into a
contract ith +Huip Corp +C2 that pro*ides CC ith e%c)usi*e use o( +C?s specia)i:edmanu(acturing eHuipment (or the (i*e-"ear period $eginning on 6anuar" 1 o( "ear 1.
ursuant to the contract, CC pa"s +C 3100,000 on Decem$er 0, "ear 0. 9o much o(
this e%penditure is CC a))oed to deduct in "ear 0 and in "ear 1&
') in year ) and '@),))) in year (. Because 66 is leasing property from >6,
economic performance on the contract occurs ratably over the five
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. [LO 4] ra*is is a pro(essiona) )andscaper. 9e pro*ides his c)ients ith a one-"ear 1'-
month2 arrant" (or retaining a))s he insta))s. In 6une o( "ear 1, ra*is insta))ed a
a)) (or an important c)ient, >hei)a. In ear)" ;o*em$er, >hei)a in(ormed ra*is thatthe retaining a)) had (ai)ed. o repair the a)), ra*is paid 300 cash (or additiona)
stone that he de)i*ered to >hei)a?s )ocation on ;o*em$er '0 o( "ear 1. ra*is a)so
o((ered to pa" a mason 3E00 to repair the a)). Due to some $ad eather and the
mason?s or $ac)og, the mason agreed to $egin the or $" the end o( 6anuar" o(
"ear '. +*en though ra*is e%pected the mason to (inish the pro/ect $" end o(
Ge$ruar", ra*is in(ormed the mason that he ou)d on)" pa" the mason the 3E00 hen
he comp)eted the /o$.
a. Assuming ra*is is an accrua)-method ta%pa"er, ho much can he deduct in "ear
1 (rom these acti*ities&
$. Assuming ra*is is a cash-method ta%pa"er, ho much can he deduct in "ear 1
(rom these acti*ities&
a. %nder the accrual method, economic performance occurs as "ravis incurs costs
associated with providing goods and services to another party. Hence, "ravis
can deduct the ';)) cost of the stone this year. However, because "ravis is
hiring another the mason! to provide a service that "ravis is liable to perform,
economic performance occurs as the mason performs the services.
6onse#uently, "ravis will not be allowed to deduct the cost for the mason until
year @ when the mason performs the services.
b. "he timing and amount of the deductions under the cash method is the same as itis under the accrual method.
5. [LO 4] =esearch Adam e)ects the accrua) method o( accounting (or his $usiness.
hat amount o( deductions does Adam recogni:e in "ear 0 (or the (o))oing
transactions&
a. Adam guarantees that he i)) re(und the cost o( an" goods so)d to a c)ient i( the
goods (ai) ithin a "ear o( de)i*er". In Decem$er o( "ear 0, Adam agreed to
re(und 3',500 to c)ients, and he e%pects to mae pa"ment in 6anuar" o( "ear 1.
$. On Decem$er 1 o( "ear 0, Adam paid 35E0 (or a one-"ear contract ith C)eaner*ices to c)ean his store. he agreement ca))s (or ser*ices to $e pro*ided on a
ee)" $asis.
1-E
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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c. Adam as $i))ed 3'50 (or annua) persona) propert" ta%es on his de)i*er" *an.
Because this as the (irst time Adam as $i))ed (or these ta%es, he did not mae
pa"ment unti) 6anuar". 9oe*er, he considers the amounts immateria).
a. $o deduction in year ) < economic performance only occurs for refunds upon
payment.
b. /educt '*) for portion of services provided to dam one month! in year ).
$ote the economic performance rules deductible as receives services from other
party!
c. /educt '@*) if recurring item exception is elected. Otherwise, taxes can only be
deducted upon payment. "he amount is immaterial, this is the first time
encountered, and payment is expected within the date for filing a return or =.?
months, thus, 1eg. I(.*(
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b. ') under both the cash and accrual method. 0n this case, economic performance
ta3es place as when the goods are provided to her. However, because the asset
will provide a benefit for more than (@ months, she must capitali7e the
expenditure and she will begin depreciating it in year ( when she places the
asset in service.
c. ',))) under both the cash method and accrual method. "axes are a payment
liability and are therefore, absent a special election, deductible only when paid.
d. ')) the interest allocable to $ovember and /ecember! under both the cash
method and the accrual method. >ven under the cash method taxpayers may not
deduct interest expense in excess of the amount of accrued interest.
@. [LO 4] BC> Corporation is a ca)endar-"ear, accrua)-method ta%pa"er. BC> as
(ormed and started its $usiness acti*ities on 6anuar" 1, "ear 0. It reported the (o))oing
in(ormation (or "ear 0. Indicate BC>?s deducti$)e amount (or "ear 0 in each o( the
(o))oing a)ternati*e scenarios.
a. BC> pro*ides to-"ear arranties on products it se))s to customers. Gor its "ear
0 sa)es, BC> estimated and accrued 3'00,000 in arrant" e%pense (or (inancia)
accounting purposes. During "ear 0, BC> actua))" spent 30,000 repairing its
product under the arrant".
$. BC> accrued an e%pense (or 340,000 (or amounts it anticipated it ou)d $e
reHuired to pa" under the orer compensation act. During "ear 0, BC> actua))"paid 310,000 (or orers compensation re)ated )ia$i)ities.
c. In 6une o( "ear 0, a disp)a" o( BC>?s product )ocated in its shoroom (e)) on and
in/ured a customer. he customer sued BC> (or 3400,000. he case is
schedu)ed to go to tria) ne%t "ear. BC> anticipates that it i)) )ose the case and
accrued a 3400,000 e%pense on its (inancia) statements.
d. Assume the same (acts as in c2 e%cept that BC> as reHuired to pa" 3400,000 to
a court-appointed escro (und in "ear 0. I( BC> )oses the case in "ear 1, the
mone" (rom the escro (und i)) $e trans(erred to the customer suing BC>.
e. On Decem$er 1 o( "ear 0, BC> acHuired eHuipment (rom +Huip Compan". Aspart o( the purchase, BC> signed a arrant" agreement ith +Huip so that +Huip
ou)d arrant" the eHuipment (or to "ears (rom Decem$er 1 o( "ear 0 through
;o*em$er 0 o( "ear '2 . he cost o( the arrant" as 31',000. BC> paid
+Huip (or the arrant" in 6anuar" o( "ear 1.
1-50
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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a. Because the accrued '@)),))) warranty expense is an estimate it is not a fixed
and determinable liability! B64 is not allowed to deduct any of the '@)),)))
accrual in year ). However, B64 is allowed to deduct the '),))) it actually
spent in year ) repairing its product under the warranty.
b. Because employer liabilities under the wor3er compensation act are payment
liabilities, B64 is allowed to deduct only the '(),))) it actually paid in year )
for wor3ers compensation
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d. s an accrual
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a. At the end o( end o( "ear 0P$eginning o( "ear 1, +rin?s $usiness has 314,000 o(
accounts recei*a$)es and 31E,000 o( accounts pa"a$)es that ha*e not $een
recorded (or ta% purposes.
$. At the end o( "ear 0P$eginning o( "ear 1, +rin?s $usiness reports 3'4,000 o(
accounts recei*a$)es and 3F,000 o( accounts pa"a$)es that ha*e not $een
recorded (or ta% purposes.
a. >rin would be re#uired to ma3e a I*=( adjustment to ensure that she does not
omit receivables and payables from taxable income under the accrual method of
accounting that she is switching to. Her net I*=( adjustment is to decrease net
income by ',))) '(?,))) receivables minus the '(=,))) payables!. Because
this is an income decreasing adjustment, >rin would deduct the full adjustment
amount in year (.
b. >rin+s net I*=( adjustment is to increase net income by '(,))) '@?,)))
receivables minus the ':,))) payables!. Because this is a income increasing
adjustment, >rin would include @? percent of the net adjustment '*,)))! in
taxable income in each of the next four years beginning with year (.
Comprehensive Problems
E1. 6oe operates a $usiness that )ocates and purchases specia)i:ed assets (or c)ients, amongother acti*ities. 6oe uses the accrua) method o( accounting $ut he doesn?t eep an"
signi(icant in*entories o( the specia)i:ed assets that he se))s. 6oe reported the (o))oing
(inancia) in(ormation (or his $usiness acti*ities during "ear 0. Determine the e((ect o(
each o( the (o))oing transactions on the ta%a$)e $usiness income.
a. 6oe has signed a contract to se)) gadgets to the cit". he contract pro*ides that
sa)es o( gadgets are dependent upon a test samp)e o( gadgets operating
success(u))". In Decem$er, 6oe de)i*ers 31',000 orth o( gadgets to the cit" that
i)) $e tested in March. 6oe purchased the gadgets especia))" (or this contract
and paid 3E,400.
$. 6oe paid 31E0 (or entertaining a *isiting out-o(-ton c)ient. he c)ient didn?t
discuss $usiness ith 6oe during this *isit, $ut 6oe ants to maintain good
re)ations to encourage additiona) $usiness ne%t "ear.
c. On ;o*em$er 1, 6oe paid 3@00 (or premiums pro*iding (or 350,000 o( !e"
man# insurance on the )i(e o( 6oe?s accountant o*er the ne%t 1' months.
1-55
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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d. At the end o( "ear 0, 6oe?s $usiness reports 3F,000 o( accounts recei*a$)e. Based
upon past e%perience, 6oe $e)ie*es that at )east 3',000 o( his ne recei*a$)es i))
$e unco))ecti$)e.
e. In Decem$er o( "ear 0, 6oe rented eHuipment (or a )arge /o$. he renta) agenc"
reHuired a minimum renta) o( three months 31,000 per month2. 6oe comp)eted
the /o$ $e(ore "ear-end, $ut he returned the eHuipment at the end o( the )ease.
(. 6oe hired a ne sa)es representati*e as an emp)o"ee and sent her to Da))as (or a
ee to contact prospecti*e out-o(-state c)ients. 6oe ended up reim$ursing his
emp)o"ee 300 (or air(are, 340 (or )odging, 3'40 (or mea)s, and 3140 (or
entertainment. 6oe reHuires the emp)o"ee to account (or a)) e%penditures in order
to $e reim$ursed.
g. 6oe uses his BM a persona) auto2 to tra*e) to and (rom his residence to his
(actor". 9oe*er, he sitches to a $usiness *ehic)e i( he needs to tra*e) a(ter he
reaches the (actor". Last month, the $usiness *ehic)e $roe don and he as
(orced to use the BM $oth to tra*e) to and (rom the (actor" and to *isit or
sites. 9e dro*e 1'0 mi)es *isiting or sites and 5@ mi)es dri*ing to and (rom
the (actor" (rom his home.
h. 6oe paid a *isit to his parents in Da))as o*er the Christmas ho)ida"s. hi)e he
as in the cit", 6oe spent 340 to attend a ha)(-da" $usiness s"mposium. 6oe paid
3'00 (or air(are, 340 (or mea)s during the s"mposium, and 3'0 on ca$ (are to the
s"mposium.
a. ') income. 5oe does not include any income in year ) from his contract with thecity because the sale is contingent upon a future event. 6onse#uently, 5oe does
not have a fixed right to the income.
b. ') deduction. >ntertainment is not a deductible business expense unless there is
a substantial business discussion on the day of the entertainment. "his payment
is not deductible.
c. ') deduction. "he insurance premiums on a 3ey
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e. %nder the economic performance rules, 5oe will deduct the cost of the lease over
the lease term. "hus he will deduct '(,))) in year ) and the remaining '@,)))
in year (.
f. 5oe is allowed to deduct the full cost of the airfare '))! and lodging '?)! as
an ordinary and necessary business expense. However, 5oe is allowed to deduct
only one
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(. 86 paid 6ac?s (ather 310,000 (or ser*ices that ou)d ha*e cost no more than
3@,000 i( 6ac had hired an" other )oca) $usiness to per(orm the ser*ices. hi)e
6ac?s dad as competent, he does not command such a premium (rom his other
c)ients.
g. In an attempt to get his name and ne $usiness recogni:ed, 86 paid 3,000 (or a
one-page ad in the 8eo)ogic >ur*e". It a)so paid 314,000 in radio ads to $e run
through the end o( Decem$er.
h. 86 )eased o((ice space in a $ui)ding donton. 86 paid rent o( 3',000 (or the
"ear.
i. In August, 86 $egan manu(acturing a specia) geo)ogica) digging too) that it se))s
to ho)esa)ers. 86?s AI (rom the acti*it" (or the "ear is 3100,000 [inc)uded in
re*enues reported in part $2]. 86 paid 310,000 o( ages to the emp)o"ees
oring on the pro/ect during the "ear and its cost o( goods so)d on the sa)es is
314,000. Assume that ta%a$)e income does not )imit the amount o( the DAD
and that no ages shou)d $e inc)uded in cost o( goods so)d.2 =emem$er that cost
o( goods so)d and ages reduce ta%a$)e income.
/. In ;o*em$er, 6ac?s o((ice as $roen into and eHuipment *a)ued at 34,000 as
sto)en. he ta% $asis o( the eHuipment as 34,400. 6ac recei*ed 3',000 o(
insurance proceeds (rom the the(t.
. 86 incurred a 35,000 (ine (rom the state go*ernment (or digging in an
unauthori:ed digging :one.
). 86 contri$uted 3,000 to he)p )o$$"ists (or their he)p in persuading the state
go*ernment to authori:e certain unauthori:ed digging :ones.
m. On 6u)" 1, 86 paid 31,E00 (or an 1E-month insurance po)ic" (or its $usiness
eHuipment. he po)ic" co*ers the period 6u)" 1o( this "ear through Decem$er 1
o( ne%t "ear.
n. 86 $orroed 3'0,000 to he)p ith the compan"?s initia) (unding needs. 86 used
3',000 o( (unds to in*est in municipa) $onds. At the end o( the "ear, 86 paid the
31,'00 o( interest e%pense that accrued on the )oan during the "ear.
o. 6ac )i*es 1' mi)es (rom the o((ice. 9e care(u))" traced his mi)eage and dro*e
his truc @,'E0 mi)es $eteen the o((ice and his home. 9e a)so dro*e an
additiona) ,'00 mi)es $eteen the o((ice and tra*e)ing to c)ient sites. 6ac did
not use the truc (or an" other purposes. 9e did not eep trac o( the speci(ic
e%penses associated ith the truc. 9oe*er, hi)e tra*e)ing to a c)ient site,
1-5
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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Chapter 01 - Business Income, Deductions, and Accounting Methods
6ac recei*ed a 3140 speeding ticet. 86 reim$ursed 6ac (or $usiness mi)eage
and (or the speeding ticet.
p. 86 purchased to season ticets '0 games2 to attend >tate
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. Deo
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6. s a sole proprietorship Deo
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Chapter 01 - Business Income, Deductions, and Accounting Methods
Ge$ruar" this "ear 4 311'
6u)" this "ear '4 3E4
August this "ear 50 3150
ota)s 150 354
1-41
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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e. On August 1 o( this "ear, IDC needed more room (or storage and paid 3F00 to
rent a garage (or 1' months.
(. On ;o*em$er 0 o( this "ear, Br"an decided it as time to get his )ogo on the
sides o( his or *an. IDC hired e aint An"thing, Inc. A2, to do the /o$.
It paid 3400 don and agreed to pa" the remaining 31,400 upon comp)etion o(
the /o$. A indicated it ou)dn?t $e a$)e to $egin the /o$ unti) 6anuar" 14o(
ne%t "ear, $ut the /o$ ou)d on)" tae one ee to comp)ete. Due to
circumstances $e"ond its contro), A asn?t a$)e to comp)ete the /o$ unti)
Apri) 1o( ne%t "ear, at hich time IDC paid the remaining 31,400.
g. In Decem$er, Br"an?s son, Aiden, he)ped him (inish some carpeting /o$s. IDC
oed Aiden 3@00 reasona$)e2 compensation (or his or. 9oe*er, Aiden did
not recei*e the pa"ment unti) 6anuar" o( ne%t "ear.
h. IDC a)so paid 31,000 (or interest on a short-term $an )oan re)ating to the period(rom ;o*em$er 1 o( this "ear through March 1 o( ne%t "ear.
Bryan+s taxable income is '*;,)) under the cash method of accounting and '(;,)
under the accrual method of accounting computed as followsG
1-4'
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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Chapter 01 - Business Income, Deductions, and Accounting Methods
1-4
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
Description Cash Accrual Explanationa. repaid carpetingservices
') '=),))) "he '=),))) received in the prioryear would have been recogni7ed intaxable income in the prior yearwhen the payment was received inthe prior year.
b. 6arpeting services @@),))) @*),))) 0ncome not recogni7ed untilreceived for cash method.
c. 6leaning services =,*) (,**) &or accrual, only amount earned isrecogni7ed mos. x '@*)!.
4ale of 0nventoryGd. 4tain remover sales ?)) ?))Gross Income '@@:,(*) '@(,:*)a. 6arpet supplies ?),))) ?),))) >conomic performance under the
accrual method re#uires that 0/6provide the goods carpet! to thehomebuilder in order to deduct thecost. "he home was finished in thecurrent year.
b. materials neededfor contracts
(),))) (),)))
d. 4tain remover ; ? 6ash method may deduct cost inyear paid. ccrual methodG '(@;for first sale ? from &ebruary M ?from 5anuary! and '@)= fromsecond sale *) from ugust M @)from 5uly!.
6ost ofDoodsC4ervices
(=),; (=),?
Gross Proit '*=,=) '(*(,)?
b. Bad debt ) ,))) 6ash method not deductiblebecause bad debt was neverincluded in income.
e. repaid rent ':)) ';? &or accrual, economicperformance occurs over leaseperiod ? months this year!. (@a)aries to shop emp)o"ees 4',400=ent e%pense 50,040Accident insurance premiums E,500Other $usiness e%penditures @,E40 - '4F,F40
;et Income 3 @,@00
9 operates as a so)e proprietorship and 9an reports on a ca)endar-"ear. 9an usesthe cash method o( accounting and p)ans to do the same ith 9 9 has noin*entor" o( donuts $ecause unso)d donuts are not sa)a$)e2. 9 does not purchase
1-45
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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350,000 death $ene(it i( 6im$o passes aa" an" time during the ne%t 1' months.
he term o( the po)ic" $egan on >eptem$er 1 o( )ast "ear and this pa"ment as
inc)uded in !other $usiness# e%penditures.
h. In the (irst "ear 9 catered a )arge $rea(ast e*ent to ce)e$rate the cit"?s
anni*ersar". he cit" agreed to pa" 3,100 (or the e*ent, $ut 9an (orgot to
noti(" the cit" o( the outstanding $i)) unti) 6anuar" o( this "ear. hen he mai)ed
the $i)) in 6anuar", 9an decided to discount the charge to 34,400. On the $i)),
9an thaned the ma"or and the cit" counci) (or their patronage and ased them
to !send a )itt)e more $usiness our a".# his $i)) is not re()ected in 9an?s
estimate o( 9?s income (or the (irst "ear o( operations.
Required:
A. 9an (i)es his persona) ta% return on a ca)endar "ear, $ut he has not "et (i)ed
)ast "ear?s persona) ta% return nor has he (i)ed a ta% return reporting 9?s
resu)ts (or the (irst "ear o( operations. +%p)ain hen 9an shou)d (i)e the ta%return (or 9 and ca)cu)ate the amount o( ta%a$)e income generated $" 9
)ast "ear.
B. Determine the ta%a$)e income that 9 i)) generate i( 9an chooses to
account (or the $usiness under the accrua) method.
C. Descri$e ho "our so)ution might change i( 9an incorporated 9 $e(ore he
commenced $usiness )ast "ear.
1-4@
7 '015 $" Mc8ra-9i)) +ducation. his is proprietar" materia) so)e)" (or authori:ed instructor use. ;ot authori:ed (or sa)e or distri$utionin an" manner. his document ma" not $e copied, scanned, dup)icated, (orarded, distri$uted, or posted on a e$site, in ho)e or part.
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. Han3 should report HF+s results on a 4chedule 6 filed with his personal tax
return which is due by the (?thday of pril. HF+s taxable income is '((,??)
calculated as followsG
1evenueG Balance djust 6orrect
/onut sales @?@,))) @?@,)))
6atering revenues ;(,??) (,;)) =),)))
,;?)
"otal 1evenue @,??) @,)))
>xpendituresG
/onut supplies (@*,@*) (@*,@*)
6atering expense @;,:()
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Chapter 01 - Business Income, Deductions, and Accounting Methods
B. "axable income for HF under the accrual method is '((),@:)< computed as
followsG
1evenueG Balance djust 6orrect
/onut sales @?@,))) @?@,)))
6atering revenues ;(,??) (,;)) =),?;?
@@?;,())
"otal 1evenue @,??) @,?;?
>xpendituresG
/onut supplies (@*,@*) (@*,@*)
6atering expense @;,:() @;,:()
4alaries to shop employees ?@,?)) ?@,?))
1ent expense *),)?)
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E@. =esearch memo =.+.M., a ca)endar-"ear corporation and Athens, 8eorgia $and,
recent)" so)d ticets 3'0,000,0002 (or concerts schedu)ed in the tates (or ne%t
"ear and the (o))oing "ear. Gor (inancia) statement purposes, =.+.M. i)) recogni:ethe income (rom the ticet sa)es hen it per(orms the concerts. Gor ta% purposes, it
uses the accrua) method and ou)d pre(er to de(er the income (rom the ticet sa)es unti)
a(ter the concerts are per(ormed. his is the (irst time that it has so)d ticets one or to
"ears in ad*ance. Michae) >tipe has ased "our ad*ice. rite a memo to Michae)
e%p)aining "our (indings.
%E%&
'e( )acts*
1.>.9., a calendar year corporation and thens, Deorgia, band, recently sold tic3ets'@),))),)))! for concerts scheduled in the %nited 4tates for next year and thefollowing year. &or financial statement purposes, 1.>.9. will recogni7e the incomefrom the tic3et sales when it performs the concerts. &or tax purposes, it uses theaccrual method and would prefer to defer the income from the tic3et sales until afterthe concerts are performed.
"his is the first time that it has sold tic3ets one or two years in advance. 9ichael4tipe has as3ed your advice. Frite a memo to 9ichael explaining your findings.
+uestion*
4hould 1.>.9. include in current income advance sales of tic3ets for concertsscheduled in future years8
ele-ant Authorities*
016 4ections *?( and **
1ev. roc. @))*
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6onclusionG
"here is ample authority to support 1.>.9.+s deferred recognition of the tic3et salesincome until the amounts are earned i.e., until the concerts are performed!. "hus,
the tic3et sale income for the concerts will be recogni7ed in the year of theperformance.
.(nopsis* "he general rule for prepaid service income is to recogni7e it in the yearof receipt. However, 1ev. roc. @))*