McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 6 Taxable Income from Business Operations McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2Objectives  Describe how taxable year relates to operating cycle  Explain why tax policy affects the taxable income computation  Apply the cash method for tax purposes  Explain the difference between GAAP conservatism and tax conservatism  Identify permanent and temporary book/tax differences  Compute tax expense per books and tax payable  Describe the tax consequences of a net operating loss (NOL)

6-3 Taxable 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”

6-4 Taxable Income  Good rule of thumb:  Receipts are taxable unless you can find a legal rule that says the receipt is nontaxable  Expenses are deductible only if you can find a legal rule that says the expense is deductible

6-5 Taxable Year  A taxable year is generally the 12-month period corresponding to a firm’s fiscal year  Individual taxpayers generally use a calendar year  Firms generally choose a tax year that reflects their annual operating cycle

6-6 Taxable 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

6-7  A new business establishes its taxable year by filing an initial tax return based on such year  Changing tax years requires IRS permission  Because of the change, the first return 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 Taxable Year

6-8 Taxable 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]

6-9 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)

6-10 Tax Methods of Accounting  Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to clearly reflect the income of each  This is a huge issue in international taxation  More discussion in Chapter 13

6-11 Methods of Accounting: Policy Objectives  Public policy  No deduction for fines, political contributions  Why?  Congress does not want to subsidize bad behavior with a tax deduction or finance the lobbying efforts of special interest groups  Limits on meal and entertainment expenses; only 50% deductible  Why?  Lavish meals and entertainment involve more pleasure than business and should not be subsidized with federal tax dollars

6-12 Methods 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

6-13 Cash 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

6-14 Cash 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

6-15 Cash 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

6-16 Cash Method Income  A calendar-year, cash-basis firm would like to defer income from this year to next year. Can it defer recognizing income this year if:  The company holds the checks received from its customers in December in its vault and does not cash them until January?  No – the income has been constructively received

6-17 Cash 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

6-18 Capital 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

6-19 Cash Method Deductions - Inventory  Inventory must be accounted for on the accrual method, even for cash basis taxpayers  This is called a hybrid method of accounting  Under this method, purchases and sales of inventories are accounted for under the accrual method and all other transactions are accounted for under the cash method

6-20 Limitations on Corporations Using Cash Method  Corporations that average more than $5 million in annual gross receipts cannot use the cash method  Prohibition applies to partnerships with a corporate partner  However, personal service corporations (corporations providing professional services such medical, legal, and accounting services) of any size may use the cash method

6-21 Accrual Method of Tax Accounting  Under the accrual method, taxpayers recognize income when the right to the income is fixed and the amount of the 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

6-22 Book-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

6-23 Permanent 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

6-24 Temporary 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)

6-25 Favorable 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

6-26 Tax 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)

6-27 Example  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 this year. 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

6-28 Solution  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

6-29 Temporary 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

6-30 Prepaid 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 this year (rent earned in December)  How much taxable income does Acme report this year?  Acme reports $12,000 taxable income this year

6-31 One-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

6-32 Temporary Differences: Accrued Expenses  An accrued expense is deductible only if it passes the all events test:  All events that establish the liability have already occurred, and  The amount must be determinable with reasonable accuracy  If an accrued expense meets these two requirements and is a recurring item that the firm treats in a consistent manner every year, the accrued expense is deductible

6-33 Economic Performance  For certain accrued expenses, economic performance must occur before a deduction is allowed  The economic performance requirement defers the deduction until payment is made (cash basis) for:  Legal settlements (tort, breach of contract, etc.)  Customer rebates/refunds  Awards, prizes  State income taxes

6-34 Accrued Expense Example  ABC Company has two accrued expenses at year end  December’s utility bill to be paid in 30 days  Customer rebate checks to be issued during the 1 st quarter of the new year  Which accrual can be deducted on the current year tax return?  Accrued utility expense

6-35 Accrual Expense Exceptions  Related party accruals  The payer cannot deduct an accrued expense until the year that the recipient recognizes income  This rule prevents accrual basis taxpayers from accruing an expense but delaying payment to a related party  Bad debt expense  GAAP requires the allowance method  For tax purposes, the direct write-off method is required

6-36 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

6-37 Accounting 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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