1. 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.

2. 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)

3. 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”

4. 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

5. 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. 6-6 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

7. 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

8. 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]

9. 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)

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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)

25. 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

26. 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)

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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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