1. #5-1 McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Taxable Income from Business Operations McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 5 Taxable Income from Business Operations

2. #5-2Objectives  Describe how taxable year relates to operating cycle.  Identify tax methods of accounting  Apply the cash method  GAAP versus tax conservatism  Book-tax permanent and temporary income differences  Explain the difference between tax expense per books and tax payable.  Accrual basis exceptions for prepaid income and accrued expenses  NOLs

3. #5-3 Taxable Income  Taxable income = gross income less allowable deductions  Gross income “means all income from whatever source derived.”  Deductions are allowed through legislative grace, and include all ordinary and necessary expenses … in carrying on any trade or business.”  Good rule of thumb: receipts are taxable UNLESS you can find a law that says it is excluded. Expenses are deductible ONLY if you can find a law that says it is deductible.

4. #5-4 Taxable Year  12-month period which generally corresponds to its fiscal year.  Individual taxpayers must generally choose a calendar year.  Firms generally choose a year = end of an annual operating cycle. See Q1.  Why does dividing time into periods (like years) create opportunities for deferral?

5. #5-5  Changing tax years requires permission - most common reason is merger of firms with different year-ends. Annualize the tax from a short-year return.  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 has income of $25,000. Annualized income = $100,000; tax on $100,000 = $22,250. Tax for 3-month short period = 5,563 (22,250/4). Taxable Year

6. #5-6 Accounting Methods  Overall method by which taxpayers determine their income, deductions and credits, as well as the time realized and recognized. Section 482 grants IRS broad powers to “distribute, apportion, or allocate income” among businesses to CLEARLY REFLECT income of each. BIG issue in multi-jurisdictional taxation (Ch 12)  CONSISTENTLY APPLIED  Establish a method by using it in the first tax return.  Requires IRS permission to change.

7. #5-7 Accounting Methods - Other policy objectives  Public policy  no deduction for fines, political contributions  Limits on meal and entertainment expenses  Economic incentives  State and local bond interest income is exempt (likewise related expenses are nondeductible).  Writeoff equipment faster for tax than useful life.

8. #5-8 Cash Method  Under the cash method, gross income includes cash or property actually RECEIVED during the tax year.  Deductions are usually taken in the year cash or property is PAID.  Cash method income includes receipt of noncash goods - Examples? See Q5.

9. #5-9 Cash Method Income  Constructive receipt of income.  Occurs when taxpayer has unrestricted access to and control of the income.  NO constructive receipt if the amount is available only on surrender of a valuable right, or if there are substantial limits on the right to receive it.  Examples?

10. #5-10 Cash Method Deductions  Cash method - deduct expenses when PAY. A check is payment when mailed.  An asset must be capitalized. The cost of the asset may be recovered over the asset life (e.g. depreciation, cost of goods sold). Major repairs may result in IRS dispute regarding expense versus capitalization.  Inventory must be accounted for on the accrual method, even for cash basis taxpayers. This is called a HYBRID method of accounting.

11. #5-11 Cash Method Deductions - Prepaid Expenses  Where an expense (e.g., rent or an insurance premium) covers more than the following tax year, the deduction must be spread over the period to which the expense applies. AP2.  However, prepaid interest must be capitalized and deducted over the period for which interest is actually charged even if prepayment < next tax year. AP5.  Exception - deduct prepaid interest (points) on the purchase of a home. Does not apply to refinancing.

12. #5-12 Limitations on Corporations Using Cash Method  Corporations that average > $5 million annual gross receipts cannot use cash method  Service firms can have up to $10 million of average annual gross receipts before they must use accrual method.  However, personal service corporations (professional services like medical, legal, accounting) of any size may still use cash method.

13. #5-13 Accrual Method of Accounting  Under the accrual method, report income when the right to the income and the amount of the income can be determined with reasonable accuracy. (REALIZATION)  MATCH expenses against revenues. Deduct when ALL EVENTS have occurred that determine the existence of the liability and the amount of the liability can be determined with reasonable accuracy.  Contrast to financial accounting (what are contingent liability rules in GAAP)?

14. #5-14 Book-Tax Differences  Contrasting principles of conservatism.  GAAP - protect shareholders and creditors: don’t overstate book income.  Tax - protect government revenues: Don’t understate taxable income. (Contrasting result may arise due to economic incentives - e.g. accelerated depreciation.)

15. #5-15 Book-Tax Permanent Differences  Permanent differences do not reverse; Temporary differences reverse over the life of the firm.  Examples of permanent non-deductible expenses  50% meals and entertainment  political contributions  fines and penalties  interest expense to generate tax-exempt municipal bond income  premiums on life insurance

16. #5-16 Book-tax Permanent Differences  Examples of permanent tax preferences that make taxable income less than book income:  Tax-exempt municipal bond income  Life insurance proceeds.  See AP10

17. #5-17 Temporary Book-Tax Differences  Examples of temporary differences:  Depreciation  Timing of accruals  Capital losses  Bad debts (allowance vs. writeoff)  Cash versus accrual accounting

18. #5-18 GAAP Tax Expense Versus Tax Payable  GAAP current tax expense = tax on taxable income.  GAAP deferred tax expense = the tax effect of temporary differences reversing in the future.  Total tax expense per books (SFAS109) = current +/- deferred tax expense.  In simple situations (APB11)  Pre-tax book income + / - permanent differences = adjusted book income  x tax rate; less credits  = Total tax expense per books same # as SFAS 109.

19. #5-19 Temporary Differences: Prepaid Income  Prepaid income is taxed when received under the Claim of Right Doctrine  Government has the right to tax income when the taxpayer has unrestricted right to use such income amounts.  Examples: Receipt of prepaid rent, royalty, bonuses, advertising, services (except see below). AP3, 4

20. #5-20 Temporary Differences: Prepaid Services  Advance payments received for services to be performed must be reported by an accrual basis taxpayer in the year received.  exception: a taxpayer can elect to defer advance payments over the period services are performed if they are received under an agreement requiring all the services to be performed by the end of the following tax year.

21. #5-21 Accrued Expenses, Generally  All events test:  1) All events that establish the liability have already occurred.  2) The amount must be determinable with reasonable accuracy.  Economic Performance requirement delays deduction until payment (like cash basis) for  legal settlements (tort, contract breach, violating law), customer rebates/refunds, awards, prizes, state income taxes.

22. #5-22 Accrual Expenses Exceptions  Related Party Accruals  The paying party cannot deduct an expense until the year that a receiving party recognizes the income.  Prevents accrual basis taxpayers from accruing an expense but delaying payment.  AP6, 7

23. #5-23 Accrual Expenses  Bad Debts  GAAP - allowance method  Tax - direct write-off method. Record income if account repaid later.  Business bad debts are ordinary deductions.  Non-business bad debts general short-term capital losses.  AP8, 9

24. #5-24 Summary Cash vs Accrual  summary:

25. #5-25 Net Operating Losses  Problem arises due to artificial time divisions (years).  Solution: carryback 2 years, carryforward 20 years.  5 year carryback for tax years ending in 2001 or 2002. (2002 Tax Act)  GAAP now allows firms to record a tax benefit for expected value of future NOL deductions.  Election available to FOREGO CARRYBACK. NPV tax benefit if expect sufficiently higher tax rate in future. (or elect 2 yr c/b in 2001/2002)