1. Chapter 6 Taxable Income from Business Operations McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 6-2
Objectives
Describe the relationship between business operating cycle and taxable year
Identify the permissible methods of accounting for tax purposes
Explain why tax policy objectives affect the taxable income computation
Apply the cash method of accounting to compute taxable income
Contrast the principles of conservatism reflected by GAAP and by the tax law

3. Objectives (continued)
6-3
Objectives (continued)
Differentiate between a permanent and a temporary book/tax difference
Explain the difference between tax expense per books and tax payable
Apply the tax accounting rules for prepaid income and accrued expenses
Explain how the NOL deduction smooths taxable income over time

4. Taxable Income Taxable income = gross income less allowable deductions
6-4
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”

5. Taxable Income Good rule of thumb:
6-5
Taxable Income
Good rule of thumb:
Receipts are taxable unless a specific rule states that the receipt is nontaxable
Expenses are deductible only if a specific rule states that the expense is deductible

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

7. 6-7
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

8. 6-8
Taxable Year
A new business establishes its taxable year by filing an initial tax return based on such year
Changing tax years requires IRS permission
The first return after the change may reflect a short period of less than 12 months
The taxable income reported on the short-period return must be annualized – mathematically inflated to reflect 12 months of business operations

9. 6-9
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]

10. Tax Methods of Accounting
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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)

11. Tax Methods of Accounting
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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
Huge issue in international taxation
More discussion in Chapter 13

12. Methods of Accounting: Policy Objectives
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Methods of Accounting: Policy Objectives
Public policy
No deduction for fines, political contributions
Why?
Congress doesn’t want to subsidize bad behavior with a tax deduction or finance the lobbying efforts of special interest groups
Only 50% of meal and entertainment expense is deductible
Lavish meals and entertainment involve more pleasure than business and should not be subsidized with federal tax dollars

13. Methods of Accounting: Policy Objectives
6-13
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
To encourage firms to make capital investments

14. 6-14
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

15. 6-15
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

16. Cash Method Income Constructive receipt of income
6-16
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

17. 6-17
Cash Method Income
A calendar year, cash basis firm wants to defer income from this year to next year. Can it defer income recognition if:
It holds the checks received from customers in December in its vault and does not cash them until January?
No – the income has been constructively received

18. Cash Method Deductions
6-18
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

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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

20. Cash Method Deductions - Inventory
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Cash Method Deductions - Inventory
Inventory must be accounted for on the accrual method, even for cash basis taxpayers
Hybrid method of accounting
Purchases and sales of inventories are accounted for under the accrual method and all other transactions are accounted for under the cash method

21. Limitations on Corporations Using Cash Method
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Limitations on Corporations Using Cash Method
Corporations that average more than $5 million in annual gross receipts can’t use the cash method
Prohibition applies to partnerships with a corporate partner
Personal service corporations (providing professional services such medical, legal, and accounting services) may use the cash method

22. Accrual Method of Accounting
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Accrual Method of Accounting
Under the accrual method, taxpayers recognize income when the right to the income is fixed and the amount of income can be determined with reasonable accuracy
Taxpayers deduct expenses when all events have occurred that establish the fact of the liability for the expense and the amount of the liability can be determined with reasonable accuracy

23. 6-23
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

24. Permanent Book-Tax Differences
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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

25. Temporary Book-Tax Differences
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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)

26. Favorable or Unfavorable Differences
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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

27. Tax Expense per Books Versus Tax Payable
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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)

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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. 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

29. 6-29
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

30. Temporary Differences: Prepaid Income
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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

31. Prepaid Income Example
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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 (December rent)
How much taxable income does Acme report this year?
Acme reports $12,000 taxable income

32. One-Year Rule for Prepaid Service Income
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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

33. Temporary Differences: Accrued Expenses
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Temporary Differences: Accrued Expenses
An accrued expense is deductible only if it passes the all events test:
All events that establish the liability have occurred
The amount must be determinable with reasonable accuracy
Economic performance with respect to the liability has occurred

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

35. Economic Performance – Payment Liabilities
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Economic Performance – Payment Liabilities
The economic performance requirement defers the deduction until payment is made for accrued:
Legal settlements for workers compensation, tort, breach of contract
Customer rebates/refunds
Awards, prizes, jackpots
Taxes imposed by a governmental authority

36. Recurring Item Exception
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Recurring Item Exception
Taxpayers may adopt the recurring item exception as a method of accounting for:
Liabilities routinely incurred from year to year and properly accrued under GAAP
Economic performance occurs within 8½ months after year-end
Taxpayer may deduct the corresponding expense in the year of accrual

37. Accrued Expense Example
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Accrued Expense Example
ABC Company has two accrued expenses at year end
December’s utility bill to be paid in 30 days
Estimated legal settlement under workers compensation claim
Which accrual can be deducted on the current year tax return?
Accrued utility expense

38. Special Accrual Rules Compensation accruals Related party accruals
6-38
Special Accrual Rules
Compensation accruals
Employer cannot deduct expense unless compensation paid within 2½ months after the close of year
Related party accruals
The payer can’t deduct an accrued expense until the year that the recipient recognizes income
Bad debt expense
GAAP requires the allowance method
For tax purposes, the direct write-off method is required

39. Net Operating Loss (NOL)
6-39
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

40. 6-40
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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