2. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

3. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 5 5 Income Measurement and Reporting

4. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-3 Tax Year Every taxable entity must have an annual accounting period ending on the last day of a month Exception: 52-53 week year C Corporations may use the same year they use for financial statement purposes Exception: Personal service corporations

5. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-4 Tax Year – Passthroughs Owner reports income from entity that falls within owner’s tax year If owner is on calendar year and entity on fiscal year, tax deferral possibilities Example: S Corporation has a year ending January 31, 2004. Income earned between February 1, 2003 and January 31, 2004. Shareholder would report entire amount on 2004 tax return although most was earned in 2003

6. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-5 Tax Year – Passthroughs Must generally adopt same tax year as owners Exception: Business Purpose Natural Business Year 25% or more of gross receipts in last two months of year

7. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-6 Partnership Tax Years Must be on same tax year as the owners of a majority of the partnership If partners owning majority of partnership are not on the same year end must use year end of principal (5%) partners If no principal partners or they are on different year ends, use year end with least aggregate deferral

8. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-7 S Corporation Tax Years S Corporations must use a calendar year end

9. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-8 Tax Accounting Methods Determines when income is reported and deductions are taken Accrual, cash or hybrid are examples of overall methods Once adopted a method may only be changed with permission of IRS

10. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-9 Cash Basis Taxpayers Income recognized when actually or constructively received Expense recorded when paid Exception: expenditures for items that have a life extending substantially beyond the current tax year must be capitalized Rent, Insurance, Supplies

11. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-10 Retailers and Manufacturers These taxpayers must maintain inventories even if they use cash method for other items Inventories must be accounted for using the accrual method Exception: Service businesses with annual gross receipts of $10,000,000 or less

12. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-11 C Corporation Accounting Methods Must generally use accrual method Exception: Corporations with average annual gross receipts not exceeding $5,000,000

13. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-12 Accrual Method Similar to but not the same as generally accepted accounting principles Accrual tax method tends to report income sooner and expenses later than GAAP

14. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-13 Book Income vs. Taxable Income Permanent Differences Income that will never be taxable Municipal Bond Interest Life insurance proceeds Dividends received deduction Items that will never be deductible Bribes Lobbying expense Premiums on key man life insurance Expenses related to tax-exempt income 50% of meals and entertainment Goodwill not amortized for books

15. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-14 Book vs. Taxable Income Temporary differences Income or deductions that will be reported in the same amount for both books and tax but in different time periods

16. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-15 Temporary Differences Income reported earlier for tax than for books Advanced rents received

17. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-16 Temporary Differences Deductions taken earlier for books than tax Nonqualified deferred compensation Reserve for estimated expenses Items where economic performance has not been completed Start up costs Inventory costs Depreciation

18. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-17 Economic Performance Rule applicable to accrual basis taxpayers Delays deduction even though liability has been established and can be determined with reasonable accuracy Services or products actually provided Payment in connection with legal liability Exception: Recurring items

19. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-18 Accounting for Income Taxes Financial statement not tax concept Purpose is to provide tax expense on financial statement Eliminates timing effects of temporary differences Result is a deferred tax liability or charge

20. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-19 Accounting for Income Taxes Rate reconciliation footnote Highlights permanent differences

21. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-20 Deferred Taxes Deferred liability if income will be subject to tax at later time than recognized for books Deferred asset if income recognized for tax before books

22. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 5-21 Estimated Payments for Corporations Corporations must make quarterly payments Must pay in 100% of tax Exceptions First quarter may be based upon prior year Small corporations may base entire year’s payments on prior year