chapter 9 business income- deductions-acct- methods howard godfrey, ph.d., cpa professor of...

Chapter 9Business Income-Deductions-Acct-

Methods Howard Godfrey, Ph.D., CPA

Professor of Accounting ©Howard Godfrey-2015

Chapter 9. Business Income, Deductions & Accounting MethodsBUSINESS EXPENSE DEDUCTION, Ordinary, [2] Necessary, Reasonable Amount [4]Unreasonable Salary, Construct. Div. Pg. 14-14LIMITS: Non-deductible Business Expend. [5: 47]Expenses to earn tax-free income - no deduct. [6]Meals, Entertainment, [also gifts: $25] [8: 48, 54] Travel & Transportation [records] [9: 50, 51]Domestic Production Activity Deduction [12]

3

General Tax Formula Gross Income 110,000$

Deductions For A.G.I. (10,000) Adjusted Gross Income (AGI) 100,000 Exemptions (7,900) Form 1040-Schedule A

Regular Item. Deductions (13,100) Misc. Item. Ded. 5,000 Less 2% of AGI (2,000) Deductible Amount 3,000 Total Deductions From AGI (18,000)

Taxable Income 82,000$

Deduction Classification

Profit-Motivated ExpensesTrade or Business orProduction-of-Income

Rental ActivityPersonal ExpendituresBus. & Personal Expenses

Classification of Expenses Profit motivated, Trade or business or Production of income, Rental, Personal, Mixed business and pleasure.Tests for Deductibility –Ordinary and necessary,Reasonable in amount.Limits on Deductions. Not against Public policy, Not political or lobbying. Not capital expenditure. Not an expense related to tax-exempt income, Not a personal expense. For taxpayer’s benefit- not paying an expense for another person.Timing – Cash or Accrual basis, Accrual to related party, Financial accounting & tax differences

Code Sections• Sec. 161 - deductions permitted only for

those expenses and losses for which a deduction is authorized

• Sec. 162(a) authorizes deductions for ordinary and necessary expenses, that are reasonable in amount, and incurred in actively carrying on a trade or business

• Sec. 212 authorizes deductions for expenses related to production of income (investment-related expenses)

Sec. 212. Expenses for Production of Income.In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year-(1) for the production or collection of

income;(2) for the management, conservation, or

maintenance of property held for the production of income; or

(3) in connection with the determination, collection, or refund of any tax.

Rules for Deductions for AGI. [1 of 7] • A taxpayer reports income and

can deduct reasonable expenses (and losses) for a trade or business operation.

• A taxpayer reports income and can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation.

Rules for Deductions for AGI. [2 of 7] • A trade or business operation often

means providing goods or services to customers. (By comparison, an employee provides services to his or her employer.)

• When you buy an asset hoping to sell it later at a profit (such as buying IBM stock) you are not in a trade or business, but this is a transaction entered into for profit.

Rules for Deductions for AGI. [3 of 7]• There is no good definition of a trade or business.

• An typical investor is not in a trade or business.

However, Wachovia Securities invests in stocks and sells stocks to its customers. It is a business.

• If you buy land and build an apartment building on it for resale, you may not be in a trade or business. If you repeat this 20 times, you are in the real estate business (possibly as a real estate developer).

• When does your activity rise to the level that causes you to be in a trade or business? Who knows?

Rules for Deductions for AGI. [4 of 7] • Expenses (and losses) are deductible

“For AGI” if they are for a trade or business operation (generally providing goods or services to customers, clients, etc.).

• Expenses are deductible “For AGI” if they are for a transaction entered into for profit, and they involve property that generates rental income or royalty income.

• Expenses for other transactions entered into for profit are deductible as Misc. Item. Deductions.

Rules for Deductions for AGI.[5 of 7] • A taxpayer can deduct reasonable

expenses (and losses) for a trade or business operation. (Sec. 162)

• A taxpayer can deduct reasonable expenses (and losses) for a transaction entered into for profit, even though it does not meet the definition of a trade or business operation. (Sec. 212)

Rules for Deductions for AGI. [6 of 7]

• Renting property to tenants (for example under one-year contract or longer) is generally not a trade or business, unless you provide substantial services.

• A golf course technically rents you the land for a few hours, but you are mainly paying for service.

• A Marriott Hotel is a trade or business.They have many customers and they provide substantial services to their customers.

Rules for Deductions for AGI. [7 of 7] • An employee is in the trade or business of

being an employee, but is subject to special limits on deductions.

• Employee expenses are deductible from AGI (Misc. Deductions) except for reimbursed expenses. (If the reimbursement is included in income, there is an offsetting deduction for AGI. Usually, reimbursed expenses are not included in income, so there is no deduction.)

Sec. 62. Adjusted Gross Income Defined.(a) General Rule. For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:(1) Trade and business deductions. The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.

Sec. 62. Adjusted Gross Income Defined. Cont’d(a) General Rule. For purposes of this subtitle, the term “adjusted gross income” means…….(2) Certain trade and business deductions of employees.(A) Reimbursed expenses of employees.The deductions allowed by part VI ( section 161 and following) which consist of expenses paid or incurred by the taxpayer, in connection with the performance by him of services as an employee, under a reimbursement or other expense allowance arrangement with his employer. The fact that the reimbursement may be provided by a third party shall not be determinative of whether or not the preceding sentence applies. (Accountable Plan)

Tests for DeductibilityOrdinary, Necessary, Reasonable in amountNot Personal ExpenseNot Capital ExpenditurePublic PolicyNot for Exempt IncomeFor Taxpayer's Benefit

Meals & Entertainment. • The deduction for business meals

and entertainment expenses is limited to 50% of the qualified expenses

• The 50% limit is imposed on person (employer or employee) that ultimately pays the expense

Transportation Expenses. • Certain transportation expenses incurred

when the taxpayer is not away from home are deductible and include–the cost of transportation from one work

location to another –transportation between home and a

temporary work location if the taxpayer has a regular place of business

–any meal costs are not deductible, however

Transportation Expenses • The prorated business portion of

actual auto expenses or a standard mileage rate (57.5¢ for 2015) plus related parking and tolls can be deducted

• Commuting expenses (between home and regular place of business) are a personal nondeductible expense

DocumentationExpenses related to Meals, Entertainment, Automobile Usage, Travel, and Business Gifts are deductible subject to limitations and strict documentation requirements–Amount–Time and place–Date and description–Business purpose–Business relationship of other person(s)

Depreciation $4,900Gas, oil, repairs $2,000Parking and Tolls $1,000Business miles 15,000 Mileage RateAuto expense ded.?

Auto ExpenseTP uses auto 100% for bus.

Depreciation $4,900Gas, oil, repairs $2,000Parking and Tolls $1,000

Total expenses $7,900Business miles 15,000 Mileage Rate $0.575Mileage expense $8,625Parking and Tolls $1,000Total Deduction $9,625

TP uses auto 100% for bus.

Travel Away From Home• Travel expenses incurred for temporary

travel away from home (over night) on business are deductible.

• Qualifying expenses include lodging: (1) 50% of meals, (2) transportation to destination and back, and (3) incidental expenses– Away from home refers to person’s tax home;

that is, the location of principal place of employment regardless of where the family residence is maintained

Temporary Assignments • Temporary is defined as one year or less• Employment away from home in a single

location that is realistically expected to last (and does in fact last) for one year or less, will be treated as temporary

• Assignment for more than one year shifts tax home to the new location (no deduction for travel and living costs)

Combining Business with Pleasure Travel• Over 50% of the activity requiring

travel must have a business purpose–Personal activity costs on a business trip

are not deductible–Incidental business expenses on a

personal trip are deductible–Travel for general educational purposes

or for investment related meetings is not deductible

Combining Business with Pleasure Travel• For U.S. travel, if the trip is primarily for

business, all transportation costs to and from destination are deductible

• If primary purpose is pleasure, no deduction for transportation

• Primary purpose is determined by the number of days on business versus personal days

TotalRound trip airfare $475

Days CostDays-business 4Days-pleasure 3Hotel at daily rate 7 $175 1,225Meals per day 7 $40 280Incidentals 7 $25 175Total Cost $2,155Total Deduction

Juan went to Atlanta for 7 days.

Business Travel Expense

Total Deduct

Round trip airfare $475 $475Days Cost

Days-business 4Days-pleasure 3Hotel daily rate 7 $175 1,225 700Meals per day 7 $40 280 80Incidentals 7 $25 175 100

Total Cost $2,155

Total Deduction $1,355

Juan went to Atlanta-7 days.

Business Travel Expense

Combining Business with Pleasure Travel Meals & lodging are deductible only for days

on which business is conducted• If a taxpayer remains in a temporary

location to reduce costs as a result of– reduced airfare for Saturday night stays or – for business conducted on both Friday and

Monday – the costs for additional days are deductible if

they are less than the cost of returning home when business is completed

Travel Expenses- Martha Martha lives with her husband in Los Angeles but works in San Diego. During the week she stays in a hotel in San Diego and eats in restaurants. On weekends she flies home to Los Angeles. During the year, Martha spent $5,000 for the hotel, and $2,000 for meals while in San Diego. Her airfare for travel between San Diego and Los Angeles was $2,500. What is Martha’s deduction for travel expenses?

Travel Expenses-MarthaMartha cannot deduct any travel expenses. Her tax home is in San Diego. Her travel to Los Angeles is purely personal and her expenses are nondeductible.

Transportation Expense-JohnJohn is a high school teacher. He travels three days per week to a school in the next county to work with gifted children in an after-school program that does not end until 6:30 P.M. He normally eats dinner before driving home. If he drives 75 miles each way on 90 days to the gifted program, his meal expense is $900, and he maintains adequate records, how much may John deduct?

Transportation Expense-John

John is allowed to deduct his mileage only. He has no deduction for meals as he is not “traveling away from home.”

Days 90Miles 150Rate 0.575$ Total 7,762.50$

Business Gifts.

Randy gave one of his best customers a $150 bottle of wine. How much can he deduct for this business gift?

Business Gifts – Slide 2

The deduction for business gifts is limited annually to $25 per donee.

Meals & Entertainment • Directly-related expenses - costs incurred

when a significant business discussion takes place between the taxpayer and a customer in atmosphere conducive to the serious conduct of business.

• Associated-with expenses - deductible when directly preceded or followed by a substantial business discussion– Deduction for entertainment tickets is limited

to 50% of the tickets’ face value

Deductions Restriction • No deduction allowed for the costs of

owning and maintaining entertainment facilities such as hunting lodges and yachts

• No deduction allowed for membership dues and fees paid to social, athletic, or sporting clubs–Deductions are allowed for dues to

professional organizations, public service organizations, and trade associations

• Deduction for business gifts limited to $25 per donee per year

Mr. Hill is self-employed. He has unreimbursed business expenses. He has adequate proof (amounts & purpose). Dues to country club- where customers are entertained $3,000Business meals $2,000Business entertainment $1,000Business gifts (10 gifts at $30 each to 10 different people) $300What is the amount Hill can deduct?

Meals, Entertainment and Gifts

Mr. Hill is self-employed. He has unreimbursed business expenses. He has adequate proof (amounts & purpose). Dues to country club- where customers are entertained $3,000Business meals $2,000Business entertainment $1,000Business gifts (10 gifts at $30 each to 10 different people) $300What is the amount Hill can deduct?

Meals, Entertainment and Gifts

Mr. Hill is self-employed. He has unreimbursed business expenses. He has adequate proof (amounts & purpose). Dues to country club- where customers are entertained $3,000 $0Business meals $2,000 $1,000Business entertainment $1,000 $500Business gifts (10 gifts at $30 each to 10 different people) $300 $250What is the amount Hill can deduct? $1,750

Meals, Entertainment and Gifts

Entertainment Expenses - JimJim, a self-employed individual, takes an important customer to the hockey playoffs. Although the face value of a ticket is only $70, he pays a scalper $400 for each ticket. Assuming all other requirements are met, how much can Jim deduct for the two tickets?

Entertainment Expenses-Jim

$70. Entertainment tickets are not only subject to the 50% limit, but the 50% limit applies to the face value of the tickets. Thus, Jim is allowed a deduction for only one-half of the face value of the tickets or $70 (50% x $140).

Income & Exp. Facts AGI From AGI T-Income

Wages earned $60,000 $60,000

Alimony Paid (10,000) (10,000)

NC Income Tax (4,000) (4,000)

Charity (3,000) (3,000)

Union Dues (1,200) (200)

AGI 50,000

Itemized ded. (7,200)

Exemption (3,900)

Tax. Income 38,900

Taxable income? (single - 1 exemption) - 2015

Salary $90,000

Dividend income 2,000

Income from rents 16,000

Expenses for rental property 9,000

Cost of stock mkt newsletter 3,000

Unreimbursed employee exp. 1,000

Which are deductible from AGI (before limits)?

a. $1,000 b. $3,000 c. $4,000 d. $9,000

An employee reports the following:

Salary $90,000

Dividend income 2,000

Income from rents 16,000

Expenses for rental property 9,000

Cost of stock mkt newsletter 3,000 $3,000

Unreimbursed employee exp. 1,000 1,000

Itemized Deductions $4,000

Which are deductible from AGI (before limits)?

a. $1,000 b. $3,000 c. $4,000 d. $9,000

An employee reports the following:

Investor Losses • An investor in the stock market deducts

investment related expenses from AGI on Schedule A.

• An investor in the stock market reports gains (and deducts losses) on the sale of stock on Schedule D, and the net gain or loss (subject to loss limits) flows from Schedule D to the front of Form 1040.

• Capital losses from stock sales are deductible for AGI.

Chapter 9. Business Income

Loss: Disposal of Bus Prop. [Chp. 11] [13]

Bus. Casualty Losses (also Pg. 7-12) [14]

Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event

–For property fully destroyed, deduct the adjusted basis less insurance recovery

–For property partially destroyed, deduct lesser of the property’s adjusted basis, or the decline in the property’s value

Involuntary Conversions • An involuntary conversion results from

– Theft – embezzlement, larceny and robbery (but not simply losing items)

– Casualty – requires a sudden, unexpected, and unusual event such as a fire, flood, tornado, hurricane or vandalism

– Condemnation – lawful taking of property for its fair market value by a government under the right of eminent domain

Casualties and Thefts• Gains and losses sustained on

casualties and thefts are not under a taxpayer’s control so they receive special tax treatment–Allowable losses (including personal

losses) are immediately deductible–Gains (due to receipt of insurance

proceeds) may be deferred if all insurance proceeds are used to repair the damaged property or to acquire qualifying replacement property

Casualty and Theft Losses• Partial destruction of Business or Investment

Property– Loss limited to the lesser of:

Decline in fair market value (or repair costs to restore property to pre-casualty condition), orThe adjusted basis of the property

Complete Destruction of Business PropertyFor business property that is completely destroyed, the loss is always the property’s adjusted basis.

• The loss computed above is then reduced by any insurance proceeds received

Business asset-Partial Destruction

FMV before fire $300,000FMV after fire 200,000

Decline in value 100,000Cost basis 150,000

< of decline or basisIns. proceedsDeductible loss

Loss: cost to repair or value decline?

What if ending FMV was $40,000?

Business asset-Partial Destruction

FMV before fire $300,000FMV after fire 200,000

Decline in value 100,000Cost basis 150,000

< of decline or basis 100,000Ins. proceeds 0Deductible loss $100,000

Loss: cost to repair or value decline?

What if ending FMV was $40,000?

Casualty &Theft Loss Deductions• Thefts are deductible in year of discovery• For casualties in designated disaster areas,

taxpayer can elect to deduct loss in preceding year

• A net business loss is deducted from ordinary income; an investment loss is an itemized deduction

• Individuals have additional limits on losses from personal-use property:– $100 floor per casualty (per event) – 10% of AGI threshold– Must itemize to deduct loss

Jim's business building was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jim received insurance reimbursement of $120,000 for the destruction of the workshop. Jim's AGI was $70,000, before considering this loss. Jim had no casualty gains during the year. What is Jim’s fire loss deduction on his tax return?a. $ 2,900 b. $ 8,500 c. $ 30,000

Business asset Jim

Adjusted gross income $70,000FMV before the casualty 130,000FMV after the casualty 0Decline in valueCost basisInsurance proceedsLoss

Business asset Jim

Adjusted gross income $70,000FMV before the casualty 130,000FMV after the casualty 0Decline in value 130,000Cost basis 150,000Insurance proceeds 120,000Loss $30,000

If not insured, deduct basis-$150,000

Gains on Involuntary Conversions

• If the insurance recovery on a casualty or theft is greater than the loss, the taxpayer has a gain

• Condemnations usually result in gain because proceeds received are usually fair market value

Gains on Involuntary Conversions• If all proceeds are used to acquire qualified

replacement property (or repair the property to its pre-casualty condition) within the required replacement period, the gain is deferred

• Gain may have to be recognized if all proceeds are not used to acquire replacement property (or make repairs to the damaged property) within the required time period

Jane's residence was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jane received insurance reimbursement of $120,000 for the destruction of her home. Jane's adjusted gross income was $70,000. Jane had no casualty gains during the year. What amount of the fire loss was Jane entitled to claim as an itemized deduction on her tax return?a. $ 2,900 b. $ 8,500 c. $ 8,600 d. $10,000

Requirements for recognizing taxable income tend to be structured to recognize income earlier than the recognition rules for GAAP accounting. Requirements for accruing tax deductions tend to be structured to recognize less accrued expenses than the recognition rules for GAAP reporting purposes. The government's main objective for writing tax laws is to collect revenues. Tax accounting rules for accrual-method businesses tend to bias against understating income.

Personal asset - totally destroyed.

Adjusted gross income $70,000

FMV before the casualty 130,000

FMV after the casualty 0

Decline in value 130,000

Cost basis 150,000

Lesser of cost or decline 130,000

Insurance proceeds received 120,000

Loss after Ins. Proceeds

10% of AGI

$100 floor

Deduction

Personal asset - totally destroyed

Adjusted gross income $70,000

FMV before the casualty 130,000

FMV after the casualty 0

Decline in value 130,000

Cost basis 150,000

Lesser of cost or decline 130,000

Insurance proceeds received 120,000

Loss after Ins. Proceeds 10,000

10% of AGI (7,000)

$100 floor (100)

Deduction $2,900

Asset Type Business Personal1 Adjusted gross income N/A 70,0002 FMV before casualty 170,000 170,0003 FMV after casualty 30,000 30,0004 Decline in value (or repair cost?) 140,000 140,0005 Cost basis 150,000 150,0006 Lesser of line 4 or 5 140,000 140,0007 Loss before insurance 140,000 140,0008 Insurance proceeds received 80,000 80,0009 Loss or (gain if insurance greater) 60,000 60,000

10 10% of AGI (7,000)11 $100 floor (100)12 Deduction $52,900

Case 1 may involve repair costs of $140,000.

Chapter 9. Business Income ACCOUNTING Periods, Methods [15]Cash Method, Accrual Method [17: 59] All-Events Test [19] Advance Collection of Income [20: 64]

Selected Sentences in Bank of Bank of America Annual ReportThere are two components of income tax expense: current and deferred.

Current income tax expense reflects taxes to be paid or refunded for the current period.

Deferred income tax expense results from changes in deferred tax assets and liabilitiesbetween periods.

Selected Sentences in Bank of Bank of America Annual ReportThese gross deferred tax assets and liabilities represent decreases or increases in taxes expected to be paid in the future because of future reversals of temporary differences in the bases of assets and liabilitiesas measured by tax laws andtheir bases as reported in the financial statements.

Deferred tax assets are also recognized for tax attributes such as net operating loss carryforwards and tax credit carryforwards.

GAAP TAX

Net Income Before Depreciation $90,000 $90,000

Cost of machine (4 year life) $40,000 $40,000GAAP depreciation, year 1 ($10,000)Tax depreciation, year 1 ($40,000)

GAAP book value - end of Yr 1 $30,000Tax basis-book value - end of Yr 1 $0Income before tax/taxable income $80,000 $50,000Basis Difference of $30,000 is a future taxable amount.With 40% tax rate, you have a deferredtax liability of $12,000

Income Taxes – Nike. The Company accounts for income taxes using the asset and liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities.

The allowance for uncollectible accounts receivable was $78 million and $78 million at May 31, 2015 and 2014, respectively, of which $24 million and $37 million, respectively, was classified as long-term and recorded in Deferred income taxes and other assets. Why?

A cash basis business owner paid the following bills on July 1, 2015

Expiration Amount Date

Business Auto Insurance $12,000 7/1/2016Business Fire Insurance $24,000 9/1/2016

What is the amount of the Deduction this year? Auto $12,000

Fire $6,000

Year-end balances in: 2015 2016

Customer Accts Receivable $100,000 $120,000

Accts Payable-Operating Exp. $10,000 $7,000

Cash basis net income Revenue - Collections $900,000 $990,000

Expenses - Payments (770,000) (790,000)

Net Income (cash basis) $130,000 $200,000

Convert to accrual basisAdjust for accounts receivable

Adjust for accounts payable

Accrual Basis Net Income

Year-end balances in: 2015 2016

Customer Accts Receivable $100,000 $120,000

Accts Payable-Operating Exp. $10,000 $7,000

Cash basis net income Revenue $900,000 $990,000

Expenses (770,000) (790,000)

Net Income (cash basis) $130,000 $200,000

Convert to accrual basisAdjust for accounts receivable $100,000

Adjust for accounts payable ($10,000)

Accrual Basis Net Income $220,000

Year-end balances in: 2015 2016

Customer Accts Receivable $100,000 $120,000

Accts Payable-Operating Exp. $10,000 $7,000

Cash basis net income Revenue $900,000 $990,000

Expenses (770,000) (790,000)

Net Income (cash basis) $130,000 $200,000

Convert to accrual basisAdjust for accounts receivable $100,000 $20,000

Adjust for accounts payable ($10,000) $3,000

Accrual Basis Net Income $220,000 $223,000

Accrual Accounting-Revenues-1 REG §1.451-1.methods of accounting.. income is included in gross income

[when] all events have occurred that fix the right to receive the income,

andthe amount can be determined with reasonable accuracy.

Rental Company - Accrual basis company Year 1

Co. rents trucks and an office building Facts GAAP

Net income from truck rental 100,000 100,000

Building cost (40 Yrs, S/L) $400,000

IBM rents building for: 3 Years

Rental charge per year $25,000

IBM payment in Year 1 $75,000

Rent Revenue from Office Building 25,000 25,000

Building depreciation-straight-line 10,000 (10,000)

Bldg. Property Tax & Insurance-Year 1 8,000 (8,000)

GAAP income before Tax-Year 1 107,000

Taxable income-Year 1 (tax rate is 40%)

Income Tax Expense and Income Tax Payable 42,800

Rental Company - Accrual basis company Year 1 Year 1

Co. rents trucks and an office building Facts GAAP Tax Return

Net income from truck rental 100,000 100,000 100,000

Building cost (40 Yrs, S/L) $400,000

IBM rents for: 3 Years

Rental charge per year $25,000

IBM payment in Year 1 $75,000

Rent Revenue from Office Building 25,000 25,000

Building depreciation-straight-line 10,000 (10,000) (10,000)

Property Tax & Insurance-Year 1 8,000 (8,000) (8,000)

GAAP income before Tax-Year 1 107,000

Taxable income-Year 1 (tax rate is 40%)

Income Tax Expense and Income Tax Payable 42,800

Rental Company Year 1 Year 1

Co. rents trucks and an office building Facts GAAP Tax Return

Net income from truck rental 100,000 100,000 100,000

Building cost (40 Yrs, S/L) $400,000 IBM rents for: 3 Years Rental charge per year $25,000 IBM payment in Year 1 $75,000

Rent Revenue from Office Building 25,000 25,000 Building depreciation-straight-line 10,000 (10,000) (10,000)

Property Tax & Insurance-Year 1 8,000 (8,000) (8,000)

GAAP income before Tax-Year 1 107,000 Taxable income-Year 1 (tax rate is 40%) Income Tax Expense and Income Tax Payable 42,800

Current Income Tax Expense (or Benefit)Current Income Tax Payable (or Receivable)

Deferred income tax expense or (or benefit)Deferred income tax asset or (or liability)

Rental Company Year 1 Year 1

Co. rents trucks and an office building Facts GAAP Tax Return

Net income from truck rental 100,000 100,000 100,000

Building cost (40 Yrs, S/L) $400,000 IBM rents for: 3 Years Rental charge per year $25,000 IBM payment in Year 1 $75,000

Rent Revenue from Office Building 25,000 25,000 75,000

Building depreciation-straight-line 10,000 (10,000) (10,000)

Property Tax & Insurance-Year 1 8,000 (8,000) (8,000)

GAAP income before Tax-Year 1 107,000 Taxable income-Year 1 (tax rate is 40%) 157,000

Income Tax Expense and Income Tax Payable 42,800 62,800

Current Income Tax Expense (or Benefit)Current Income Tax Payable (or Receivable)

Deferred income tax expense or (or benefit)Deferred income tax asset or (or liability)

Rental Company Year 1 Year 1

Co. rents trucks and an office building Facts GAAP Tax Return

Net income from truck rental 100,000 100,000 100,000

Building cost (40 Yrs, S/L) $400,000 IBM rents for: 3 Years Rental charge per year $25,000 IBM payment in Year 1 $75,000

Rent Revenue from Office Building 25,000 25,000 75,000

Building depreciation-straight-line 10,000 (10,000) (10,000)

Property Tax & Insurance-Year 1 8,000 (8,000) (8,000)

GAAP income before Tax-Year 1 107,000 Taxable income-Year 1 (tax rate is 40%) 157,000

Income Tax Expense and Income Tax Payable 42,800 62,800

Current Income Tax Expense (or Benefit) 62,800Current Income Tax Payable (or Receivable) 62,800

Deferred income tax expense or (or benefit) 20,000Deferred income tax asset or (or liability) 20,000

Chapter 9. Business Expense Inventories, Uniform Capitalization [21] Cost-flow methods: FIFO, Specific ID [22]ACCRUAL OF DEDUCTIONS, All-Events Test,[24] Economic Performance, Warranties [24: 62, 76]BAD DEBTS EXPENSE: (instructor handout) [27] Direct Write-off vs. Allowance Method Limits on Accrual to Related Parties [28: 79]Compare Cash and Accrual Methods [29]Adopt or Change an Accounting Method [30: 80]

Note: We will not cover inventory methods in this course. We assume you have covered several chapters on inventories in prior accounting courses.

So you will not have test questions on inventory in this course. None on Uniform Capitalization rules either.

An accrual basis business owner had the unpaid bills on December 15, 2015

Amount To be Nature of expense Owed PaidEquipment maintenance fee $12,000 2/1/2016Annual Radio Advertising $24,000 9/1/2017

What is the amount of the Deduction this year? Maintenance $12,000Economic Performance? Advertising $0

Timing of Deductions – Tax Rules• Accrual method – expenses deductible when

– “All events” have occurred that fix liability and

– “Economic performance” occurs (property or services provided or used)

• Cash basis taxpayer - expenses deductible when paid– Date check is mailed– Date charged on credit card

Accrual Accounting-Expenses-1 REG §1.461-1. ..methods of accounting…a liability is incurred, …,

[when] all events have occurred that establish the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.

86

Accrual Accounting-Warranty-1Manufacturer provides a 3-year warranty. Financial statement for its first year:

Sales $1,000,000Cost of sales 600,000Expenses 300,000Net income before taxes $100,000

Expenses include a reserve of $20,000[Reserve for future repair costs on units sold in the current year.]What is taxable income for current year?a. $100,000 b. $80,000 c. $120,000

87

Accrual Accounting-Warranty-2Manufacturer provides a 3-year warranty. Financial statement for its first year:

Sales $1,000,000Cost of sales 600,000Expenses 300,000Net income before taxes $100,000

Expenses include a reserve of $20,000[Reserve for future repair costs on units sold in the current year.]What is taxable income for current year?a. $100,000 b. $80,000 c. $120,000

88

Accrual Accounting-Warranty-3Manufacturer provides a 3-year warranty. Financial statement for its first year:

Sales $1,000,000Cost of sales 600,000Expenses 300,000Net income before taxes $100,000

Expenses include a reserve of $20,000

account at end of Year 1?Balance in deferred tax asset or liability

[Reserve for future repair costs on unitssold in the current year.] Tax Rate 40%.

89

Accrual Accounting-Warranty-4Manufacturer provides a 3-year warranty. Financial statement for its first year:

Sales $1,000,000Cost of sales 600,000Expenses 300,000Net income before taxes $100,000

Expenses include a reserve of $20,000

account at end of Year 1? $8,000Balance in deferred tax asset or liability

[Reserve for future repair costs on unitssold in the current year.] Tax Rate 40%.

Using the information on the next slide.How much did the company spend onwarranty claims during the year?Warranty expense is the only expensewith a different balance using GAAP andTax rules. What is taxable income? GAAP Net Income $60,000 Adjust Taxable Income

Guaranty Company End of first year (2015). Income tax rate of 40%. Cash 60,000

Machine - Bought Jan. 2, 2015 50,000

Accumulated Dep.-S.L.- 5 years 10,000

Warranty Liability 12,000

Common Stock 28,000

Retained Earnings

Repair revenue 200,000

Warranty Expense 18,000 Salaries, supplies, depreciation, etc. 122,000

Totals 250,000 250,000

Using information on previous slide.How much did the company spend onwarranty claims during the year?Warranty expense is the only expensewith a different balance using GAAP andTax rules. What is taxable income? GAAP Net Income $60,000 Warranty reserve increase Taxable Income

Deferred tax asset

Using the information on the next slide.How much did the company spend onwarranty claims during the year?Warranty expense is the only expensewith a different balance using GAAP andTax rules. What is taxable income? GAAP Net Income $60,000 Warranty reserve increase $12,000 Taxable Income $72,000

Deferred tax asset $4,800

Provide journal entry for warranty provision

Warranty Expense

Warranty liabilityProvide journal entry for warranty payments

Warranty liability

Cash

Balance in the deferred tax assetor liability at the end of the first year?

Deferred Tax Asset

Provide journal entry for warrenty provision

Warranty Expense 18,000

Warranty liability 18,000Provide journal entry for warranty payments

Warranty liability 6,000

Cash 6,000

Balance in the deferred tax assetor liability at the end of the first year?

Deferred Tax Asset 4,800

Journal entry for current income tax expense (benefit).

Current income tax expense (benefit)

Current income tax payable

Journal entry for deferred income tax expense (benefit).

Deferred income tax asset

Deferred income tax expense (benefit)

Journal entry for current income tax expense (benefit).

Current income tax expense (benefit) $28,800 Current income tax payable $28,800

Journal entry for deferred income tax expense (benefit).

Deferred income tax asset $4,800 Deferred income tax expense (benefit) $4,800

Bad Debt Expense. • Specific charge-off method must be

used• Investment and personal loans are

considered nonbusiness (capital losses)

• Loan must be valid debt• No bad debt deduction for cash basis

taxpayers who have not previously included amount in income

99

GAAP- 2015- Income Statement:

Sales (Gross) $200,000Cost of sales 100,000

Gross Profit 100,000 Expenses - includes bad debts 60,000

Net income before taxes $40,000

In GAAP statements, bad debtsexpense is 4% of gross sales ($8,000). Allow. for bad debts, 12/31/2014 $5,000Allow. for bad debts, 12/31/2015 4,000What is taxable income for 2015? a. $ 40,000 b. $42,000 c. $39,000 d. $38,000

Accounting for Bad Debts

Sales (All on credit) $100Bad debts (provision) 5Other Expenses 70Total Expenses 75Net Income before Taxes $25

Beg. End.Accounts Receivable $30 $35Allowance for Bad Debts $7 $4

Amount of Accounts Rec. written off?What is taxable Income?

Bad Debts Problem ($000) 1 of 5

Beg. Bal. XXX1 Sales

3 Collection

4 Write-off

5 Other Exp.

6 Provision

Balance

1 Sales

5 Other Exp.

5 Provision

Revenue

Revenue and Expense ($000)Bad Debts Exp.Other Exp.Transaction

Bad Debts Problem (2 of 5)

Cash AllowanceAccts. Rec.Transaction

Beg. Bal. XXX 80 7 1 Sales 100 3 Collection 87 87 4 Write-off 8 8 5 Other Exp. 70 6 Provision 5

Balance

1 Sales 100 5 Other Exp. 70 5 Provision 5

Revenue

Revenue and Expense ($000)Bad Debts Exp.Other Exp.Transaction

Bad Debts Problem (3 of 5)

Cash AllowanceAccts. Rec.Transaction

Allowance Balance- Jan 1. $7,000

Provision for Bad Debts 5,000

Subtotal 12,000

Accounts Written Off ?

Allowance Balance- Dec. 31. $4,000

Amount Written Off $8,000

Allowance for Bad DebtsBad Debts Problem 4 of 5

Receivables Balance- Jan 1. $30,000Credits sales for year 100,000Subtotal 130,000Accounts Written Off (8,000)Rec. Balance after write-off 122,000Collections of Receivables ?

Receivables Balance- Dec. 31. 35,000

Collections $87,000

Accounts ReceivableBad Debts Problem 5 of 5

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Hurd, Inc. reported for year ending 12-31-2015:Info. Return

Book net income before taxes $900,000 $900,000Records show:Interest on municipal bonds 70,000 Depreciation on tax return in excess of deprec. per books 130,000 Warranty expense- accrual basis 40,000 Actual warranty expenditures 60,000Taxable incomeTax Rate 40% 40%Tax liability

Compute taxable income for Hurd, Inc.

106

Hurd, Inc. reported for year ending 12-31-2015:Info. Return

Book net income before taxes $900,000 $900,000Records show:Interest on municipal bonds 70,000 ($70,000) Depreciation on tax return in excess of deprec. per books 130,000 ($130,000) Warranty expense- accrual basis 40,000 40,000 Actual warranty expenditures 60,000 ($60,000)Taxable income 680,000Tax Rate 40% 40%Tax liability $272,000

Compute taxable income for Hurd, Inc.

The End