[noodles]

It seems Becker didn’t teach us how to use the accrual method for individuals at all… All I remember is rental payments received in advanced is taxed immediately for both individuals and corps.

For corps, all I remember is bonuses paid by 3/15 next year is deductible this year…

Am I royally screwed or what?

Are there any other rules that we should know? Any help is appreciated!

[Anonymous]

Base for federal income tax = taxable income (gross income – allowable deductions)

Gross income: Sec 61 all income from whatever source derived

Glenshaw Glass —> undeniable accession to wealth, clearly realized, over which the taxpayer has control

-Wages and salaries

-Treasure trove (money found)

-Forgiveness of debt except foreclosures (bad debt expense on forgiveness can be deducted under accrual method NOT CASH METHOD #5)

-Investment income

-Use of intellectual properties like copyrights and trademarks

Deductions and expense: No deduction or expense shall be taken unless specifically allowed under the law

-Ordinary and necessary business expenses

-Depreciation

-Ordinary if it is customary for a particular type of trade or business and is commonly or frequently incurred

Taxable year

-Usually corresponds to annual accounting period for f/s

-Calendar or fiscal year

Choose the one that best reflects the firms operating cycle

-Can change by requesting (effects sole proprietors the most)

Get a short-period return to accommodate the change

Taxable income will be annualized and inflated to reflect 12 months of operations (so taxable income % is same as it would normally be)

Hybrid method allows for inventory costs to be capitalized as inventory and then expensed when sold, rather than when the cash is paid to the supplier.

Cash-income recognized when cash is “received” expenses recognized when paid

Accrual: When realized or realizable, when get cash or when income is earned

Expenses when incurred (Don’t forget matching principle)

Once a method of accounting is chosen it cannot be changed unless formally requested

Tax policy objectives

-Not just accurate measurement of income, wants to be consistent with public policy and political concerns

-Lobbying not deductible (GAAP expense)

-Only 50% of most meal and entertainment expenses are deductible

-Tax law will encourage some behaviors

Life insurance deduction (when policy is paid out is tax free but policy payments aren't deductible for corporation)

DPAD reduces tax rate on domestic manufacturing (9% of lower of domestic income or total income not more than 50% of w-2 wages)

CASH METHOD: Record revenues when payment is received and expenses when paid regardless of when revenue or liability occured

-noncash items like securities work also

-Net income does not always equal cash flows

4 exceptions for cash method:

Doctrine of constructive received: income shall be recognized when the cash is received or constructively received; No hindrance except for taxpayers own doing, the income

-When have unrestricted access to and control of income even if it's not actually in possession

-Interest constructively received the day the taxpayer has right to withdraw the interest

-Can't defer income by holding checks received from customers

-If hindrance is on part of someone else (state of Illinois) then not income

-receive income when check is in the mail (constructively) mailing transfers title

2. Prepaid Expenses

“12-month rule”

If the prepaid expense results in a benefit a duration of 12 months or less and does not extend past the end of the year following payment then it is deductible

If test is not met, use accrual method, so how much as been incurred

So how much in current year, then how much in next year (6/14 current 8/14 next year)

If extends past end of year following payment then do same accrual method except in two subsequent years

3. Inventory may only be expensed when sold

-Firms selling merchandise to their customers MUST USE ACCRUAL METHOD for purchases and sales of merchandise

-Hybrid method

-Inventory always on accrual method

Capitalize as inventory and expense only the cost of inventory sold during the year

Record revenue when sale occurs not when cash received (this is hybrid, account for purchases and sales of inventory with accrual method but all other transactions cash method

If under $10 million in gross receipts can use simplified cash method so no accrual but must account for product inventory on hand at year-end as an asset

4. Prepaid interest expense

– Always on accrual method (interest expense) so can't be prepaid and deducted

– Always always always capitalized and deducted in the year the interest is actually charged

Loan not taxable unless debt is forgiven

Corporations with more than $5 million in average annual gross receipts cannot use csh method for tax purposes (also partnerships and corporate partners)

Does not apply to professional services (medical, legal, accounting) performed by individual shareholders/employees for corporate clients pg129

Accrual Method: Matches expenses against revenues

Taxpayer's right to receive income generally is fixed when earnings process is complete or when the taxpayer receives payment, whichever happens first

So must recognize many types of prepaid income in the year of receipt

Realization: when the earnings process with respect to provision of goods or services is complete, regardless of when payment is made

When have two equally allowable methods, choose one that reduces income or total assets –> rule of conservatism

CEO's want GAAP NI to be high because they want the stock price to be high

Tax income is high because they want more money now, CEO's and shareholders want taxable income to be low

Permanent versus Temporary Differences

-Permanent difference occurs when income is realized for book purposes but never tax purposes. (only effects year incurred)

-Also when a expense for GAAP but never for tax

-Also when we get a deduction that is never a book expense or loss

Tax-exempt interest

Fines and penalties

DPAD deduction

-Temporary differences happen when something like a gain, loss, rev, exp is taken in a different year for book purposes than tax purposes

Depreciation

Excess of book income over taxable income creates tax liability (favorable)

Excess of tax income over book income creates tax asset

GAAP–> Revenue recognized when realized or realizable and earned

Tax–> Earlier of when it is earned or when cash is received

Both have expenses recognized when incurred

Exceptions

Prepaid Income

Services: One year deferral rule: If receive prepaid income for a future performance of a service, recognize a % of the income that corresponds to the percent of services performed this year. All remaining income is reported next year

Inventory: For future sale of inventory then can choose to recognize and record income immediately when prepayment is received or use GAAP method (unearned revenue) and wait till payments are received for financial reporting purposes

Classifications

1. Income for GAAP not tax(Taxable income lower)

2. Income for tax not GAAP(Taxable income higher)

3. Expense for GAAP not tax (Taxable income higher)

4. Expense for tax not GAAP (Taxable income lower)

Accrued expenses: Expenses recognized but not paid — All Events test

Liability for unpaid expense must be fixed because all events establishing the liability have occurred

Liability amount must be determinable with reasonable accuracy

Economic performance with respect to the liability has occurred pg 134

1. All events that give rise to the liability must be known

2. The amount of the liability must be known with “reasonable accuracy” <—- almost always a bill

3. Economic performance must be complete

a. Product: have title of product

b. Services: must have been completed

c. Certain things like lawsuits, award, state income taxes, prizes, must have actually paid it (aka payment liabilities)

For taxes economic performance occurs when taxes are paid pg 149# 21 (unless adopt recurring item exception)

In GAAP we would estimate warranty expense (warranty liability credit)

For tax the warranty expense must go through “All events test”

So for tax with warranty expenses book income today and expense as incurred when guy comes out to fix the TV

For prize the company would wait till actually paid to deduct for tax purposes

“Recurring item exception to the all-events test”

If economic performance occurs within 8.5 months after the end of the year in which the liability is incurred, then the liability may be deducted as an expense in the year it is incurred, rather than the year economic performance occurs.

-This can be a portion of the activity done within 8.5 months doesn't have to be all. pg 148 #18

This expense must be recurring in nature, happen every year

Compensation of Employees and Officers of Corporations

Cannot be deducted until it is paid <— General Rule

Exception, if compensation is accrued this year, and is paid within 2.5 months after the end of this year, then it is deductible this year (March 15th)

Related Party Exception

If a transaction exists between 2 related parties, the expense side of the transaction cannot be deducted until the other party recognizes the income. This test supersedes all other rules.

Question: ABC company had a beginning balance of $10,000 and (or) an ending balance of $150,000 in their allowance for doubtful accouts. The GAAP income statement shows $6000 of expense for bad debts, and $30,000 of net income. What is taxable income?

Tax uses direct write off method

GAAP uses the allowance method

-Write offs for GAAP will go to allowance and won't directly hit F/S unless goes over that allowance (I think). Also recovery would go towards allowance for bad debt and won't increase NI when a write off gets paid off

Both these situations WILL HIT TAXABLE INCOME

Expenses for GAAP not tax

-Lobbying Expense

-50% of meals and entertainment (focus meals not entertainment)

-Fines and Penalties

-Premiums on Life insurance Policies

If employer is not getting money when I die then they can deduct, but if they do get money (benefit) then cannot deduct because we aren't being taxed on it

-Political Contributions

-Interest expense on loan to buy tax-exempt bonds

Because if make income from tax exempt bonds it cannot be taxed

Income for GAAP not Tax

-Proceeds from life insurance policies

Since proceeds are not taxable then cost will not be deductible

When we don't get taxed on something, the cost of that benefit cannot be deducted generally

-Tax-exempt bonds

Net Operating Losses NOL

-Negative taxable income

-Carryback 2 years against positive income during that time

-Carryforward 20 years

-Don't have to carry back, can hold on and go forward if think tax rates will go up in the future (but if go back then HAVE to go back two years can't choose just one)

-Go back to farthest year first! so 2006 then 2007 not reverse

Cannot generally deduct prepaid interest until the year it is due

KEY SOURCES OF BOOK/TAX DIFFERENCES

Permanent

-Interest on state and local bonds (never taxable income)

-Key-person life insurance proceeds and premiums (can never be deducted for tax)

-Fines and penalties (can never be deducted for tax)

-Political contributions and lobbying (can never be deducted for tax)

-Meals and entertainment expense(only 50% can ever be deducted)

-DPAD (Never a GAAP expense)

Temporary

-Prepaid income

-Bad debts

-Accrued expenses failing all-events test

-Compensation accruals

-Related party accruals

-NOL carryforwards

[Anonymous]

Those are some messy but accurate notes I took and a few things you should probably know. I don't think its all inclusive but should help some.

Good luck!

[noodles]

holy s*** that looks like something from a tax law class!

But it was really helpful. I was looking for the exceptions you mentioned. Thanks a bunch.

[Author]

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