Principles of Taxation
Chapter 5
Taxable Income from
Business Operations
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Objectives
Slide 5-2
 Describe how taxable year relates to operating
cycle.
 Explain realization and matching principles
 Cash versus accrual methods
 GAAP versus tax conservatism
 Book-tax income differences
 Constructive receipt
 Accrual basis exceptions
 NOLs
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Taxable Income
Slide 5-3
 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.
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Taxable year
Slide 5-4
 12-month period which generally corresponds
to its financial year.
 Individual taxpayers must generally choose a
calendar year.
 Firms generally choose a financial and tax year
that corresponds to the end of an annual
operating cycle. See Q1.
 Why does dividing time into periods (like
years) create opportunities for deferral?
 Changing tax years requires permission - most
common reason is merger of firms with
different year-ends.
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Accounting Methods
Slide 5-5
 Overall method by which taxpayers
determine their income, gains, losses,
deductions and credits, as well as the time
realized and recognized. CLEARLY
REFLECTS INCOME
 CONSISTENTLY APPLIED
 Establish a method by using it in the first
tax return.
 Requires IRS permission to change.
 What kinds of transition rules do you think the
IRS has? E.g. a firm with LIFO layer $1,000,000
switches to FIFO
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Accounting Methods General Principles
Slide 5-6
 Like financial accounting, we follow:
 REALIZATION principle (earnings process
complete)
 MATCHING principle (expenses with
revenues)
 Exceptions generally arise due to risks of tax
evasion, convenience for government or
taxpayer, ability to pay, economic incentives.
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Accounting Methods General Principles
Slide 5-7
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 The CASH method is mandatory where the
individual taxpayer's records reflect only cash
transactions and there are no inventories.
 The ACCRUAL method is mandatory for:
 purchases and sales where inventories must be
used.
 C corporations, and partnerships with a C
corporation as a partner, with average annual
gross receipts >= $5,000,000.
 HYBRID method - Use accrual for inventories
(CGS), but cash for everything else.
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Cash Method
Slide 5-8
 Under the cash method, gross income
includes cash or property actually or
RECEIVED during the tax year.
 Deductions are usually taken in the year cash
or property is PAID.
 It doesn't matter when the income was
earned, or when the expense was incurred.
 Cash method income includes receipt of
noncash goods - Examples? See Q5.
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Cash Method Income
Slide 5-9
 Constructive receipt of income.
 Income not actually received is
constructively received and reportable:
IF within the taxpayer's control.
 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?
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Cash Method Deductions
Slide 5-10
 Cash method - deduct 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.
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Cash Method Deductions
Prepaid expenses
Slide 5-11
 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.
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Accrual Method of Accounting
Slide 5-12
 Under the accrual method, income is reported
in the tax year in which the right to the
income and the amount of the income can be
determined with reasonable accuracy.
 Deductions are claimed in the period in which
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)?
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Accrual Income Exceptions prepaid income
Slide 5-13
 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: rent, royalty, bonuses, advertising,
services (except see below). AP3, 4
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Accrual Income Exceptions prepaid services
Slide 5-14
 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.
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Accrual Income - goods
Slide 5-15
 Advance payments received for merchandise
or construction = delayed taxation.
 OK to use accrual method if that method is
used for all tax reporting and for credit and
financial purposes.
 Small contractors may also use the
completed contract method to further
delay taxation.
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Accrual Income Exceptions advances and deposits.
Slide 5-16
 A deposit that guarantees the customer's
payment of amounts owed to the creditor isn't
a deposit but an advance payment includible
in income. (E.g., apartment last months’
rent?).
 Deposit securing someone's property is a true
security deposit and not an advance
payment. (E.g., apartment security damage
deposit).
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Accrual Expenses Exceptions
Slide 5-17
 Related Party Accruals
 The paying party cannot deduct an
expense until the year that a receiving
party deducts the expense.
 Prevents accrual basis taxpayers from
accruing an expense but delaying
payment.
 AP6, 7
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Accrual Expenses
Slide 5-18
 Bad Debts
 GAAP - allowance method
 Tax- direct write-off method. Record
income if account repaid later.
 AP8, 9
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Accrual Expenses
Slide 5-19
 GAAP accrued liabilities must be probable
and estimable under SFAS 5.
 Tax
 All Events Test requires 1) liability fixed
 2) amount determined with reasonable
accuracy.
 Economic Performance test for
nonrecurring expenses requires that all
activities to satisfy the liability have
occurred - often requires payment.
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Summary Cash vs Accrual
Slide 5-20
 summary:
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CASH
ACCRUAL
Income
EXCEPT:
When received
When earned
 Constructive receipt
 Inventory sale
 Ppd income.
 Ppd. services > next
year
Expense
EXCEPT:
When paid
When accrued
 Asset purchase
 Related party accrual
 Ppd. expenses > next  Write-off bad debts
year
 All events & economic
performance
 Prepaid interest
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Section 482 - Broad IRS Powers
Slide 5-21
 IRS has authority to “distribute, apportion, or
allocate gross income, deduction, credits or
allowances” among businesses to CLEARLY
REFLECT income of each.
 BIG issue in multi-jurisdictional taxation. See
Chapter 12.
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Book-Tax Differences
Slide 5-22
 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)
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Book-Tax Differences
Slide 5-23
 Permanent differences do not reverse;
Temporary differences reverse over the life of
the firm.
 GAAP current tax expense is based on taxable
income.
 GAAP deferred tax expense is the tax effect of
temporary differences reversing in the future.
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Book-Tax Differences
Slide 5-24
 Examples of permanent non-deductible
expenses (that are still deductible for financial
statements)
 50% meals and entertainment
 political contributions
 fines and penalties
 interest expense to generate tax-exempt
municipal bond income
 premiums on life insurance
 See AP10
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Book-Tax Differences
Slide 5-25
 Examples of permanent tax preferences that
make taxable income less than book income:
 Tax-exempt municipal bond income
 Life insurance proceeds.
 Examples of temporary differences:
 Depreciation
 Timing of accruals
 Capital losses
 Bad debts (allowance vs. writeoff)
 Cash versus accrual accounting
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Book-Tax Differences
Slide 5-26
 GAAP total tax expense (SFAS109)
 = current + deferred tax expense
 in simple situations, this approximates tax
rate on book income + or - permanent
differences (old APB11).
 Let’s look at a financial statement (see link on
Jones Ch 5 web page).
 We’ll see this material again in Chapter 10.
 AP8, 11, 18.
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Net Operating Losses
Slide 5-27
 Problem arises due to artificial time divisions
(years).
 Solution: carryback 2 years, carryforward 20
years.
 GAAP now allows firms to record a tax
benefit for expected value of future NOL
deductions.
 Election available to FOREGO CARRYBACK.
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©The McGraw-Hill Companies, Inc., 2000