Unformatted text preview: Tax Accounting Principles – Accrual Method of Accounting When? GAAP? Tax? 1 Accrual Method GAAP Report revenues when earned, even if not yet received Report expenses when incurred, even if not yet paid Tax 2 Accrual Method Tax General Rule— Accrual method taxpayers report income in the taxable year in which income is earned All events test: All the events have occurred which
• • fix the taxpayer’s right to the income and it can be determined with reasonable accuracy Fixed at earlier of: required performance occurs, payment is due or payment is made 3 Accrual Method Example:
In Hallmark Cards, the calendar year accrual basis taxpayer shipped Valentine cards before year end but deferred income from the sales to the following year. Early shipment was necessary to deal with certain production and shipping problems related to supplying cards in a timely manner to its customers (more than 20,000 retailers at over 35,000 locations). Contracts with the customers specified that title and risk of loss passed to customers on January 1. The IRS believed that the income should be reported in the previous year when it was shipped. What result?
5 Here are some examples of this “all events” test Problems 5-48, 49, 50 6 Accrual Method Example: H&N, an accrual basis company, agrees with Client to analyze its operations and determine to what it extent it might qualify for the research tax credit. H&N receives 25 percent of the any credit ultimately recovered. On December 15, 2005, H&N completed its study, determining that Client was entitled to $1,000,000 that could be recovered by filing amended returns. It presents Client with a bill of $250,000. What result?
7 Accrual Method
Example X Corp is an automobile dealer. It has an excess amount of 2003 model inventory and wishes to sell the excess inventory by the end of 2003. On October 1, 2003 X enters into a $1,000,000 contract with an advertising agency (ABC, who is a calendar year, accrual method taxpayer) to do a 3-month marketing blitz using TV and newspaper advertising in order to promote the sale of its excess inventory. The advertising services will be performed over this 3-month period beginning October 1, 2003 and ending December 31, 2004. Under the contract, X will pay ABC on January 1, 2004 for its services. In order to be paid, ABC must submit an invoice to X at the end of the campaign. Such invoice must include proof that the advertising was done in accordance with X’s specifications. When is ABC required to recognize income on the $1,000,000 advertising services contract?
8 Accrual Method
Exceptions: Dividends reported when received rather than date of record Certain items of prepaid income 9 Accrual Method of Accounting “Claim of Right Doctrine” Defined: Actual or constructive receipt of income under a claim of right (an unrestricted claim) is included in gross income for tax purposes Applies to both cash basis and accrual basis Claim of right doctrine supercedes all events test Prepaid income: rents, interest, royalties, etc. Examples: Problem 5-37 10 Special Accounting Methods
11 Prepaid Income and Accrual Method: When report? Accrual Method: Prepaid Income GAAP Tax
Generally report when received even though accrual method Why? Claim of right doctrine Wherewithal to pay principle 13 Accrual Method: Prepaid Income Report when received Prepaid interest, rents, royalties included in income when received Deposits distinguished 14 Accrual Method: Prepaid Income Prepaid service income: Rev. Proc. 2004-34 Full inclusion method: All in first year Limited deferral method • First Year: Same as financial accounting • Second year: Balance year: Balance 15 Accrual Method: Prepaid Income Prepaid rents vs. prepaid services Is “rent” a service? 16 Accrual Method: Prepaid Income Deposits Treatment Not income since there is an obligation to repay Problem 5-38 17 Accrual Method: Prepaid Income vs. Deposits
Example Indianapolis Power & Light 110 S.Ct. 589 (USSC, 1990) Indianapolis Power and Light, an accrual basis taxpayer, requires potential credit risks to transfer certain amounts—normally twice the customer’s estimated monthly bill—to insure payment of their future utility bills. IPL pays 6% interest on a deposit held for a year or more. Customers can obtain a refund if made timely payments for 9 months or satisfying a credit test. Are the amounts received income?
18 Example HHG sell appliances. It also offers a warranty at the time of the sale. The warranty generally covers all repairs during the warranty period that normally runs for 3-5 years depending on the appliance (e.g., television, washer-dryer, dishwasher, CD player). When will it report the warranty income? 19 Prepaid Dues and Subscriptions
Accrual Method of Accounting Prepaid dues (§ 455) reported ratably Prepaid subscriptions reported ratably 20 Accrual Method: Prepaid Income Advance payments for goods 21 Advance Payment for Goods Accrual basis taxpayers may elect either Full Inclusion Method Tax year of receipt Earlier of tax year • Amounts would be recognized for tax purposes without regard to receipt; or • Amounts are recognized for financial reporting purposes Income Deferral Method 22 Advance Payment for Goods – Exceptions Reg. § 1.451-5(c) – Inventoriable Goods Include by year after year of “substantial advance payment” if a “Substantial advance payment” (payment or payments that equal or exceed taxpayer’s cost) is received AND Inventory on hand or available through normal source of supply 23 Advance Payment for Goods
Example Needless Markup, a department store, sells gift certificates in December, 2005 for $1,000,000 and the gift certificates are still outstanding at the end of year 2006. When does the company report the $1,000,000 advance payment? Needless has met both tests (1) received “substantial advance payments” (amounts equal to or exceeding its costs) in 2006 and (2) the goods are in inventory or can be secured through normal channels. When payments exceed costs and the inventory is available, the amount must be included no later than next tax year, 2007. There will probably be no matching deduction in cost of goods sold because the goods are not likely to be identified before the certificate is redeemed. Note that if the goods have been identified by the end of the first year, inventory costs for the goods (actual or estimated) are included in the cost of goods sold for the year, even if the goods have not been delivered by year-end.
24 LONG-TERM CONTRACTS
25 Long-Term Contracts
Defined LONG-TERM CONTRACTS—Building, installation, construction, or manufacturing contract which is not completed within taxable year in which it is entered into For manufacturing contracts, items must be unique or require more than 12 months to complete. If does not qualify, advance payment rules may apply Contracts for services normally do not qualify Treatment Completed Contract Percentage of Completion
26 Long Term Contracts Completed Contract Method
Treatment Report revenue and expense when contract is complete 27 Long Term Contracts Completed Contract Method
May elect only if meet 1 of following 4:
1. Expected completion time is no more than two years and the contractor is “small” (average annual gross receipts < $10 million) 2. Contract for “home construction” (80% of costs related to buildings with 4 or fewer dwelling units) 3. Contract for “residential construction” (70% rule) 4. Contract for qualified ship contracts 28 Long Term Contracts
Percentage of Completion Method Treatment Report portion of total contract price each taxable year Total Contract Price x Direct & indirect costs this period/total estimated costs. Revenue Recognized Initial Phase Exemption: defer reporting if at end of tax year, less than 10% of total contract costs incurred Look-back rule: upon completion, recompute annual income using actual rather than estimated total costs
• Interest paid on over/under reporting • Interest paid on over/under reporting
29 Long-Term Contracts
Problem 5-35 Completed-contract not available (construction period > 2 yrs), PCM Revenue Expense Gross Profit 19X1 (2,000,000) 19X2 (500,000) 19X3 (1,000,000) (1) $2,000,000 actual cost / $4,000,000 est. cost) x $5,000,000 contract = $2,500,000 (2) $500,000 actual cost / $4,000,000 (remaining est. cost) x (remaining revenue) $5,000,000 = 625,000 (3) $3,500,000/$3,500,000 (remaining revenue 5,000,000 – 2,500,000 – 625,000) $1,875,000.
30 Long-Term Contracts
Long-Term Construction Contracts Alternative Minimum Tax— If the completed contract method is allowed and used for regular tax purposes, the deferred income is a tax preference item for the alternative minimum tax
• Exception for home construction contracts). 31 Interest Income When report Recognize interest income when received (cash basis) or when earned (accrual basis) Always report prepaid interest income when received 32 Interest: Buying or Selling Bonds Interest income on sale of bonds between interest dates:
Seller must accrue interest to date of sale even if cash basis and include in income Buyer: purchase price deemed to include accrued interest; later receipt is nontaxable return of capital 33 34 Interest Income Treasury products Bills Notes Bonds Series E or EE bonds Series I bonds 35 Interest Income Treasury Bill (T-Bills) Purchased at discount Periods of 13 or 26 weeks Cash basis taxpayer reports discount when redeemed or sells Accrual reports as accrues 36 Interest Income Treasury Notes (T-Notes) Sold in 2, 3, 5 or 10 year maturities Pay interest every six months Treasury Bonds 30-year maturity Pay interest every six months 37 Interest Income Series E and EE Savings Bonds Return
Earn interest for up to 30 years Do not pay interest, but purchased at discount (50% of face value, $50 EE bond costs $25) Increase in value annually May cash in at any time Sold in various denominations $50, $75, $100, $200, $500, $1,000, $5,000, $10,000 38 Interest Income Series E and EE Savings Bonds
Optional reporting methods for cash or accrual taxpayers Report increase in redemption value annually annually when bond is redeemed. when bond is redeemed. 39 Educational Savings Bonds
(see also Chapter 6) Series EE Bonds Issued After 1989:
Accrued interest is exempt from taxation if redeemed Series EE bonds are used to pay for “qualified educational expenses”: Tuition, fees, books, and supplies LESS: scholarships, fellowships and employer provided assistance Exclusion available only if issued to those age 24 or older, and is taken on the tax return of the original purchaser and his/her spouse But, excluded interest may be spent on TP, spouse, or dependents 40 Educational Savings Bonds Exclusion is phased out for “high income” taxpayers Exclusion of interest allowed only to extent TP uses redemption proceeds for qualified educational expenses
If redemption proceeds > qualified educational expenses, include interest received in excess of the exclusion amount: qualified educational expenses paid during year x
total bond redemption proceeds during the year accrued bond interest = exclusion amount 41 Z, A’s parent, cashed $9,500 of qualifying savings bonds to pay for A’s college expenses. A’s expenses included $3,500 tuition and fees, $700 books, $100 supplies, $2,500 meals and $2,700 dormitory room. The bonds included $1,500 of accrued interest. How much, if any, of the interest is taxable?
$4,300 X 1,500 = $678.95 exclusion 9,500 $1500 - 678.95 = $821.05 addition to income
42 Interest Income Discounted Investments: (see Chapter 16) Generally, for any investment Purchased at a discount Report as income the amortized discount or the difference between the instrument’s stated interest rate and market rate, TIMES the principal Example: OID
43 Interest Income Examples Buy bond at original issue with face value of $1,000 and 0% interest rate for $700 (i.e., $300 discount)
1000 700 300 Face Value Purchase Price Original Issue Discount (OID): to become interest income; amortized at market interest rate using the effective interest method $1000 bond which pays 3% interest is purchased for $950 when market interest rate = 4%
Interest Income = 3% interest paid annually plus amortized portion of the discount ($1000 - $950)
44 Reporting Interest Income From Investments
Reporting By Cash Basis TPs OID Series E, EE Accrual reporting required TP may use cash or accrual method Accrual Basis TPs Accrual reporting required TP may use cash or accrual method Must report on accrual basis
45 T-Bills and Notes Report on cash basis ...
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- Spring '09
- Revenue, Taxation in the United States, Generally Accepted Accounting Principles, accrual method, ee savings bonds, EE Accrual