Chapter5_3of4 - Tax Accounting Principles – Accrual...

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Unformatted text preview: Tax Accounting Principles – Accrual Method of Accounting When? GAAP? Tax? 1 Accrual Method s GAAP s Report revenues when earned, even if not yet received; Report expenses when incurred, even if not yet paid s s Tax 2 Accrual Method Tax s General Rule— s s s Accrual method taxpayers report income in the taxable year in which income is earned All events test: s All the events have occurred which • fix the taxpayer’s right to the income and • it can be determined with reasonable accuracy 3 Accrual Method s s 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 s s 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 Exceptions: s Dividends reported when received rather than date of record Certain items of prepaid income s 8 Accrual Method of Accounting s “Claim of Right Doctrine” s 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 s s s Claim of right doctrine supercedes all events test Prepaid income: rents, interest, royalties, etc. s s Examples: s s Problem 5-37 9 Special Accounting Methods 10 Prepaid Income and Accrual Method: When report? Accrual Method: Prepaid Income s s GAAP Tax Generally report when received even though accrual method s Why? s s s Claim of right doctrine Wherewithal to pay principle 12 Accrual Method: Prepaid Income s Report when received s s Prepaid interest, rents, royalties included in income when received Deposits distinguished 13 Accrual Method: Prepaid Income s Prepaid service income: s Rev. Proc. 2004-34 s s Full inclusion method: All in first year Limited deferral method • First Year: Same as financial accounting • Second year: Balance 14 Problem 5-39 a. LL Corporation, a calendar year and accrual basis taxpayer, is engaged in the lawn care business, providing fertilizer treatments four times a year. It sells one‑ two‑ and three-year contracts. Each contract provides that the customer will receive four treatments (fall, winter, spring and summer). An analysis of its customer contracts revealed that it received $200,000 during the fall for a one-year contract. Each of these customers will receive one treatment in 2008 and three treatments in 2009. in its financial accounting statements, the company reports the income as services are performed. What amount of income must th corporation report in 2008 and 2009? 15 Problem 5-39 (c) The Indiana Pacers reports on the calendar year and uses the accrual basis. In August and September, it collected $7,000,000 in pre-season ticket sales. Of its 41 game home season, 15 games were played prior to the end of the year. How much included in 20085? 16 Accrual Method: Prepaid Income s Prepaid rents vs. prepaid services s Is “rent” a service? 17 Problem 5-39 (d) s A posh resort hotel in Florida reports on the calendar year and uses the accrual method. During 2008, it collected $10,000 in advance payments for rooms to be rented during January and February 2009. What amount of income must be included in 2008? 18 Accrual Method: Prepaid Income s Deposits s s Treatment Not income since there is an obligation to repay s Problem 5-38 19 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? 20 Example s 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? 21 Prepaid Dues and Subscriptions sAccrual Method of Accounting s Prepaid dues (§ 455) reported ratably s Prepaid subscriptions reported ratably 22 Accrual Method: Prepaid Income s Advance payments for goods 23 Advance Payment for Goods s Accrual basis taxpayers may elect either s s Full Inclusion Method s 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 24 Income Deferral Method s Advance Payment for Goods – Exceptions s Reg. § 1.451-5(c) – Inventoriable Goods s Include by year after year of “substantial advance payment” if a s “Substantial advance payment” (payment or payments that equal or exceed taxpayer’s cost) is received AND s Inventory on hand or available through normal source of supply 25 Advance Payment for Goods Example Example s 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? s 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. 26 LONG-TERM CONTRACTS 27 Long-Term Contracts sDefined s LONG-TERM CONTRACTS—Building, installation, construction, or manufacturing contract which is not completed within taxable year in which it is entered into s s s 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 sTreatment Completed Contract s Percentage of Completion s 28 Long Term Contracts s s Completed Contract Method Treatment s Report revenue and expense when contract is complete 29 Long Term Contracts s s 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 30 Long Term Contracts sPercentage of Completion Method s Treatment s Report portion of total contract price each taxable year Total Contract Price x Direct & indirect costs this period/total estimated costs. Revenue Recognized s s 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 31 Long-Term Contracts sProblem 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. 32 Problem 5-52 Problem PCM Revenue Expense Gross Profit Revenue 5,000,000 X 5,000,000 X 5,000,000 19X1 2,500,000 (2,000,000) 500,000 19X2 625,000 (500,000) 125,000 19X3 Total 1,875,000 5,000,000 (1,000,000) 3,500,000 875,000 1,500,000 Accumulated /Estimated Total 2,000,000/4,000,000 500,000/4,000,000 Less Revenue Earned To Date 2,500,000 + 625,000 = (3,125,000) 2,500,000 625,000 1,875,000 PCM Problem 5-52 Problem 19X1 19X2 625,000 (500,000) 125,000 19X3 Total Revenue Expense Gross Profit Revenue 5,000,000 X 5,000,000 X 5,000,000 2,500,000 (2,000,000) 500,000 1,875,0005,000,000 (1,000,000)3,500,000 875,0001,500,000 Accumulated /Estimated Total 2,000,000/4,000,000 500,000/4,000,000 Less Revenue Earned To Date 2,500,000 + 625,000 = (3,125,000) 2,500,000 625,000 1,875,000 Long-Term Contracts 5-35 cont. Lookback? Estimated cost $4,000,000 vs. Actual 3,500,000 Year 1 actual percentage complete 2,000,000/3,500,000 = 57.1% Contract x New revenue Costs New income Reported Underestimate Tax rate Tax Interest rate Interest due 5,000,000 2,855,000 (2,000,000) 855,000 (500,000) 355,000 x 34% 120,700 x 10% 12,070 35 Long-Term Contracts sLong-Term Construction Contracts s Alternative Minimum Tax— s If the completed contract method is allowed, the deferred income is a tax preference item for the alternative minimum tax (exception for home construction contracts). 36 Interest Income s When report s Recognize interest income when received (cash basis) or when earned (accrual basis) Always report prepaid interest income when received s 37 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 38 Buying Bonds with Accrued Interest 39 Buying Bonds with Accrued Interest 40 Interest Income s Treasury s s s s s products Bills Notes Bonds Series E or EE bonds Series I bonds 41 Interest Income s Treasury Bill (T-Bills) s s s s Purchased at discount Periods of 13 or 26 weeks Cash basis taxpayer reports discount when redeemed or sells Accrual reports as accrues 42 Problem 5-42 • G purchased $10,000, 90-day U.S. Treasury bill at 99. Matures 1/30/05. 43 Interest Income s Treasury Notes (T-Notes) s s Sold in 2, 3, 5 or 10 year maturities Pay interest every six months 30-year maturity Pay interest every six months s Treasury Bonds s s 44 Problem 5-42 • G purchased $100,000 of AFB Inc. 10% bonds for $95,000. The bonds were issued at par in 1996. Bonds pay interest semiannually on 3/1 and 9/1. On 3/1/06 received payment $5,000 Monthly Interest: 10% x $100,000 x 1/12 = $833/month Interest accrued at 11/1 date of purchase $833/month x 2 months (Sep, Oct) Interest accrued after purchase thru y/e $833/month x 2 months (Nov, Dec) Interest accrued for Jan, Feb • Receive payment on 3/1 Cash $1,667 1,667 1,667 5,000 5,000 5,000 Accrual • • 45 46 Interest Income s Series E and EE Savings Bonds s Return s s s s 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 $50, $75, $100, $200, $500, $1,000, $5,000, $10,000 s Sold in various denominations s 47 Interest Income s Series E and EE Savings Bonds s Optional reporting methods for cash or accrual taxpayers s Report increase in redemption value s s s s annually when bond is redeemed. 48 Interest Income s s Discounted Investments: (see Chapter 16) Generally, for any investment s s 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 49 Interest Income Examples s Buy bond at original issue with face value of $1,000 and 0% interest rate for $700 (i.e., $300 discount) 1000 Face Value 700 Purchase Price 300 Original Issue Discount (OID): to become interest income; amortized at market interest rate using the effective interest method s $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) 50 ...
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