Chapter 6Questions and Problems for Discussion1. a. The annual business cycle for a plant and garden center might end in the late autumnindicating an October 31 or November 30 fiscal year end.b. A bakery has no obvious annual business cycle to suggest a particular taxable year.c. The annual cycle for a chimney cleaning business might end in late spring indicating anApril 30 fiscal year end, or the cycle might end in early autumn indicating a September30 fiscal year end.d. The annual cycle for a moving and transport business might end in late summerindicating an August 31 fiscal year end.e. A software consulting business has no obvious annual cycle to suggest a particulartaxable year.2. Corporation DB can elect a different overall method of accounting for each of its threebusiness ventures.3. This lucky event increased Firm LK’s net worth by $72,000 and, therefore, resulted in$72,000 recognized income to the firm.4. If the two corporations have different marginal tax rates, an intercompany transaction couldresult in a shift of income from the high tax entity to the low tax entity or a shift of adeduction from the low tax entity to the high tax entity. A method of accounting thataccomplishes such a shift and does not reflect an arm’s length transaction price between the related corporations is highly vulnerable to IRS challenge.5. Firms that provide audited financial statements to external users (investors, creditors,regulatory agencies, etc.) must prepare the statements in accordance with GAAP. The SEC requires publicly held corporations to follow GAAP in the preparation of financialstatements.6. No, the cash method does not require that the taxpayer receive currency. The receipt ofproperty (such as the case of wine) triggers income recognition based on the value of the property.7. Evidently, the increase in the after-tax cost of business lunches reduced KJ Inc.’s demandfor the service provided by Al’s Steak House. To the extent that the restaurant’sprofitability declined because of the aggregate reduction in demand by the businesscommunity, the restaurant’s owners bear the incidence of the indirect tax increase.8. The death benefits received by a corporate beneficiary under its key-person life Insurancepolicies are nontaxable. Therefore, the cost associated with the nontaxable income (the annual premiums on the policies) is nondeductible by the corporation. In contrast, if other parties (the officer’s spouse and children) are named as beneficiaries, the premiums paid by the corporation represent additional officers’ compensation, which is a deductiblebusiness expense.9. Under GAAP, income is not realized until earned. If a firm receives payment for goods orservices to be provided in a future year, the prepayment is recorded in a liability account as unearned revenue. Under the tax law, many prepayments of income must be included in taxable income, even if the income has not yet been earned. The GAAP treatment isconservative because it prevents an overstatement of book income. The tax treatment is conservative because it prevents an understatement of taxable income (financial ability to pay).10. a. Taxable income exceeds book income by $55 (disallowed 50 percent of meal expense).b. Book income exceeds taxable income by $700 ($3,500 tax-exempt interest $2,800nondeductible interest expense).c. Taxable income exceeds book income by $17,400 ($7,400 nondeductible lobbyingexpenses + $10,000 nondeductible political contribution).11. Under the cash method, income from the provision of goods and services is not recognizeduntil payment for the goods and services is received, an event that usually occurs after the income is earned under the accrual method. Thus, the cash method results in deferral from the year income is earned until the year payment is received. In a growing business, this annual deferral results is continuous. Therefore, in NPV terms, the tax cost associated with the cash method is less than the tax cost associated with the accrual method, even though each method results in the same total income recognition over the life of the business. 12. A deferred tax asset is similar to a prepaid tax resulting from an excess of taxable incomeover book income. The asset creates no independent value for the firm. A deferred taxliability is similar to a deferred tax resulting from an excess of book income over taxable income. The liability has no independent cost to the firm.13. A net operating loss suggests that a business is losing money. Most unprofitable businessventures don’t last for 20 years.14. A tax preference may take the form of an income item reported for financial statementpurposes but never included in gross income, or a tax deduction that is not based on an expense or loss reported for financial statement purposes. The resulting book/taxdifferences are permanent differences, which are more valuable than temporary differences in NPV terms.Application Problems1. a. Nello must recognize the $8,400 excess of the account payable over the settlementpayment ($23,400 - $15,000) as discharge-of-debt income. Nello’s tax cost of theincome is $2,940 ($8,400 × 35%), and its net cash outflow is $17,940 ($15,000 cashpaid + $2,940 tax cost).b. Bonview can deduct the $8,400 excess of the account receivable over the settlementpayment ($23,400 - $15,000) as a bad debt. Nello’s tax savings from the deduction is$2,520 ($8,400 × 30%), and its net cash inflow is $17,520 ($15,000 cash received +$2,520 tax savings).2. a. PT’s tax on $92,000 income is $19,530 ($13,750 + 34% [$17,000 excess income over$75,000]).b. In this case, PT must annualize the $92,000 income reported on the short-period return.$92,000 short-period income ⨯ (12 months ÷ 4 months) = $276,000 annualized income.The tax on $276,000 annualized income is $90,890 ($22,250 + 39%[$176,000 incomeover $100,000]). This tax must be deflated to reflect the four months of operations inthe short period.$90,890 ⨯ (4 months ÷ 12 months) = $30,297.3. a. Because the property and casualty insurance premium is deductible, the after-tax cost is$3,640 ($5,600 – [$5,600 × 35%]).b. Because the fine is nondeductible, the after-tax cost is $1,200.c. Because the life insurance premium is nondeductible, the after-tax cost is $3,700.d. Because the political contribution is nondeductible, the after-tax cost is $50,000.e. Because only 50 percent of the entertainment expense is deductible, the after-tax cost is$6,435 ($7,800 – [$3,900 × 35%]).4. Northwest Company is allowed a domestic production activities deduction equal to 6% ofnet income generated by the Portland plant. Consequently, its taxable income is computed as follows.Net income from Portland plant $3,100,000Net income from Vancouver plant 4,800,000Domestic production activities deduction(6% × $3,100,000) (186,000)Taxable income $7,714,0005. a. $22 taxable income. Although Firm B received $522 cash, the $500 principal repaymentwas a nontaxable return of investment. Only the $22 interest is income.b. No taxable income. Although Firm B received $600 cash, the receipt created a liabilityfor repayment of the deposit and did not increase net worth.c. No taxable income. Although Firm B received $10,000 cash, the receipt created aliability for repayment of the loan and did not increase net worth.d. $888 taxable income. Although Firm B earned only $180 of the prepaid rent this year,(15 days in December × $12), the income is recognized in the year payment is received.6. a. The recording of the account receivable had no effect on Firm F’s taxable income.b. The write-off of the account receivable had no effect on Firm F’s taxable income.7. Although Firm Q is a cash basis taxpayer and received only $10,000 cash, it recognizes the$23,400 total value of the cash and noncash payment as taxable income.8. a. As a cash basis taxpayer, RTY recognizes no income for the services performed and$4,000 prepaid rent income.b. As an accrual basis taxpayer, RTY recognizes $17,800 income for the servicesperformed and $4,000 of prepaid rent income.9. a. No deduction. The $50,000 results in a benefit extending beyond the following taxableyear and must be capitalized.b. No deduction. Brillo must use the accrual method to account for purchases ofinventory. Thus, the $79,000 is capitalized to inventory.c. No deduction. The $1,800 cost of the refrigerator is capitalized to an asset account.d. $4,800 deduction.e. $22,300 deduction.10. a. Even though NC adopted the cash method as its overall method of accounting, it mustuse the accrual method to account for inventory purchases. Therefore, its cost of goods sold for its first taxable year is $254,400 ($319,000 purchases $64,600 inventory onhand at year-end), and it is using a hybrid method of accounting.b. $254,400 (no difference)11. a. LSG can deduct the entire $9,450 expenditure in 2009, the year of payment, because theexpenditure results in a benefit with a duration of less than 12 months and the benefitdoes not extend beyond 2010.b. LSG must capitalize the $9,450 expenditure because it results in a benefit with aduration of more than 12 months. LSG can amortize the capitalized expenditure at arate of $525 per month ($9,450 ÷ 18 months), and can amortize and deduct $1,050 in2009 ($525 × 2 months).12. a. Even as a cash basis taxpayer, Firm F can deduct only $4,720 of the interest payment(the interest relating to the four-month period from September 1 through December31).b. $4,720 (no difference)13. a. Under the cash method of accounting, Wahoo must recognize the entire $36,000prepayment as 2009 income.b. Even as an accrual basis taxpayer, Wahoo must recognize the entire $36,000prepayment as 2009 income.14. a. GreenUp should report $20,000 revenue in 2009, $65,000 revenue in 2010, and $15,000revenue in 2011 for financial statement purposes.b. Under the one-year deferral method, GreenUp must recognize $20,000 taxable incomein 2009 and $80,000 taxable income in 2010.15. Cornish cannot deduct an accrued expense that fails the all-events test. Cornish’s liabilityfor the accrued expense is fixed because it has a binding contract with the constructioncompany. The $65,000 amount of the accrual is an estimate; only $7,200 (the billed amount) is determinable with reasonable accuracy. Economic performance with respect to the$7,200 accrual has occurred because the construction company has provided the services to Cornish. Consequently, Cornish’s current year deduction is limited to $7,200.16. a. If KLP uses the cash method of accounting, it can deduct $100,000 in the year ofpayment.b. For financial statement purposes, KLP must accrue a $100,000 expense in the year thewinner was selected and its liability to pay the prize became fixed. However, because of the economic performance requirement for awards, prizes, or jackpots, KLP is notallowed a tax deduction until the year of payment.17. a. Economic performance with respect to Ernlo’s liability for the purchased oil does notoccur until the oil is delivered in October. Consequently, Ernlo can deduct the $12,450cost in its fiscal year ending June 30, 2010.b. Under the recurring item exception, Ernlo can deduct the $12,450 cost in its fiscal yearending June 30, 2009, because economic performance (delivery) occurred within 8½months after the close of the year.18. a. Economic performance with respect to HomeSafe’s liability for future service callsdoes not occur until HomeSafe provides the service. Consequently, HomeSafe cannotdeduct any of the $48,900 accrued expense in 2009. In 2010, it can deduct the $36,300cost of the service calls provided in 2010 (484 service calls × $75 cost per call).b. Under the recurring item exception, HomeSafe can deduct $27,150 of the $48,900accrued expense in 2009 (362 service calls made within 8½ months after the close of2009 × $75 cost per call). It can deduct $9,150 in 2010 (122 service calls made fromSeptember 16 through December 31 × $75 cost per call).19. a. BZD can deduct the $55,000 accrued compensation expense in 2009 because thecompensation was paid by March 15, 2010 (2½ months after year-end).b. BZD can deduct $20,000 of the $40,000 accrued bonus expense: the amount paid byMarch 15, 2010. The $20,000 bonus payment made on May 1, 2010, is deductible in2010.c. BZD cannot deduct any of the $219,700 accrued vacation pay expense because none ofthe expense was paid by March 15, 2010. BZD will deduct the expense in the year ofpayment.20. a. Deduction for accrued expense in 2008 $180,000Tax rate .352008 tax savings $63,000PV of 2010 payment($180,000 ⨯ .873 discount factor at 7%) (157,140)NPV of after-tax cost $(94,140)b. After-tax cost in 2010($180,000 payment - $63,000 tax savings) $(117,000)NPV of after-tax cost ($117,000 ⨯ .873 discount factor at 7%)$(102,141)21 a. Economic performance with respect to Extronic’s liability for state income tax occurswhen the tax is paid. Consequently, Extronic can deduct the $273,900 tax paid during2009 ($41,900 balance due of 2008 tax + $232,000 estimated tax payments).b. Under the recurring item exception, Extronic deducted the $41,900 accrued expensefor 2008 tax in 2008 because the liability was paid within 8½ months after the close of2008. It can deduct the $19,200 accrued 2009 expense because the liability was paidwithin 8½ months after the close of 2009. Consequently, Extronic’s 2009 deductionfor state income tax is $251,200 ($232,000 estimated tax payments + $19,200 accruedtax payable).22. a. Company N can deduct the $7,740 interest payment in 2010, the year in which relatedparty Creditor K recognized the payment as income.b. Company N can deduct the $7,740 interest expense in 2009. Even though Creditor K isa related party, it recognized the payment as income in 2009 under its accrual method ofaccounting.c. Company N can deduct the $7,740 interest expense in 2009 because Company N andCreditor K are unrelated.23. a If Mrs. T owns no Acme stock, she and Acme are not related parties. Thus, Acme candeduct the $20,000 bonus in 2009, the year in which the expense was accrued.b. If Mrs. T owns 63 percent of Acme’s stock, she and Acme are related parties. Thus,Acme must wait to deduct the $20,000 bonus until 2010, the year in which Mrs. Tincludes the payment in income.24. a. GK’s bad debt expense for financial statement purposes is $90,000, which is theaddition to the allowance for bad debts.b. GK’s tax deduction for bad debts is $77,300, the amount of actual write-offs ofaccounts receivable.25. a. For financial statement purposes, the $65,000 write-off was charged against theallowance for bad debts and did not reduce financial statement income. For taxpurposes, the $65,000 write-off was deducted in the computation of taxable income.b. For financial statement purposes, the $65,000 recovery was credited to the allowancefor bad debts and did not increase financial statement income. For tax purposes, the$65,000 recovery was included in taxable income under the tax benefit rule.26. EFG’s net book income before tax $500,000Bad debt expense per books $12,500Bad debt deduction (write-offs) (13,800)(1,300)Nondeductible fine 17,500Nondeductible contingent liability 50,000Advanced payment for inventory no differenceEFG’s taxable income $566,20027. a. 35% × $31,000 excess of book income over taxable income = $10,850 deferred taxliabilityb. No deferred tax asset or liability from permanent book/tax difference.c. 35% × $55,000 excess of taxable income over book income = $19,250 deferred taxasset28. a. GT’s tax expense is $238,000 (34% × $700,000 book income).b. GT’s tax payable is $275,400 (34% × $810,000 taxable income).c. The excess of tax payable over tax expense is a $37,400 net increase in deferred taxassets.29. a. Net income before tax $600,000Permanent book/tax differences 15,000$615,000Tax rate .34Corporation H’s tax expense $209,100b. Taxable income $539,000Tax rate .34Corporation H’s tax payable $183,260c. Tax expense $209,100Tax payable (183,260)Net increase in deferred tax liabilities $25,84030. a. Net income before tax $378,200Permanent book/tax differences (33,500)$344,700Tax rate .34Corporation H’s tax expense $117,198b. Taxable income $457,100Tax rate .34Corporation H’s tax payable $155,414c. Tax payable $155,414Tax expense (117,198)Net increase in deferred tax assets $38,216 31. Micro’s net book income before tax $505,100Domestic production activities deduction(6% × $319,600) (19,176) Prepaid royalty income 40,000Accrued bonus expense no differenceNOL carryforward deduction (21,400) Micro’s taxable income $504,52432. TRW’s taxable income for the eight-year period is computed as follows:2001 2002 2003 20042005 2006 2007 2008 Tax. income beforeNOL deduction20,000 158,000 81,000 (741,000)21,000 398,000 687,000 905,000 NOL deduction (158,000) (81,000) NA (21,000) (398,000) (83,000)Taxable income 20,000 -0- -0- -0- -0- 604,000 905,00033. a. 34% × $90,000 unfavorable temporary difference = $30,600 deferred tax assetb. 34% × $710,000 NOL carryforward = $241,400 deferred tax assetc. Negative tax expense $272,000 ($30,600 + $241,400). Negative tax expense can also becomputed by multiplying Rony’s $800,000 book loss by its 34 percent tax rate.34. a. Rony’s tax expense is $408,000 (34% × $1,200,000 book income).b. Rony’s tax payable is $136,000 (34% × $400,000 taxable income).c. Rony’s reduction in its deferred tax assets is $272,000.Issue Recognition Problems1. Must Corporation DS recognize the $15,000 discharged debt as income, even though thecancellation did not increase the insolvent corporation’s net worth?2. Is the discovery of the underlying painting a realization event that triggers $249,700 incomefor the theater company? Did the discovery of the underlying painting merely increase the value of the asset purchased for $300, an increase that does not represent realized income?3. Is BL Inc. required to request permission from the IRS to change from an incorrect to acorrect method of accounting?4. In which year (2009 or 2010) does Company A recognize the $160,000 income from theconsulting engagement? Because Company A used the cash method in 2009 (when theconsulting engagement was completed) and the accrual method in 2010 (when the cash was received), does the $160,000 income from the consulting engagement escape taxationentirely?5. Was Mr. RJ in constructive receipt of the $3,500 income in the earlier year because he couldhave picked up the check from the client’s receptionist if he had checked his phonemessages during the holidays?6. Assuming that Maxo accrues a liability for the $14,420 bill from the publisher, can it deductthe accrued expense? Does an accrued liability fail the all-events test if the taxpayer notifies the creditor that it is contesting the amount of the liability?7. Is $75,000 an arm’s length price for the advertising provided by HT to LT? Did HTundercharge for the service rendered to LT to shift income to a related party with a zero marginal tax rate?8. Does the $18,000 property tax refund represent either financial statement income or taxableincome to Firm K?9. Should Firm G have recognized $200,000 or only $150,000 income in 2007? If Firm Grecognized $200,000 income in 2007, can it deduct the $30,000 settlement paid in 2009? If Firm G recognized $200,000 income in 2007, can it request a $11,700 refund ($30,000 ⨯ 39 percent), or must it be content with a $10,200 tax savings from a 2009 deduction ($30,000 ⨯34 percent)?10. Can a taxpayer choose the carryback year in which an NOL is deducted or must an NOLcarryback be deducted in chronological order?11. Can BL deduct TM’s NOL carryforwards? If a taxpayer purchases a business thatgenerated NOL carryforwards, does the purchaser acquire the carryforwards along with all the other business properties?Research Problems1. Section 458 provides a special method of accounting available to publishers and distributorsof magazines, paperback books, and musical records, tapes, and discs. According to Section 458(a), accrual basis taxpayers can exclude the income realized on sales of these items that are returned before the close of the “merchandise return period.” According to Section 458(b)(7), the merchandise return period for magazines is the two-month and 15-day period after the close of the taxable year. According to Section 458(b)(6), the income excluded is limited to the refund paid by the taxpayer for the returned items. Based on these rules,Bontaine Inc. can exclude $82,717 (refund paid in January 2010 for December 2009 sales) from its 2009 taxable income.2. In CharlesSchwab Corp. v. Commissioner, 107 T.C. 282 (1996), aff’d, 161 F.3d 1231 (CA-9, 1998), cert. denied (1999), the Tax Court and the Ninth Circuit Court of Appeals held that discount brokerage houses must accrue commission income on the earlier trade date instead of the later settlement date. Based on this decision, CheapTrade should recognize $1,712,400 commission income in 2009.3. The answer to this research problem depends on whether Moleri has made an election underSection 461(c) and Reg. Sec. 1.461-1(c) to accrue real property tax ratably over the twelve months of the calendar year to which the tax relates. If this election is in effect, Molerideducts $17,395 (7 months × [$29,820 ÷ 12 months]) of the 2009 tax on its return for the fiscal year ending July 31, 2009. It also deducts the 5 months of its 2008 property taxpayment relating to August through December 2008. If this election is not in effect, Moleri deducts the entire 2009 tax because it paid the tax (i.e. economic performance occurred) during the year. Reg. Sec. 1.461-4(g)(6)(iii)(A).4. This case is based on U.S. Freightways Corp. v. Commissioner, 270 F. 3d 1137 (CA-7, 2001),rev’g 113 TC 329 (1999). The accrual basis freight company deducted its entire annual payment for permits and licenses, even when the annual term of the permit or licenseextended into the following year. The company based this accounting treatment on the regulatory rule allowing a deduction for prepaid expenses providing a benefit that does not extend substantially beyond the end of the year following the year of payment. The IRS argued that this “12-month” rule applied only to cash basis taxpayers. Although the Tax Court agreed with the IRS, the Seventh Circuit reversed the Tax Court and allowed the deduction. This decision paved the way for Reg. Sec. 1.263(a)-4(f) (promulgated on December 31, 2003), paragraph (f) of which provides a 12-month rule applying to both cash and accrual basis taxpayers. Under this regulation, Jetex Inc. can deduct $1,119,200 in 2009.Tax Planning Cases1. The net income deferred from 2009 until 2010 through use of the cash method iscomputed as follows.Accrual method:Income from billings $3,500,000Expenses incurred (800,000)Net income in 2009 $2,700,000Cash method:Cash received $2,900,000Expenses paid (670,000)Net income in 2009 (2,230,000)Income deferred until 2010 under cash method $470,000The value of this deferral is computed as follows.Tax on income deferred one year($470,000 ⨯ 34%) $159,800NPV of deferred tax($159,800 ⨯ .935 discount factor at 7%) (149,413)Decrease in tax cost from cash method $10,3872. a. Yes. VB’s positive taxable income in 2007 indicates that the corporation either carriedback its 2006 NOL or claimed it as a carryforward deduction in 2007.b. VB’s carryback of $170,000 of the 2009 NOL would generate the following refund.Tax paid in 2007 $10,000Tax after $60,000 NOL carryback -0-Refund $10,000Tax paid in 2008 $26,150Tax after $110,000 NOL carryback -0-Refund 26,150Total refund received $36,150The NPV of VB’s remaining $180,000 NOL carryforward into 2011 is computed asfollows.NOL carryforward deduction $180,000Projected 2011 marginal tax rate .34Projected tax savings from deduction $61,200NPV of tax savings($61,200 ⨯ .873 discount factor at 7%) $53,428The total value of the 2009 NOL is $89,578 ($36,150 + $53,428).c. The NPV of a $350,000 NOL carryforward into 2011 is computed as follows.NOL carryforward deduction $350,000Projected 2011 marginal tax rate .34Projected tax savings from deduction $119,000NPV of tax savings($119,000 .873 discount factor at 7%) $103,887To maximize the value of the NOL deduction, VB should give up the carryback and carry the 2009 NOL forward as a deduction to 2011.。
