Chapter 6 - Taxable Income from Business Operations

Question 1

Define Accrual Method of Accounting

Answer 1

An overall method of accounting under which revenues are realized in the year the earnings process is complete and expenses are matched against revenues in the year the liability expense is incurred.

Question 2

Define All-Events Test

Answer 2

The test for determining if an accrued expense is deductible. The test is satisfied if the liability on which the accrued expense is based is fixed, the amount of the liability is determinable with reasonable accuracy, and economic performance with respect to the liability has occurred.

Question 3

Define Allowance Method

Answer 3

The GAAP method for computing bad debt expense. The expense is based on the estimated losses from current year receivables.

Question 4

Define Annualized Income

Answer 4

The taxable income reported on a short-period return mathematically inflated to reflect 12 months of business operated.

Question 5

Define Calendar Year

Answer 5

The 12-month period from January 1 through December 31.

Question 6

Define Cash Method of Accounting

Answer 6

An overall method of accounting under which revenue is accounted for when payment is received and expenses are accounted for when payment is made.

Question 7

Define Constructive Receipt

Answer 7

The point at which a taxpayer has unrestricted access to and control of income, even if the income item is not in the taxpayer’s actual possession.

Question 8

Define Deferred Tax Asset

Answer 8

The excess of tax expense per books over tax payable resulting from a temporary difference between book income and taxable income. Unfavorable

Question 9

Define Deferred Tax Liability

Answer 9

The excess of tax payable over tax expense per books resulting from a temporary difference between book income and taxable income. Favorable

Question 10

Define Direct Write-Off Method

Answer 10

The method for determining a bad debt deduction required by the law. Only receivables that are written off an uncollectable during the year are deductible.

Question 11

Define Domestic Production Activities

Answer 11

A tax preference deduction for U.S. manufacturers equal to a % of net income from a qualified domestic production activity.
=9% deduction of the firm’s net income derived from the sale of property “manufactured, produced, grown, or extracted” within the United States.

Question 12

Define Economic Performance

Answer 12

The third requirement of the all-events test.

Question 13

Define Fiscal Year

Answer 13

Any 12-month period ending on the last day of any month except December.

Question 14

Define Generally Accepted Accounting Principals

Answer 14

The set of accounting rules developed by the Financial Accounting Standards Board and adhered to by the public accounting profession.

Question 15

Define Gross Income

Answer 15

Realized increases in wealth from whatever source derived. In the business context, gross profit from sales of goods, performance of services, and investments of capital.

Question 16

Define Hybrid Method of Accounting

Answer 16

An overall method of accounting that combines the accrual method for purchases and sales of inventory and the cash method for all other transactions.

Question 17

Define Key-Person Life Insurance Policies

Answer 17

Insurance purchased by a firm on the life of a high-level employee. The firm is the beneficiary of the policy.

Question 18

Define Method of Accounting

Answer 18

A consistent system for determining the point in time at which income and deduction are recognized for tax purposes.

Question 19

Define Net Operating Loss (NOL)

Answer 19

An excess of allowable deduction over gross income.

Question 20

Define NOL Carryback

Answer 20

A net operating loss allowed as a deduction in the two years prior to the year of loss.

Question 21

Define NOL Carryover

Answer 21

A net operating loss allowed as a deduction in the 20 years following the year of loss.

Question 22

Define Payment Liabilities

Answer 22

Accrued liabilities for which economic performance does not occur until payment is maid.

Question 23

Define Permanent Difference

Answer 23

A difference between financial statement income and taxable income that does not reverse over time.

Question 24

Define Personal Service Corporations

Answer 24

Closely held corporations owned by individuals who perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting for the corporation’s clientele. Personal service companies are subject to a flat 35% tax rate.

Question 25

Define Prepaid Income

Answer 25

Payment for goods and services made in advance of the provision of the goods or performance of the services

Question 26

Define Realization

Answer 26

Income is taken into account when the earnings process with respect to the income is complete and an event or transaction occurs that provides an objective measurement of the income.

Question 27

Define Recognition

Answer 27

Inclusion of an item of income or deduction in the computation of taxable income.

Question 28

Define Recurring Item Exemption

Answer 28

An exception to the economic performance requirement under which a liability is considered incurred in a taxable year in which it meets the first two requirements of the all-events test and economic performance occurs within 8 1/2 months after year-end.

Question 29

Define Short-Period Return

Answer 29

A tax return for a taxable year consisting of less than 12 months.

Question 30

Define Tax Benefit Rule

Answer 30

The recovery of an amount deducted in an earlier year must be included in gross income in the year of recovery.

Question 31

Define Taxable Income

Answer 31

Gross income minus allowable deductions for the taxable year.

Question 32

Define Temporary Difference

Answer 32

A difference between financial statement income and taxable income that reverses over time.

Question 33

According to judicial interpretation, what makes an expense ordinary?

Answer 33

If it is customary for a particular type of trade or business and is commonly or frequently incurred.

Question 34

What makes an expense necessary?

Answer 34

If it is appropriate and helpful for the development of the business and the generation of revenue.

Question 35

How are state, local, and foreign taxes that are incurred by a company reflect in federal income taxes?

Answer 35

It is subtracted from revenue and therefore is accounted for already in the gross income figure.

Question 36

On what figure is the federal income tax imposed on in a business?

Answer 36

Taxable income (reflecting both permanent and temporary differences)

Question 37

Why would a business use a fiscal year?

Answer 37

Because it more accurately represents the annual cycle of business. (A ski resort would not prefer to end their business year on Dec 31 in the middle of their season)

Question 38

How would a firm change their taxable year?

Answer 38

By formally requesting and receiving permission to do so from the IRS. With permission granted with that short year between the change they then file a short-period return.
-The need to change applies also to passthrough entities to reflect their tax cycle as different than their owners

Question 39

Why does the a form filing a short-term return have to annualize income? To whom does this not apply?

Answer 39

To find out the more appropriate tax margin that would have applied to their taxable income.
-To businesses that have a short-period return because their business only began at the beginning of that shorter cycle. Also the same logic applies to a short final return as well.

Question 40

What does recognized mean?

Answer 40

Taken into account

Question 41

Which times of fines/penalties that a business incurs is deducitble? Which are not?

Answer 41

Penalties such as damages are deductible

Fines paid to any government for violation of a law is not deductible.

Question 42

What is a corollary to the tax-exempt status of municipal bond interest and key-person life insurance proceeds?

Answer 42

The expenses related to those income items are nondeductible.

Question 43

Why should the term cash method not be taken to literally?

Answer 43

The receipt of noncash forms of payment creates revenue equal to the value of the payment Income doesn’t necessarily have to equal cash

Question 44

When does the doctrine of constructive receipt apply?

Answer 44

When income is credited to a taxpayer’s account, set apart for him, or otherwise made available so the taxpayer can draw on it during the taxable year.
(Income earned in a savings account is constructively received every time it is deposited and available for withdrawal, not when it is actually withdrawn)

Question 45

What business must use the accrual method? What is the exception?

Answer 45

Firms that sell merchandise must use it to account for the purchases and sale of merchandise.
-Service firms that sell tangible products as a secondary component of their principal service activity that average gross receipts of $10 million or less. (But they must still account for inventory at year end and record it as an asset)

Question 46

What kind of companies cannot use the cash method of accounting? Exception?

Answer 46

Corporations that average more than $5 million annual gross receipts. Extends to partnerships with corporate partners.
-Does not apply to personal service corporations.

Question 47

What does the SEC require of every publicly held corporation?

Answer 47

To prepare accrual basis financial statements in accordance with GAAP.

Question 48

What do many differences between financial accounting records and tax records stem from? (If the firms keeps records things in two books under two methods of accounting)

Answer 48

The contrasting principles of conservatism reflecting in GAAP and the federal tax law.

• The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested. the major responsibility of the accountant is to keep these parties from being misled
• The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the IRS is to protect the public treasury.

Question 49

When may a permanent difference occur?

Answer 49

• When income or gain is realized for book purposes but never recognized for tax purposes. (Nondeductible fines and penalties for instance)
• When the tax law provides for a deduction that never corresponds to a book expense or loss.(Domestic production activities deduction for instance)

Question 50

What time period is affected by a permanent book/tax difference? Where is that permanent expenses not seen?

Answer 50

It affects only the year in which it occurs

-Income tax expenses for financial statement purposes is based on book income adjusted for all permanent differences.

Question 51

When do temporary differences occur?

Answer 51

When an item of income, gain, expense, or loss is taken into account in a different year (or years) for book purposes than tax purposes.

Question 52

How is the calculation for a deferred tax asset or liability done?

Answer 52

By multiplying the temporary difference between book and tax income by the firm’s tax rate.

Question 53

Because of the tax accounting rule that says a taxpayer’s right to receive income is generally fixed when the earnings process is complete or when the taxpayer receives the payment, which ever happens first, what to accrual basis firms have to do?

Answer 53

Record income paid in advance of being billed as prepaid income in the year of receipt - causing a temporary difference.