Chapter 2B. Corp.

Taxation Reconciliation of Book and Taxable Income

Howard Godfrey, Ph.D., CPA Professor of Accounting Copyright 2011 Edited December 28, 2010

Reconcile tax and book income [Page 25+]

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 Corporation governed largely by Section 162 when determining deductibility of payments to shareholders. Shareholders governed largely by Sections 162 and 212 when making corporate related expenditures, but are limited by Sections 262 and 263(a)(1).
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162(a) In General. There shall be allowed as a deduction all the ordinary and necessary expenses in carrying on any trade or business, including(1) a reasonable allowance for salaries .. (2) traveling expenses (3) rentals

 What is the presumption in the Code regarding the relationship of corporate activities and Section 162(a)? Does Section 212 apply to corporations?

Corporation's Taxable Income.

Business Expenses. Deductions are allowed for ordinary and necessary business expenses.

No deduction is allowed for interest on amounts borrowed to purchase taxexempt securities, illegal bribes or kickbacks, fines or penalties imposed by a government, or insurance premiums incurred to insure the lives of officers and employees when the corporation is the beneficiary.
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Char. Corp.-organized 1-1-2011 Income per books-2011 Book Income includes: Municipal bond Interest Meals & entertain. Exp. Prem. - officers' life ins. (corp. is beneficiary) Capital losses Fines What is taxable income? 8,000 20,000 3,800 1,000 200

Return

$400,000 $400,000

Char. Corp.-organized 1-1-2011 Income per books-2011 Book Income includes: Municipal bond Interest Meals & entertain. Exp. Prem. - officers' life ins. (corp. is beneficiary) Capital losses Fines What is taxable income? 8,000 20,000 3,800 1,000 200

Return

$400,000 $400,000 (8,000) 10,000 3,800 1,000 200 $407,000

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UNCC Corporation - 1 of 3
Compute Tax. Income Debit Credits Sales $700,000 Cost of sales $400,000 Mun. bond interest 2,000 Compensation 100,000 Meals, entertain-Gross 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax
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UNCC Corp - 2 of 3

Debit

Sales Cost of sales $400,000 Mun. bond interest 2,000 Compensation 100,000 Meals, entertain. (Gross) 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax 42,000 Add: one half of entertain. Less: Mun. bond interest Taxable income Income Tax Compute E & P (Similar to Retained Earnings)
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Credits $700,000

UNCC Corp - 3 of 3

Debit

Sales Cost of sales $400,000 Mun. bond interest 2,000 Compensation 100,000 Meals, entertain. (Gross) 20,000 Other Expense 140,000 Subtotal 660,000 702,000 Net Income before tax 42,000 Add: One half of entertain. 10,000 Less: Mun. bond interest (2,000) Taxable income 50,000 Income Tax 7,500 Compute E & P (Similar to Retained Earnings)
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Credits $700,000

Blue Corporation Blue Corp. reported GAAP net income before income tax of $400,000 in its first year of operation. Financial Statements include bad debts expense of $3,000. Blue Corp. wrote-off bad debts totaling $2,000 in first year. Taxable income for the year?____
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X Corp. taxable income in first year: $400,000. Fin. Statements: bad debts exp. of $3,000. X Corp. wrote-off bad debts totaling $2,000. Taxable income will be $400,000 in future. Fin. statements at end of first year include: a. Deferred tax asset of $340 b. Deferred tax asset of $660 c. Deferred tax liability of $340 d. Deferred tax liability of $660
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Big Corp. Bad Debts-Sec. 166

GAAP- 2011- Income Statement: Sales (Gross) $200,000 Cost of sales 100,000 Gross Profit 100,000 Expenses 60,000 Net income before taxes $40,000 For GAAP, company charges 4% of gross sales to bad debts expense. Allow. for bad debts, 12/31/2010 $5,000 Allow. for bad debts, 12/31/2011 4,000 What is taxable income for 2011? a. $ 40,000 b. $42,000 c. $39,000 d. $38,000

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Sales Co. (Co. started in 2010) [1]

Bad Debts. Direct write-off for Tax Purposes
Amounts in 2010 2011 $Thousands GAAP Tax GAAP Tax Sales $800 $800 $800 $800 Cost of Sales 500 500 500 500 Gross Margin 300 300 300 300 Bad Debts Expense 80 60 50 60 Total other expenses 100 100 120 120 Net Income Before Tax $120 $140 $130 $120 Amount of the deferred tax asset at 12-31-2011? Assume income tax rate is 34%

Sales Co. [2]

Year 2008 2009 Total Difference Marginal rate Deferred Tax Asset Book Income $120,000 130,000 250,000 Taxable Income $140,000 120,000 260,000 10,000 34% $3,400

Bad Debts Problem ($000)

Sales $100 Bad debts (provision) 5 Other Expenses 80 Total Expenses 85 Net Income before Taxes $15 Accounts Receivable Allow. for Bad Debts Beg. End. $80 $85 $7 $4

Amount of Acct. Rec. written off? What is taxable income?

Bad Debts Problem

Transaction
Beg. Bal. 1 2 3 4 5 Sales Collection Write-off Other Exp. Provision Balance

Cash
XXX

Accts. Rec.
80

Allowance
7

Revenue and Expense ($000)

Transaction
1 4 5 Sales Other Exp. Provision

Revenue

Other Exp.

Bad Debts Exp.

Maxwell Corp. Book/Tax Differences Book income before tax $400,000 Revenue included: Tax-exempt interest income 8,000 Expenses included: Meal & Entertainment Exp. Life insurance premium Fines Taxable income Tax Rate Income Tax Liability 22,000 3,300 200

Maxwell Corp. Book/Tax Differences Book income before tax $400,000 Tax-exempt interest income Meal & Entertainment Exp. (50% x $22,000) Life insurance premium Fines Taxable income Tax Rate 34% Income Tax Liability All adjustments - permanent differences.

Maxwell Corp. Book/Tax Differences

Book income before tax Tax-exempt interest income Meal & Entertainment Exp. (50% x $22,000) $400,000 (8,000) 11,000

Life insurance premium 3,300 Fines 200 Taxable income $406,500 Tax Rate 34% Income Tax Liability $138,210 All adjustments - permanent differences?

Maxwell Corp. Book/Tax

Please prepare schedule M-1. Appendix pg. B-32 of your textbook.

Schedule M-1

Reconciliation of Income (Loss) per Books with Income per Return

Income recorded on books this year not included on this return (itemize):

1 Net income (loss) per books............................ 7 2 Federal income tax............................. 3

Excess of capital losses over capital gains ............

Tax-exempt interest.

4 Income subject to tax not recorded on

books this year (itemize):. 8 Deductions on this return not charged
against book income this year (itemize):

5 a b c 6

Expenses recorded on books this yr, not deducted on this retum (itemize): Depreciation .............. Contributions .... Travel and entertainment...

a. b.

Depreciation Charitable Contributions

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Add lines 1 throuqh 5

Add lines 7 and 8

Income (Line 28, pg 1) - ln 6 less ln 9

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Schedule M-1

Reconciliation of Income (Loss) per Books with Income per Return

Income recorded on books this year not included on this return (itemize):

$400,000 7 1 Net income (loss) per books............................

2 Federal income tax............................. 3

Excess of capital losses over capital gains ............

Tax-exempt interest.

$8,000 $8,000

4 Income subject to tax not recorded on

books this year (itemize):. 8 Deductions on this return not charged
against book income this year (itemize):

5 a b c 6

Expenses recorded on books this yr, not deducted on this retum (itemize): Depreciation .............. Contributions .... Travel and entertainment... $11,000

a. b.

Depreciation Charitable Contributions

Life Ins. Prem. $3,300

Add lines 1 throuqh 5

Fines $200

$14,500 $414,500

9 10

Add lines 7 and 8

Income (Line 28, pg 1) - ln 6 less ln 9

$8,000 $406,500

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Accrual to Cash. ($000)-Slide 1

Sales Bad debts (provision) Other Expenses (cash) Total Expenses Net Income before Taxes Accounts Receivable Allow. for Bad Debts $100 5 80 85 $15 Beg. End. $80 $85 $7 $4

Amount collected from customers?

Amount of Net Cash Flow-before taxes? What is Taxable Income?

Accrual to Cash Problem - Slide 2

Transaction
Beg. Bal. 1 2 3 4 5 Sales Collection Write-off Other Exp. Provision Balance

Cash
XXX

Accts. Rec.
80

Allowance
7

Revenue and Expense ($000)

Transaction
1 4 5 Sales Other Exp. Provision

Revenue

Other Exp.

Bad Debts Exp.

Client recorded 2011 transactions on cash basis and prepares the tax return on the accrual basis. Collections from customers in 2011 $300,000 Cash payments for expenses 200,000 Other information Beginning Accounts Receivable 100,000 Ending Accounts Receivable 90,000 Write-off of uncollectible accounts 4,000 Depreciation Expense 50,000 Change in accounts payable 0 All sales are on credit Direct Charge-Off Method is used. What is amount of sales (accrual)? What is taxable income?

Client - Slide 2 of 3
Cash Ac-Rec. Other Rev. Exp. Beg. Bal. Sales Collection Write-off Deprec. Other Exp. Balance

Client - Slide 3 of 3
Cash Ac-Rec. Other Rev. Exp. Beg. Bal. Sales Collection 300 Write-off Deprec. Other Exp. (200) Balance 90 100 294 (300) (4) (50) 4 50 200 294

Office Rental Inc. Slide 1 of 6.

Office Rental, Inc. collects rent in advance from some tenants and bills others at the end of each month for that months rent. The accrual basis income statement (GAAP) for Year 2 shows revenue earned of $54,700. Rent Receivable was $3,100 at start of Year 2 and $2,500 at the end of Year 2. Unearned Revenue Account had a balance of $2,600 at start of Year 2 & $1,300 at end of Year 2. What is cash basis revenue for Year 2 (collections from tenants)?

Office Rental Inc.-Slide 2 of 6

Year 2 Balance Sheet Rent receivable Unearned revenue $2,500 $1,300 Year 1 $3,100 $2,600 $49,800

GAAP Income Statement: Rent Revenue $54,700 Cash Collections from tenants for rent?

Office Rental Inc.-Slide 3 of 6

Year 2 Revenue Earned-Yr 2 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Collected from tenants In Year 2, you collected receivables of $3,100 for rent in Year 1, etc. $54,700 3,100 2,500 2,600 1,300 Year 2 $54,700

Office Rental Inc.-Slide 4 of 6

Year 2 Revenue Earned-Yr 2 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Collected from tenants of $3,100 for rent in Year 1, etc. $54,700 3,100 2,500 2,600 1,300 Year 2 $54,700 3,100 (2,500) (2,600) 1,300 $54,000

In Year 2, you collected receivables

Office Rental Inc.-Slide 5 of 6

Revenue-accrual basis-Year 2 tax return?

GAAP Revenue for Year 2 54,700 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue End. Unearned Revenue Revenue on Tax Return Tax law follows GAAP for accruing receivables, but not for reporting rent income received in advance.

Office Rental Inc.-Slide 6 of 6

Revenue-accrual basis-Year 2 tax return?

GAAP Revenue - Year 2 54,700 Beg. Rent Receivable End. Rent Receivable Beg. Unearned Revenue (2,600) End. Unearned Revenue 1,300 Revenue on Tax Return $53,400 Tax law follows GAAP for accruing receivables, but not for reporting rent income received in advance.

Realty Corp. Rental Income

Realty Co. was organized on Jan-1, year 1. Realty bought a building on that date for $400,000, having an estimated 40-year life with no salvage. The S/L depreciation method is used for tax & GAAP. Depreciation is $10,000 per year on the tax return and in the GAAP statements. Realty rented the building to IBM for 2 years at $20,000 per year. Rent of $40,000 was received on Jan-1, year 1. Realtys income tax rate is 40%. Year 1 operations are described on the next slide.

Realty Corporation - Slide 2. GAAP Tax Rent Revenue $20,000 Cash Expenses (5,000) Depreciation Exp. (10,000) NIBT/Taxable Income 5,000 Income Tax Rate 40% Income Tax Expense Income Tax Paid Net Income What is the amount of the deferred tax asset or liability at end of Yr 1?

Realty Corporation - Slide 3. GAAP Tax Rent Revenue $20,000 $40,000 Cash Expenses (5,000) (5,000) Depreciation Exp. (10,000) (10,000) NIBT/Taxable Income 5,000 25,000 Income Tax Rate 40% 40% Income Tax Expense 2,000 Income Tax Paid 10,000 Net Income 3,000 What is the amount of the deferred tax asset or liability at end of Yr 1?

Realty Corporation - Slide 4. GAAP Tax Rent Revenue $20,000 $40,000 Cash Expenses (5,000) (5,000) Depreciation Exp. (10,000) (10,000) NIBT/Taxable Income 5,000 25,000 Income Tax Rate 40% 40% Income Tax Expense 2,000 Income Tax Paid 10,000 Net Income 3,000 What is the amount of the deferred tax asset or liability at end of Yr 1? 8,000

Income Tax Accounting

Gross sales in year 1 $500,000 Cost of sales in year 1 250,000 Other Expenses in year 1 100,000 Net Income Before Taxes- Yr 1 $150,000 Year 1 sales collected in: Year 1 $300,000 Year 2 $200,000 Income Tax Rate 40% Method used for GAAP: Accrual Method used for Tax: Inst. Sales Amount of deferred tax asset or liability at end of Year 1? Is it a Def. Asset or Liability?

Income Tax Accounting

Gross sales in year 1 $500,000 Cost of sales in year 1 250,000 Other Expenses in year 1 100,000 Net Income Before Taxes- Yr 1 $150,000 Year 1 sales collected in: Year 1 $300,000 Year 2 $200,000 Income Tax Rate 40% Method used for GAAP: Accrual Method used for Tax: Inst. Sales Amount of deferred tax asset or liability at end of Year 1? $ 80,000 Is it a Def. Asset or Liability? Liability

Note, the installment sales method is generally prohibited for dealers in inventory. However it is allowed in limited circumstances. The problem on the preceding slide is included to help illustrate the differences between accrual accounting and other revenue recognition methods and the impact on deferred taxes.

The End
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