Question 1

Ivory Fast Delivery Company, an accrual basis taxpayer, frequently has claims for damages to property the company delivered. Often the claim is not filed until a month after the delivery. In the past, approximately 80% of the claims are paid by Ivory. In 2014, claims for $80,000 were filed. The company refused to pay $20,000 of the claims (because they were not valid), and paid $50,000. The remaining $10,000 in claims were processed and paid in January 2015. Also, in January 2015, claims for $8,000 were filed for deliveries made in 2014, and $6,000 was paid on these claims by March 15, 2015. Ivory has not elected to use the recurring item exception to economic performance. Under the all-events and economic performance tests, Ivory can accrue as an expense for 2014:

Accepted Answer

Under the all-events and economic performance tests, Ivory can only accrue expenses that have been incurred and for which economic performance has occurred. In 2014, Ivory paid $50,000 in claims, which satisfies these criteria. The remaining claims paid in 2015 do not meet the economic performance test for 2014.

Question 2

Pink Corporation is an accrual basis taxpayer that uses the recurring item exception to the economic performance test for all relevant years. For 2014, the corporation's income subject to state income tax was $500,000 and the state corporate tax rate was 6%. During 2014, the corporation paid $24,000 on its estimated state income tax liability for that year. The remaining $6,000 of 2014 state income tax was paid in April 2015. In June 2014, the corporation paid $9,000 on its year 2013 state income tax liability, as a result of an audit of the 2013 return that was conducted in 2014. The company has elected to use the recurring item exception to economic performance. As a result of the above, the corporation should deduct in 2014 on its Federal income tax return state income taxes of:

Accepted Answer

The answer of Pink Corporation is an accrual basis taxpayer...

Question 3

Juan, not a dealer in real property, sold land that he owned. His adjusted basis in the land was $700,000 and it was encumbered by a mortgage for $100,000. The terms of the sale required the buyer to pay Juan $200,000 on the date of the sale. The buyer assumed Juan's mortgage and gave Juan a note for $900,000 (plus interest at the Federal rate) due in the following year. What is the gross profit percentage (gain ÷ contract price)?

Accepted Answer

The answer of Juan, not a dealer in real property,...

Question 4

Generally, deductions for additions to reserves for estimated future costs (e.g., an allowance for estimated warranty costs) are not allowed for Federal income tax purposes because allowing the deduction would:

Accepted Answer

The economic performance requirement stipulates that expenses must be incurred before they can be deducted for tax purposes. Estimating future costs in the form of a reserve may not meet this requirement as the costs have not yet been incurred.

Question 5

In 2014, Beth sold equipment used in her business. Her basis in the property was $300,000 ($500,000 cost less $200,000 of depreciation). Beth sold the property for $400,000, with $100,000 due on the date of the sale and $300,000 (plus interest at the Federal rate) due in 2015. Beth's recognized gain from the installment sale in 2014 is:

Accepted Answer

The recognized gain in an installment sale is calculated as the gross profit percentage multiplied by the cash received in the year of sale. The gross profit percentage is calculated as the gross profit divided by the contract price (selling price plus any liabilities assumed by the buyer). In this case, the selling price is $400,000 and there are no liabilities assumed by the buyer, so the contract price is also $400,000. The gross profit is calculated as the selling price minus the basis, which is $400,000 - $300,000 = $100,000. The gross profit percentage is therefore $100,000/$400,000 = 25%.

In 2014, Beth received $100,000 in cash, so her recognized gain is $100,000 x 25% = $25,000. The remaining $300,000 (plus interest) is not included in her recognized gain until it is received in 2015.

Question 6

Which of the following statements regarding the matching principle is correct?

Accepted Answer

The matching principle of financial accounting is sometimes relevant to timing deductions for an accrual basis taxpayer's recurring items. While tax accounting does not strictly follow the matching principle, the concept can still be relevant in determining the timing of deductions for recurring expenses. Option A is incorrect because tax accounting does not strictly follow the matching principle, while Option B is incorrect because the matching principle is not specific to the cash method of accounting. Option D is incorrect because while tax accounting may not strictly follow the matching principle, the concept can still be relevant in certain situations.

Question 7

In 2014, Swan Company discovered that it had for the past 10 years capitalized as a production cost certain expenses that are properly classified as administrative expenses. The total amount of the expense for 2013 was $300,000, $60,000 of the item was included in the ending inventory that year and $240,000 was deducted as cost of goods sold.

Accepted Answer

The company should change its accounting method in 2014 and make a negative § 481 adjustment equal to the amount of the ending inventory that was previously capitalized as a production cost ($60,000). This will decrease the company's taxable income for 2014. The company cannot amend its 2013 tax return as the statute of limitations has expired for that year. It also cannot recognize a positive § 481 adjustment as there was no additional income in 2013 due to the error in accounting. Option D is also incorrect as there is no need to spread the adjustment over multiple years.

Question 8

Todd, a CPA, sold land for $300,000 cash on the date of sale plus a note for $500,000 due in one year. The interest rate on the note was equal to the Federal rate. The fair market value of the note was $400,000. Todd's basis in the land was $80,000.

Accepted Answer

Since the fair market value of the note is less than the face amount, Todd is considered to have received an additional $100,000 ($400,000 - $500,000) in taxable income. Todd can use the installment method to report the gain on the sale of the land. The contract price for installment sales is the total payments received, which is $800,000 ($300,000 cash + $500,000 note).

Question 9

The installment method can be used for which of the following sales with payments being made in the year following the year of sale?

Accepted Answer

The installment method is typically used for sales of property, such as a family-owned business, rather than sales of stock or department store credit card sales. The installment method may also be used for depreciable equipment sold for less than its original cost, but this is not listed as an option.

Question 10

Abby sold her unincorporated business which consisted of equipment and goodwill. The equipment had an original cost of $200,000 and Abby had claimed $120,000 in depreciation (adjusted basis = $80,000). Abby had no basis in the goodwill. The sales price for the business was $250,000, with $150,000 for the equipment and $100,000 for the goodwill. The buyer agreed to pay $120,000 on June 30, 2014, and $130,000 (plus interest at the Federal rate) in two years. Abby's gain to be reported in 2014 (exclusive of interest) is:

Accepted Answer

The answer of Abby sold her unincorporated business which consisted...

Question 11

Hal sold land held as an investment with a fair market value of $100,000 for $36,000 cash and a note for $64,000 that was due in two years. The note bore interest of 7% when the applicable Federal rate was 4%. Hal's cost of the land was $40,000. Because of the buyer's good credit record and the high interest rate on the note, Hal thought the fair market value of the note was at least $74,000.

Accepted Answer

Hal can choose to use the installment method for reporting the sale. The gain from the sale is the selling price minus the cost, which is $60,000 ($100,000 - $40,000). Because Hal received $36,000 in cash, only the remaining $64,000 is eligible for installment reporting, and the gain to be recognized each year is the gross profit percentage times the amount received in that year. The gross profit percentage is the selling price minus the cost, divided by the selling price, which is 0.6 ($60,000/$100,000). Therefore, Hal must recognize $38,400 ($64,000 x 0.6) of gain in the first year, and the remaining gain of $21,600 ($60,000 - $38,400) will be recognized in the second year when the note is collected.

Question 12

In the case of an accrual basis taxpayer, an item of income:

Accepted Answer

For an accrual basis taxpayer, an item of income is recognized when all the events have occurred to fix the taxpayer's right to receive the income and the amount of the income can be determined with reasonable accuracy, regardless of whether or not cash has been received. This is known as the income recognition principle. Option A is incorrect because cash doesn't need to be received before income is recognized under the accrual basis. Option B is incorrect because income from services is recognized once the services are performed, regardless of whether or not cash has been received. Option C is incorrect because income is recognized at the time of sale, despite the possibility of returns.

Question 13

The accrual basis taxpayer sold land for $100,000 on December 31, 2014. He did not collect the $100,000 until January 2, 2015. The land was held as an investment.

Accepted Answer

According to the installment method, a taxpayer may elect to report the gain from the sale of property over the period of time in which payments are received rather than recognizing the gain in the year of sale. In this case, since the taxpayer did not receive the full payment until 2015, they would have the option to report the gain over the period of time in which payments are received. However, if the taxpayer chooses not to use the installment method, the gain would be recognized in 2015 since that is the year in which payment was received. The taxpayer's basis in the land is not relevant to the timing of the gain recognition, as it only affects the amount of gain or loss reported.

Question 14

The taxpayer had consistently used the cash method of accounting even though inventories were a material income- producing factor to its business. The taxpayer decided to voluntarily change to the accrual method of accounting. The adjustment to income due to the change was that the correct beginning balances for the year of the change as follows: $60,000 for inventories, $30,000 for accounts receivable, and $12,000 for accounts payable. The adjustment due to the change in accounting method is:

Accepted Answer

The answer of The taxpayer had consistently used the cash...

Question 15

The installment method applies where a payment will be received after the tax year of the sale:

Accepted Answer

The installment method allows taxpayers who sell property at a gain to defer payment of their taxes. This is particularly relevant for real estate transactions, where it's common for payment to be received over an extended period of time. The other choices either do not involve the sale of property, or do not have circumstances that would require the installment method.

Question 16

Gray Company, a calendar year taxpayer, allows customers to return defective merchandise for a full refund within 30 days of the purchase. In 2014, the company refunded $400,000 for claims involving sales. The $400,000 consisted of $350,000 in refunds from 2014 sales and $50,000 in refunds from 2013 sales. All of the refunds from 2013 sales were for claims filed in 2013 and were paid in January and February 2014. At the end of 2014, the company had $12,000 in refund claims for sales in 2014 for which payment had been approved. These claims were paid in January 2015. Also in January 2014, the company received an additional $30,000 in claims for sales in 2014. This $30,000 was paid by Gray in February 2015. With respect to the above, Gray can deduct:

Accepted Answer

Gray can deduct the $350,000 in refunds from 2014 sales and the $12,000 in refund claims for 2014 sales that were approved and paid in January 2015. These total $362,000.

The $50,000 in refunds from 2013 sales that were paid in January and February 2014 cannot be deducted in 2014 because they relate to 2013 sales. Therefore, options A and D are incorrect.

The $30,000 in claims received in January 2014 for sales in 2014 cannot be deducted in 2014 because they were not paid until February 2015. Therefore, option C is also incorrect.

Overall, Gray can deduct $350,000 + $12,000 = $362,000 in 2014.

Question 17

The taxpayer has consistently, but incorrectly, used an allowance for bad debts. At the beginning of the year, the balance in the allowance account is $90,000.

Accepted Answer

If the taxpayer voluntarily changes methods, the $90,000 adjustment can be spread over the current and three following years. This is allowed under the IRS's automatic change in accounting method procedures. Option A is incorrect because the full $90,000 would be recognized in the current year or divided into two years if the change is due to an IRS examination. Option C is incorrect because a change in accounting method would result in the elimination of the reserve account, meaning that the balance cannot be used to absorb bad debts. Option D is incorrect because the consistency with prior bad debt experience does not affect the requirement for adjusting the reserve account.

Question 18

When the IRS requires a taxpayer to change accounting methods:

Accepted Answer

When the IRS requires a taxpayer to change accounting methods, the taxpayer may be subject to penalties and interest, and is generally required to make the change as of the beginning of the earliest open year. Additionally, the adjustments due to the change cannot be spread over subsequent years. Therefore, option E (a., b., and c. are correct) is the correct answer.

Question 19

Color, Inc., is an accrual basis taxpayer. In December 2014, the company received from a customer a $500 claim for defective merchandise. Color paid the customer in January 2015. Also, in December 2014, the company received a bill of $800 for office supplies that had been purchased and used in November 2014. The bill was not paid until January 2015. In January 2015, the company received a claim for $600 for defective merchandise purchased in 2014. Color paid the customer the $600 in February 2014. Assuming Color uses the recurring item exception to economic performance, the company's deductions for 2014 as a result of the above are:

Accepted Answer

The all-events test was not satisfied in 2014 for the $600 claim for defective merchandise because the customer had not filed a claim in that year.The economic performance test was satisfied for the office supplies ($800)when they were delivered (i.e. ,the other party provided the property).The all-events test was satisfied in 2014 for the $500 customer claim and the economic performance test was also satisfied when the payment was made within 8 1/2 months after year end.

Question 20

The taxpayer had incorrectly been using the cash method of accounting. For 2014, the company voluntarily changed to the accrual method. The adjustment due to the change in method as calculated at the beginning of 2014 was $120,000 (positive). The adjustment as calculated as of the end of 2014 was $80,000 (positive). As a result of the change in method, the company must:

Accepted Answer

The adjustment is spread over four years. The difference between the beginning and end of 2014 is $40,000 ($120,000 - $80,000), and one-fourth of this amount, $30,000, is recognized in 2014.

Quiz 16: Accounting Periods and Methods