Question 1

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 mandates that costs must be incurred before they can be deducted for tax purposes. Anticipated or estimated future costs do not meet this requirement and thus cannot be deducted for tax purposes.

Question 2

In 2012, 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 2011 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 2012, with a $60,000 negative § 481 adjustment which decreases its 2012 taxable income. This means that the company is correcting its mistake from the past and recognizing the $60,000 in 2012, which will result in a lower taxable income for that year. The negative § 481 adjustment accounts for the fact that $60,000 of the expense was previously capitalized and therefore deducted from income in prior years. This adjustment decreases the company's taxable income in the year of the adjustment, which is the most appropriate way to account for the previous error. Amending the 2011 tax return and reducing income by $240,000 is not the best choice as it does not properly account for the correction of the mistake in the current year. Recognizing a $60,000 positive § 481 adjustment that increases income in 2012 is also not the best choice as it does not reflect the fact that $60,000 of the expense was previously deducted in prior years. Recognizing a negative § 481 adjustment that is spread over multiple years (choice D) is also not necessary as the entire adjustment can be recognized in the current year.

Question 3

In 2012, 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 2013.Beth's recognized installment sale gain in 2013 is:

Accepted Answer

Beth recognized $100,000 of gain in 2012, the year of sale, because the amount realized ($400,000) exceeded her adjusted basis ($300,000). In 2013, she will recognize gain and interest income on the $300,000 she received in that year. To calculate the installment sale gain, we first need to determine the gross profit percentage:

$400,000 sale price - $300,000 adjusted basis = $100,000 gross profit 
$100,000 gross profit ÷ $400,000 sale price = 25% gross profit percentage

Beth will recognize 25% of the $300,000 payment in 2013 as gain:

$300,000 payment × 25% gross profit percentage = $75,000 gain

Therefore, her recognized installment sale gain in 2013 is $75,000. However, since this is an installment sale, Beth will also receive interest income on the $300,000 payment in 2013, which will increase her total income.

Question 4

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. The taxpayer generally is required to make the change as of the beginning of the earliest open year. The adjustments due to the change cannot be spread over subsequent years. Therefore, all options (a), (b), and (c) are correct.

Question 5

The taxpayer had incorrectly been using the cash method of accounting. For 2012, the company voluntarily changed to the accrual method. The adjustment due to the change in method as calculated at the beginning of 2012 was $120,000 (positive). The adjustment as calculated as of the end of 2012 was $80,000 (positive).As a result of the change in method, the company must:

Accepted Answer

The answer of The taxpayer had incorrectly been using the...

Question 6

Gray Company, a calendar year taxpayer, allows customers to return defective merchandise for a full refund within 30 days of the purchase.In 2012, the company refunded $400,000 for claims involving sales.The $400,000 consisted of $350,000 in refunds from 2012 sales and $50,000 in refunds from 2011 sales.All of the refunds from 2011 sales were for claims filed in 2011 and were paid in January and February 2012.At the end of 2012, the company had $12,000 in refund claims for sales in 2012 for which payment had been approved.These claims were paid in January 2013.Also in January 2013, the company received an additional $30,000 in claims for sales in 2012.This $30,000 was paid by Gray in February 2013.With respect to the above, Gray can deduct:

Accepted Answer

The answer of Gray Company, a calendar year taxpayer, allows...

Question 7

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

If Todd uses the installment method to report the gain, the contract price is the sum of the cash received and the fair market value of the note, which totals to $700,000. Option A is incorrect because Todd can still use the installment method even if he uses the cash basis to report his practice income. Option B is incorrect because Todd can use the installment method regardless of the accounting method used for his practice income. Option D is incorrect because even without using the installment method, the gain would only be $620,000 ($300,000 + $500,000 - $80,000).

Question 8

Juan, not a dealer in real property, sold land that he owned.His adjusted basis in the land was $500,000 and it was encumbered by a mortgage for $200,000.The terms of the sale required the buyer to pay Juan $100,000 on the date of the sale.The buyer assumed Juan's mortgage and gave Juan a note for $600,000 (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 9

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 10

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

Accepted Answer

The installment method applies to taxpayers who sell property, including real estate, and receive a payment in a tax year after the year of sale. This allows the taxpayer to recognize the gain over the course of receiving the payments, rather than all at once in the year of sale.

Question 11

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, they can spread the $90,000 adjustment over the current and three following years. This option allows the taxpayer to potentially minimize the impact of the adjustment on their current tax liability.

Question 12

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 11% when the applicable Federal rate was 7%.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

Since Hal sold the land for $100,000, the amount realized is $100,000. From this, we subtract Hal's basis of $40,000 to arrive at a gain of $60,000. However, since Hal received $64,000 in the form of a note, he can only recognize a portion of the gain in the year of sale. Hal can choose to use the installment method to defer the gain recognition.

To calculate the gain to be recognized in the year of sale, we must first calculate the gross profit percentage. This is calculated as follows:

Gross Profit Percentage = (Selling price - Basis) / Selling price 
= ($100,000 - $40,000) / $100,000 
= 0.6 or 60%

Using the gross profit percentage, we can calculate the gain to be recognized in the year of sale as follows:

Gain to be Recognized = Gross Profit Percentage x Payments Received in the Year 
= 0.6 x $36,000 
= $21,600

Therefore, Hal must recognize $21,600 gain in the year of sale unless he elects not to use the installment method.

Question 13

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, 2012, and $130,000 (plus interest at the Federal rate) in two years.Abby's gain to be reported in 2012 (exclusive of interest) is:

Accepted Answer

Abby's total gain is calculated as the sales price minus the adjusted basis. The sales price is $250,000, and the adjusted basis is $80,000 for a total gain of $170,000.

However, only a portion of the gain is recognized in 2012 because part of the sales price is paid in two years. The recognized gain in 2012 is calculated by multiplying the total gain by the percentage of the sales price received in 2012:

$120,000 / $250,000 = 0.48

So, the recognized gain in 2012 is:

$170,000 x 0.48 = $81,600

However, the gain is limited to the amount of cash received in 2012, which is $120,000. Therefore, the recognized gain in 2012 is $118,000 ($120,000 - $2,000 of unallowed gain).

The interest received in 2014 will be reported as interest income on Abby's tax return for that year.

Question 14

Pink Corporation is an accrual basis taxpayer that uses the recurring item exception to the economic performance test for all relevant years.For 2012, the corporation's income subject to state income tax was $500,000 and the state corporate tax rate was 6%.During 2012, the corporation paid $24,000 on its estimated state income tax liability for that year.The remaining $6,000 of 2012 state income tax was paid in April 2013.In June 2012, the corporation paid $9,000 on its year 2011 state income tax liability, as a result of an audit of the 2011 return that was conducted in 2012. The company has elected to use the recurring item exception to economic performance. As a result of the above, the corporation should deduct in 2012 on its Federal income tax return state income taxes of:

Accepted Answer

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

Question 15

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 2012, 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 2013. Also, in January 2013, claims for $8,000 were filed for deliveries made in 2012, and $6,000 was paid on these claims by March 15, 2013.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 2012:

Accepted Answer

The answer of Ivory Fast Delivery Company, an accrual basis...

Question 16

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. This means that expenses should be recognized in the same period as the related revenue, even if the payment is made later. This principle is important in determining when a taxpayer can deduct expenses for tax purposes. However, it is not relevant to tax accounting under the cash method, which does not recognize revenue or expenses until cash is received or paid.

Question 17

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 capital assets, such as the sale of common stock in a family owned business, where payments are made in the year following the year of sale. It is not typically used for credit card sales or sales of publicly-traded securities. The sale of depreciable equipment sold for less than its original cost would most likely result in a loss recognized in the year of sale, rather than spreading the gain over multiple years using the installment method.

Question 18

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

Accepted Answer

An accrual basis taxpayer recognizes income when all 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. This means that income is recognized when the earnings process is complete, regardless of when cash is received. Services performed or goods sold are considered to be complete when the obligations related to the performance or sale have been fulfilled. The possibility of a return or refund does not impact recognition of income for tax purposes under the accrual basis.

Question 19

Color, Inc., is an accrual basis taxpayer.In December 2013, the company received from a customer a $500 claim for defective merchandise.Color paid the customer in January 2014. Also, in December 2013, the company received a bill of $800 for office supplies that had been purchased and used in November 2013.The bill was not paid until January 2014. In January 2014, the company received a claim for $600 for defective merchandise purchased in 2013.Color paid the customer the $600 in February 2014.Assuming Color uses the recurring item exception to economic performance, the company's deductions for 2013 as a result of the above are:

Accepted Answer

The answer of Color, Inc., is an accrual basis taxpayer.In...

Question 20

The accrual basis taxpayer sold land for $100,000 on December 31, 2012.He did not collect the $100,000 until January 2, 2013.The land was held as an investment.

Accepted Answer

According to the installment method, if the taxpayer elects to use it, the gain or loss does not need to be recognized until the payments are received. Therefore, if the taxpayer's basis in the land was $60,000 and they choose to use the installment method, the gain of $40,000 would be reported in 2013 when the payment is received, unless the taxpayer chooses not to use the installment method.

Quiz 16: Accounting Periods and Methods