BULAW5916 | Taxation Law & Practice | The Accrual Method Of Accounting
Part 1
On 1 July 2016 Frank Lloyd commenced business as an architect. He operated as a sole proprietor from a converted garage at the rear of his residence. Much of his work consisted of preparing building designs and specifications for local council building permits but he quickly gained a reputation for quality drawings prepared within tight timeframes. By the end of 2016/17 he had a small client base of local builders and private referrals and billings (fees) of $75,000.
During the year (2016/17) Frank submitted a design as part of a national competition for
‘The Citadel’, the centrepiece of an ambitious urban redevelopment. His visionary design and revolutionary use of local materials left the judging panel speechless with admiration and, to national acclaim, he was awarded the prize and commissioned to build the structure. Immediately he borrowed $1 million, rented premises in Main Terrace, acquired state of the art equipment and employed six draughtsmen and two administrative staff. During 2017/18 his billings were $2.5 million.
Required 1:
Should Frank return on a cash or accrual basis in 2016/17 and 2017/18?
You must refer to appropriate case law. Your answer must include (but should not be limited to) a discussion of the following:
Part 2
Ruby Engineering Pty Ltd [Ruby] was incorporated in 1990 and produced engine components used in the Australian car industry. In 2016 the business and company assets were sold to Diamond Ltd. Under the terms of the agreement, Ruby remained liable for any claims arising before 2016. The company used the funds to invest in real estate and shares.
During the year ended 30 June 2018 Ruby incurred the following expenses:
Required 2:
Advise the directors of Ruby Pty Ltd of the tax deductibility of the above amounts. You must make reference to appropriate authorities and legislation.
- Ruby has owned and rented a residential property since 2008. Rental income for the current year is $35,000. During the year the company replaced the old kitchen fittings, including cupboards that had deteriorated through water damage and wear and tear. The new cupboards were of the same type as the old ones and the kitchen layout was not altered substantially. The cost was $8,500.
- In another of the rental properties a visitor to the tenants slipped on the steps and sustained injuries requiring medical attention. She claims one of the steps was loose and commenced legal proceedings against the partnership alleging her injuries were caused by the poor condition of the building. Ruby incurred legal expenses to date of $7,000 and the action has not been settled at 30 June.
- In March 2015 the company owned sold a batch of parts that were subsequently found to be defective. The purchaser, an Australian car manufacturer lodged a claim for damages in the Federal Court. The claim was settled in November 2017 and the company paid an amount of $750,000 to the car manufacturer.
- The directors of Ruby were concerned about the claim in (c) and the effect it had on the year’s reported profit. They resolved to set aside a small amount of funds annually to meet any future claims. Accordingly, an amount of $100,000 was set aside in a provision in the accounts for the year ended 30 June.
- In August 2017 the directors of Ruby decided to investigate the possibility of re-entering the car parts manufacturing industry using a new type of alloy. An amount of $220,000 was paid to consultants investigating the proposal but, due to uncertainty in the motor vehicle industry, the directors decided not to proceed at the time.
Advise the partners and directors of Ruby Pty Ltd of the tax deductibility of the above amounts. You must make reference to appropriate authorities and legislation.
Answer:
Requirement 1:
1. The important nature of the dissimilarities in the accrual method of accounting is seen to be associated to the purchase and sale of the recorded in the accounts. The cash method of the accounting has been further identified with the expenditure and revenue which are susceptible to changes as per the accounting method. In the accrual concept the recognition of the recognition of the accounts is considered with specific factors and the cash method may be easier for interpretation and maintenance (Braithwaite, 2017).
It needs to be also seen that there is no requirement for accruals and computation of allocation. In reality the business functions in a different nature in compare to the cash method as the business may sell products which are paid at a later date in other forms of transactions which takes place after receiving payment a later stage. The use of the accrual concept of accounting needs to be also seen to be defined as per the various type of the concepts of the accounting which are associated to give better scenario depiction related to expenditure and income originating from profitability. The various types of the other factors such as double entry bookkeeping may be considered to be useful method which a business adopts as per the knowledge related to the overall equation for accounting. The factors related to the cash flow is seen as the best method in deciding the accounting method which is suitable for a business in better prediction of the cash flow.
Based on the assertions made in the case of “Carden v FCT” in significant nature of factors considered for taxation accounting procedure needs to include substantial view of true income of the taxpayer. On the other hand,
the rulings of “Henderson v FCT” case held that for a specific taxpayer there should be one appropriate method of accounting the taxable income(Law.ato.gov.au, 2018). These assertions need to be confirmed in choosing the appropriate accounting method pertaining to
- Business size
- Allocation of income of businesses or originated directly from taxpayers
- Intricacies involved in the business
- Receivable of the debts
- Accounting practice or methodology evidenced by following the actual accounting model
2. It needs to be seen that in the given situation Frank has option of selecting of either the cash or accrual basis of accounting. The adoption of the cash basis of accounting will be conducive for Frank in determination of the revenue which are seen as a receipt of the cash and expenditure. This method of accounting would be beneficial for Frank in terms of identification of the receivable or accounts payable. In addition to this, Frank has the option of considering cash basis due to its simplicity in maintenance and ease of understanding (Snape & De Souza, 2016).
Moreover, it becomes easier for assertion of the transactions which does not require tracking of the payables or receivables. Frank is depicted to be having a choose from either of the cash or accrual accounting. The choice related to the adoption of the accrual or cash is seen to be represented with the accounting for the GST amount which will be able to include the period in which a business makes the payments associated to purchase or sales (Ali et al., 2017).
The decision is passed in the court for “Carden v FCT” relates to the accounting method which shall provide the appropriate view of true income pertaining to the taxpayer. On the contrary, Henderson v FCT” ruled that the correct method of assertion for taxable income needs to be considered with the accrual basis of accounting. Referring to the case of “Henderson v FCT” accrual accounting basis is seen to be appropriate for Frank despite of his liberty in choosing the accounting basis for recognising revenue (Ato.gov.au, 2018).
3. As per the given situation the commissioner of the taxation is seen to be having the rights of insisting a certain method of accounting. In addition to this, the taxation commissioner has stated that the person held assessable for taxation needs to be depicted in terms of the payments which are received as per the business irrespective of the work performed. In such a circumstance the commissioner under the cash basis of accounting will include the payments which are received as a result of the taxable income. The commissioner of taxation has further included the business aspects as per the total left in the previous year, which was less than $ 10 million for a particular account as per the GST and the cash method of accounting.
The counting as per the cash method will be also able to account for the business activities which will cover the payments made for the purchase and sales. It needs to be also discerned that the commissioner of taxation has insisted on gaining the advantage as per cash concept of accounting which will be helpful for the business in the better alignment of the of the liabilities of the activity statement and also easier cash flow monitoring (Braverman, Marsden & Sadiq, 2015).
“FCT v Dunn (1989)” identified that taxpayer have applied accrual accounting method however shifting to cash basis at a later stage. The Commissioner for their asses that the taxpayer as per accrual basis was considered to be appropriate in nature. Similarly, in the case of “FCT v Firstenberg (1976)” the taxpayer was seen to return the cash as per assessment done by accrual method. It was further decided in the case that cash basis for accounting is the correct approach (Law.ato.gov.au, 2018).
4. As per the given case study it can be discerned that in year ended 2016/17 the company has been depicted to be earning an income of $ 75000 in the year of 2017-18 the annual turnover of the company was depicted to be seen as per amounting to be $ 2.5 million. Therefore, in both the aforementioned financial years the total annual turnover of the business was lower than the suggested limit of $ 10 million. The accounting method as per the cash basis is seen to be requiring for significant nature of the assistance as per the cash basis in case the annual turnover is lesser than $ 2 million and $ 10 million (Woellner, Barkoczy & Murphy, 2018).
It is further evident that the accounting method for Frank will not change for both accounting year small business which will be below the annual turnover threshold of $ 10million. He also needs to attribute the input tax for the creditors for a particular tax period along with the offers and consideration during the tax period. The cash basis of accounting will remain same in case of accounting period of 2017 and 2018. This shows that Frank should consider remaining in the cash basis of accounting (Graetz & Warren, 2016).
5. The availability of the present software packaging will include the traditional criteria of accounting. The cash or accrual basis of accounting is not seen to be anymore important. The electronic system has further created several types of the difference as per highly suitable business and turnover lesser than $ 2 million (McGregor-Lowndes, 2016).
The accrual and cash method of accounting needs to be identified to different from the tadeonal method as it helps in the treatment of the accounts in different manner. For instance, in terms of maintenance of the business this system of accounting has been depicted to be conducive in terms of the various types of the aspects related to the bookkeeping and keeping track of the expenditure and income such as stock valuation, stock of the business at the end of the accounting period and also the payments which are made to the employees. The availability of the accounting software should be able to monitor the business activities and at the same time provides a better picture of the total amount of the money associated to the cash in hand and the bank accounts.
Requirement 2:
1. As stated under “Section 8-1 of the ITAA 1997”, the deductions from a taxpayer are allowed from the assessable income which are a part of the assessable income as per the expenses which are non-capital in nature. The individuals are further allowed to claim rental deductions as per the rented property or other aspects of the rent. It needs to be also discerned that as stated under “subsection 25-10 (1)” repair is defined as any activity which is inclusive of the restoration of the assets to their previous conditions without the necessary function or character (Cao et al., 2015).
The repairs may be considered with the replacement and replacement as per the subsidiary portions of the reconstruction. Such a cost will be based on replacing the fittings of the kitchen and deteriorated cupboard which is seen as per the deductions under “section 8-1 of the ITAA 1997”. These repairs are further constituted as per the general repairs relating to which the deductions may be claimed. The repairs are further seen to be based on restoring of the function and efficiency of the asset and improvement in the character (Taylor et al., 2018).
2. The legal expenditures incurred are needed to be considered as per the deductible income. These costs are seen to comprise of the non-paying tenant taken by any court which may lead to loss of income and claimable for rental deduction required for deducting the claims associated to the injuries suffered by the third party associated to the rental property. In most of the situation the legal expenditure of capital in nature are non-deductible. The non-deductible legal expenditures may be of capital nature but they are considered as a part of the cost of the property pertaining to the CGT (Braithwaite, Reinhart & Job, 2018).
In the given case Ruby has reported the legal expenditure as $ 7,000 as a tenant met with an accident on the steps and suffered injuries, the legal expense of $ 7000 will be adjusted with the deductions as the expenses are consisting of the defending for the damages claims as a result of the injuries sustained on a rental property. In addition to this, the expenditure from letting out the premises to the tenant was depicted with the motive for generating assessable income. Moreover. The legal expenditure were a result of the Ruby’s possession of the rental income which is held incidental as per producing of the taxable rental income. There has been no scope of enduring benefit as per the benefits which was expenses appropriate with the revenue account.
3. As stated under “section 8-1 of the ITAA 1997” the various types of the deductions allowed under the outgoing losses have occurred as a result of the income which is taxable and excluding the circumstances in which there has been losses or outgoings which are capital in nature and associated to the computation of the exempted income. As decided in the case of “Hallstroms Pty Ltd v FCT (1946)” of ascertaining whether deductions as per the legal expenditure can be allowed as per the provision of “section 8-1 of the ITAA 1997”, the nature of the expenditure needs to be taken into account. In the present situation it has been further evident that Ruby Pty Ltd mainly suffered the expenses as result of the compensation for the damages. The claim settlement amount was seen as $750,000 pertaining to the manufacturing of the car (Frecknall-Hughes & Kirchler, 2015).
In the findings of the “Sun Newspaper Ltd v FCT (1938)” stated for the expenditures which were related in the direction of the structural changes rather than the operational purpose and capital in nature along with the non-allowable deductions. The compensation was further taken into account as per the operational purpose. The expenditure is seen to be concerning towards the operational and structural purpose. As the expenses are seen to be capital in nature they will not be allowed for the deductions for Ruby Pty Ltd.
4. As per the statement of Australian taxation office, expenditure is seen as a non-allowable deduction for an eligible period. In order to obtain the deduction as per section 63of the Act, the expenses needs to be considered before they are considered for deductions. A deduction of fund is seen to be applicable to the taxpayer as per the subsection 63 (1) which is generally written off as a part of the expenses. Based on the present situation Ruby has set separately a provision of $100,000 in the books of accounts for the income year ended 30 June. As a general rule the provisional expenditure pertaining to the business is not allowed under deductions as they are incurred as per the assessable income and non-allowable deductions are taken into account with the provision as per “section 8-1 of the ITAA 1997”.
5. Outgoings and losses which are seen to be preliminary in nature are seen with the commencement of the income generating ability of an business which has not taken in aspect as per general provision under “section 8-1 of the ITAA 1997”. Reference to the to the decision taken in the case of “Softwood Pulp & Paper v FCT (1976)” the company was subjected to expenditure as per the feasibility study due to the new production unit pertaining to the paper mill. The commissioner of the judgment has further given his opinion on the allowable deductions under the feasibility assessment which are preliminary in nature and considered before the income generation (Townend, 2016).
A similar situation is evident in the situation of the Ruby Pty Ltd in which the company has investigated on the total expense of $220,000 for a possible entry associated to the auto parts industry. These expenses are further seen to be considered to be preliminary and taken into account in the beginning of the income generating activities. The market investigations on these expenses will be taken onto account with the allowable deductions sated under the “section 8-1 of the ITAA 1997”.
References
Ali, M., Sales, A. B. I. C. L., Barwick, J., Digirolamo, L., Australia, C. R., Officer, D. R., ... & Khalid, A. (2017). School of Business.
Ato.gov.au. (2018). Legal Database. [online] Available at: https://www.ato.gov.au/law/view/document?docid=LIT/ICD/NSD165of2010/00001 [Accessed 12 Sep. 2018].
Braithwaite, V. (2017). Taxing democracy: Understanding tax avoidance and evasion. Routledge.
Braithwaite, V., Reinhart, M., & Job, J. (2018). Getting on or getting by? Australians in the cash economy. In Size, Causes and Consequences of the Underground Economy (pp. 55-69). Routledge.
Braverman, D., Marsden, S., & Sadiq, K. (2015). Assessing Taxpayer Response to Legislative Changes: A Case Study of In-House Fringe Benefits Rules. J. Austl. Tax'n, 17, 1.
Cao, L., Hosking, A., Kouparitsas, M., Mullaly, D., Rimmer, X., Shi, Q., ... & Wende, S. (2015). Understanding the economy-wide efficiency and incidence of major Australian taxes. Canberra: Treasury working paper, 2001.
Frecknall-Hughes, J., & Kirchler, E. (2015). Towards a general theory of tax practice. Social & Legal Studies, 24(2), 289-312.
Graetz, M. J., & Warren, A. C. (2016). Integration of corporate and shareholder taxes.
Law.ato.gov.au. (2018). ATO ID 2014/1 - Where the method of accounting changes from cash to accruals basis in an income year, does section 118-20 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to reduce any capital gain made when a debt that arose from the provision of services in the previous income year is discharged?. [online] Available at: https://law.ato.gov.au/atolaw/view.htm?docid=%22AID%2FAID20141%2F00001%22 [Accessed 12 Sep. 2018].
Law.ato.gov.au. (2018). TR 98/1 - Income tax: determination of income; receipts versus earnings (Published on 29 March 2017). [online] Available at: https://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR981/NAT/ATO/00001 [Accessed 12 Sep. 2018].
McGregor-Lowndes, M. (2016). Lawyers, reform and regulation in the Australian third sector. Third Sector Review, 22(2), 33.
Snape, J., & De Souza, J. (2016). Environmental taxation law: policy, contexts and practice. Routledge.
Taylor, C., Walpole, M., Burton, M., Ciro, T., & Murray, I. (2018) Understanding taxation law.
Woellner, R., Barkoczy, S., & Murphy, S. (2018). Australian Taxation Law 2018 ebook 28e. Melbourne: OUPANZ.
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