Accounting Method And Tax Implications For Architects And Corporations Essay.

Understanding Accrual Basis and Cash Basis Accounting

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.

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:

• What factors affect the choice of a cash or accrual basis?
• Does Frank have a choice of the basis he adopts?
• Does the Commissioner of Taxation have a right to insist on a particular basis?
• Should Frank’s basis be the same in both years?
• Given the present availability of accounting software packages, in your view, is the traditional criteria for the cash/accrual distinction still relevant?

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:

a. 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.

b. 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.

c. 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.

d. 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.

e. 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.

Understanding Accrual Basis and Cash Basis Accounting

The present case facts brings forward the issue of accounting process and tax implications. As understood from the case of Frank Lloyd he began the business of architect. During the early phases Frank worked from garage before being appointed as the architect for the plan. Frank was even appointed as the architecture and soon began his business with the annual turnover amounted to $2.5 million.

According to the “ITAA 1997 section 6-5” the concept income comprises of the outcome resulting from carrying out the professional services and for commencing any business activities in a manner which results in reliable inflow of cash (Bushman et al., 2016). A business can record revenues either on cash basis or on accrual basis of accounting.

Under the accrual method of accounting the revenues are treated as the income irrespective of fact whether the income is earned (Ato.gov.au, 2018). Under accrual method of accounting the expenses are matched with the relevant revenues to reproduce the profit that is earned from the activities performed. While under the cash method of accounting the revenues and expenses are identified in the financial statement upon the realisation of cash.

According to the judgement of court in “Henderson v FCT (1970)”, the accrual method of accounting are held as the appropriate measurement of accounting for business (Pinto, 2013). However the court in “Carden v FCT (1938)” held that the cash basis of accounting can be followed by small business entrepreneurs whose revenue is low or does not possess sufficient level of knowledge in accrual basis of accounting (Barth et al., 2016). Hence, it is recommended that accrual method of accounting must be followed by the clients. Additionally, where the burden of loan is on the client then in such situation cash basis of accounting must not be considered.

According to the “Taxation Ruling of TR 98/1” the taxpayers are required to record their revenue based on the accrual method of accounting if the gross revenue does not goes past $10 million during the accounting year (Ato.gov.au, 2018). The payment of $75,000 that is received by Frank will be considered as income under the accrual basis of accounting. Other factors that should be included by a business in determining the accrual basis of accounting are given below;

1. Size of the business
2. Complexity involved in the business
3. Debts that are receivable
4. Amount of business income that is derived by the personal efforts of the taxpayer.

Paragraph 8 and 9 of the “taxation ruling of TR 98/1” explains that a business should account for either cash basis or accrual basis (Ato.gov.au, 2018). In the present situation of Frank, the assesse is operating a medium level business. In such a situation the assesse has the power of selecting any desired accounting method since the gross total income of the business does not exceed greater than $10 million in agreement with the definition stated under “section 6-5 of the ITAA 1997”.  

Paragraph 20 of the “taxation ruling 98/1” defines that the business must follow the accrual method of accounting (Ato.gov.au, 2018). Referring to the above stated discussion it is advisable that Frank should follow the accrual method of accounting.

Case Law on Accounting Method for Businesses

According to the “taxation ruling of TR 98/1” a business that has the total annual turnover of greater than $10 million, the commissioner requires the business to account under the accrual basis of accounting (Ato.gov.au, 2018). On noting that the turnover not exceeding $10 million than the taxpayers has the right of choosing any method of accounting for preparing the income statement of the customers. The taxation commissioner in such situation does not has the authority of enforcing the accounting method (Bankman et al., 2017). Instead the taxation commissioner might request the assesse to follow the particular method of accounting. While in case of any conflict in interest the taxpayer and the commissioner of taxation will be guided by the tribunal.

In the present case study, Frank can change the method of accounting based on the explanations provided under the TR 98/1 since the gross revenue did not went past $10 million. However, to reflect the present position of the assesse it is recommended that the accrual method of accounting must be followed in preparing the financial statements in the following financial year (Murphy & Higgins, 2016). Furthermore, the business has outstanding amount of fees and has also engaged in loan. Therefore, it is advisable to follow the accrual method of accounting.

During the accounting year of 2016/17 Frank reported a revenue of $75,000 whereas in the following year of 2017/18 the annual turnover of the company stood $2.5 million. Hence for both the accounting year the revenues stood below the threshold limit of $10 million. Frank in such situation must follow the accrual basis of accounting since the annual turnover for both the accounting year stood lower than the ATO stated limit of $2 million and $10 million respectively.  

The availability of the current software package makes the traditional method of accrual or cash basis of accounting irrelevant. The current software packages provides a business with different result than using the traditional method of accounting (Simmons et al., 2017). The cash method of accounting under the software packages are treated as highly relevant for the business that reports an annual turnover of less than $2 million.

The cash and the accrual method of accounting is regarded as the different from traditional accounting method since it enables the business in treating items that are different. The use of accounting software packages such as MYOB and XERO are created in a manner that suits more for the accrual basis or cash basis of accounting. The software packages are even helpful for business in determining their physical stock take (Miller & Oats, 2016). The availability of the accounting software packages helps in keeping track of the inflow and outflow of cash with better understanding of the business balances such as cash in hand and at bank.

a. According to the Australian taxation office general repairs means making something good by repairing defects, damage or deterioration of the rental property. According to the “subsection 25-10 (1)” repairs usually restores the efficiency and functions of the asset without causing any change or improving the character of the asset. Maintenance can be done to prevent the asset from deterioration in the future (Barkoczy, 2018). There are common examples stated by Australian Taxation Office of repairs which includes replacing of the guttering or windows that are damaged in storm and repairing of any electrical appliances.

Factors to Consider in Determining Accounting Method

As understood in the current case study of Ruby Pty Ltd, an expense was incurred for replacing the fittings of Kitchen together with the deteriorated cupboard that were damaged through water and wear and tear. “Section 25-10 (1) of the ITAA 1997” allows the taxpayer to claim deduction for the expenditure that is incurred in repairing the premises or the depreciating asset that is entirely for the producing the income (Grange et al., 2014). The cost that is incurred by Ruby Pty Ltd on repairing the kitchen fittings and cupboard will be allowed for deductions under “section 25-10 (1) of the ITAA 1997” since it involves restoring the efficiency and functions of the asset without causing any change or improving the character of the asset.

b. According to “section 8-1 of the ITAA 1997” certain legal expenditure that is occurred in producing the rental income are held deductible (James, 2014). These comprises of defending the damages for claims of injuries that is suffered by the third party on the rental property. As held in “FC of T v Snowden & Wilson Pty Ltd (1958)” taxpayer was allowed to claim deduction for all the losses or outgoings that up the amount that they are occurred in gaining the taxable earnings. A deduction is however denied to a taxpayer where the outgoings are of capital, private or domestic in nature or it is related in the derivation of exempted income. As held in “Herald & Weekly Times Ltd v Federal Commissioner of Taxation (1991)” usually legal expenditure are held deductible given that the expenses have occurred as the consequence of taxpayer’s revenue generating activities given the legal expenditure are not capital, private or domestic in nature (Jover-Ledesma, 2014).

As obvious in the present situation the Ruby Pty Ltd incurred a legal expense for defending the damage relating to the case brought against the taxpayer by a visitor to the tenant that slipped on the rental property and suffered injuries. Referring to “Herald & Weekly Times Ltd v Federal Commissioner of Taxation (1991)” the expenses incurred by Ruby Pty Ltd is from the risk which is generally present in the rental property (Pinto, 2013). The expenses can be allowed for deduction because it originated from letting the property to the tenants for producing taxable income. Referring to “FC of T v Snowden & Wilson Pty Ltd (1958)” the expenses can be adequately treated as having been occurred in the course of generating the taxable income. Hence, Ruby Pty Ltd are entitled to claim an allowable deductions under the “section 8-1 of the ITAA 1997” for the legal expenditure occurred in defending the damages claim. 

c. As defined in “section 8-1 of the ITAA 1997” a taxpayer is allowed to claim a permissible deductions for the expenses that is associated to the losses or outgoings only to the amount that they are occurred in generating the chargeable earnings (Kenny et al., 2018). Expenses that are related to business penalties are not allowed as deductions under “section 26-5 of the ITAA 1997”.  However, the taxpayers are denied deductions where the outlays are not incurred in producing the assessable income or in the nature of capital or derivation of exempted earnings. The commissioner in “Hallstroms Pty Ltd v FCT (1946)” held that nature of the expenses must be ascertaining while obtaining deduction under the provision of “section 8-1” (McCouat, 2018). The present case facts obtained from Ruby Pty Ltd it is understood that the company occurred expenses on paying claim for compensation damage. The taxpayer reached the settlement sum of $750,000 for the car producing firm.

Mentioning the decision of commissioner in “Sun Newspaper Ltd v FCT (1938)” it was decided that outgoings that are dedicated for the structural improvements rather than incurring for the functional purpose, the expenses in such situations are not allowed as deductions (Miller & Oats, 2016). The compensation expenses that is occurred by Ruby Pty Ltd constitutes a business penalties which is a non-allowable deductions under “section 26-5 of the ITAA 1997”.

d. As stated by the Australian Taxation Office expenses that are occurred for creating business provisions are held as non-deductible expenses (Ato.gov.au, 2018). In order to claim deductions for the taxpayers under “section 63 of the ITAA 1997” the expenses must be existent prior to claiming deductions (Sadiq, 2018). An individual taxpayer is allowed to claim deduction under “subsection 63 (1)” of the act if the expenses are written off by the taxpayer.

Referring to the present situation of Ruby Pty Ltd, the company has set aside the provision of $100,000 in accounts during the income year ended 30 June. As a general rule, business expenses of provisional nature are non-allowable deductions because they are not occurred in producing the taxable income and therefore non-allowable for deduction under the general provision of “section 8-1 of the ITAA 1997”. 

e: The common provision of “section 8-1” explains that the losses or outgoings which are preliminary in the beginning of the revenue producing activities are not allowed for deductions. The reason for being the expenses held as non-deductible is because they are incurred in the course of business activity (Murphy & Higgins, 2016). A decision of the court in “Softwood Pulp & Paper v FCT (1976)” can be cited by stating that the company reported an expense related to feasibility study and certain other costs to ascertain whether the taxpayer can establish a new production mill (Simmons et al., 2017). The commissioner of taxation deprived the taxpayer from claiming the allowable deductions because everything that was done by the taxpayer was preliminary to beginning of business.

Similarly, in the present situation of Ruby Pty Ltd, the company incurred the investigation expenses of $220,000 to determine the probable entry in the car manufacturing industry. The expenses which was incurred by the firm to commencement of business and not in the course of producing assessable income. Hence, the market study expenses will not be allowed for deductions under “section 8-1 of the ITAA 1997”.

References:

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