MGMT 127A Lecture Notes - Lecture 2: Accrual, Tax Law, Income Tax

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8 May 2016
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1. Lecture 2
Section 1: Intro to tax law
Tax Law vs Financial Accounting
"the primary goal of financial accounting is to provide useful information to management,
shareholders, creditors, and others properly interested. The major responsibility of the accountant
is to protect these parties from being misled"
"the primary goal of the income tax system, in contrast is the equitable collection of revenue…
consistently with its goals and responsibilities, financial accounting has as its foundation the
principle of conservatism, with its corollary that 'possible errors in measurement (should) be in
the direction of understatement rather than overstatement of net income and net assets.' In view
of the Treasury's markedly different goals and responsibilities, understatement of income is not
destined to be its guiding light
oAka the main way people commit fraud for taxes is by understating revenue and
overstating expenses (which count as deductions)
"Financial accounting, in short, is hospitable to estimates, probabilities, and reasonable
certainties. The tax law, with its mandate to preserve the revenue, can give no quarter to
uncertainty"
4 main estimates we see in financial acctng
oBad debt
oWarranty costs
oUseful life (part of depreciation calcs)
oSalvage value (part of depreciation calcs)
In tax law, salvage value will always be 0- this allows us to depreciate all the way
down to 0 which gives more deductions and lower taxable income and less taxes
We cannot use estimates at all in tax
Primary goals:
Financial accounting:
identifying and recording economic events of an economic
entity and reporting the results to users of the financial
statements. The goal is to protect shareholders, creditors etc
from being misled
Income tax system:
the equitable
collection of revenue
Revenue recognition:
Financial accounting:
conservatism principle is strictly followed. Possible errors in
measurement should be in the direction of understatement
rather than overstatement of net income and net assets
Tax law (IRS goal):
to collect as much
money as possible
Accounting method:
Financial accounting:
accrual basis of
accounting
Tax law:
individuals generally have a cash basis of accounting and
corporations generally have accrual basis of accounting
oIn accrual, revenue is recognized when it is EARNED not when actual money changes
hands- so you earn revenue by shipping goods or providing the service
oSo we use a cash basis unless it is a schedule C selling inventory (only use the accrual
accounting JUST for the schedule C)
Related party transactions:
Financial accounting: Tax law:
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related parties disclosure
only
important to distinguish between related party
transactions and arms length transactions
Substance over form
oTax law looks into the economic substance of a transaction over its legal form
oThe IRS can collapse or telescope transactions to determine their true nature
oCollapsing: the IRS makes 2 transactions into 1
When someone dies, everything in their estate over the first $5 million is taxed
So any high worth individual should try to transfer $ to the next generation
before they die or else it will be heavily taxed
The executer of your estate has to shore up all of your assets and pay all of your
liabilities to find your equity left over and that is what is taxed
You can give up to $14k to someone per year (as of 2013- before 2013 the max
was $13k)
So basically every time you give $14k to a kid, you are saving 40% of 14k every
year (which is what you would have been taxed)
You can give a $14k check to anyone- doesn’t even have to be your children,
only once a year to that person
So you and your husband could both give every kid $14k every year to limit your
taxes later on
So basically, we have a $5 million bucket- anything that you gift away above
$14k each year is added to the bucket over your whole life (ie if mom and dad each
give the kid $14k every year, this number is not included in the bucket)
If mom gives you 1,014,000, then the bucket has 1 million
The next year she gives the same and now the bucket has 2 million
After 5 years of this, the bucket is full and has 5 million
At year 6, the 1 million over the bucket is taxed at the rate on page 54
Now mom has to pay taxes on each gift
Everybody has their own bucket
Called the "unified gift and estate tax"
This is taxing your balance sheet which has already been taxed when you earned
it which should piss you off!
Pages 53 + 54 have more info on gifts and inheritances
Gifts and inheritances are tax free to the inheritents - you can receive a gift for
more than $14k and not be taxed- only the gift giver needs to pay
The giver of the gift has to pay gift tax and it has to be given in "disinterested
generosity" to be counted as a gift otherwise it could be income to the person
receiving
Example page 9:
A mom gives a gift to her child of $14k and mom gives $14k to a friend
with the understanding that the friend will give it to the child
This way the mom is passing on a total of $28k instead of just $14k
The IRS is going to collapse the situation and see what really happened-
see that mom actually gave the kid 28k
Example 2 page 9:
A taxpayer makes one cor into 2 to have both taxed at lower rates
The IRS will call both corporations related and treat them as one
oTelescope: when the IRS makes 1 transaction into 2
Example on page 10: if a majority shareholder receives a large, unreasonable
salary from the corporation, part is deemed salary and part is deemed dividend
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