INCOME RECEIVED IN ADVANCE
Monies that are received for goods or services to be rendered over a period of time are not required to be brought to account until they have been earned.
Examples of this would be where monies are paid in advance for the provision of fixed term service contracts such as computer services, the provision of
magazine subscriptions, the provision of tennis lessons, etc. This principle also applies to deposits for goods or services to be manufactured and
delivered at a later date – including lay-by sales. It is therefore essential in these instances that the accounting records of a business identify
the advance payments as liabilities and not income.
PREPAID EXPENSES
Section 8(1) of ITAA 1997 allows a deduction for a loss or outgoing incurred in the relevant income or business activities if it is not of a capital, private
or domestic nature.
Accordingly, a payment incurred for goods or services to be provided in the future appears to be deductible under this section.
However, there are specific prepayment provisions (sections 82KZL to 82KZO of the ITAA36) that potentially apply to these types of expenditures. In effect,
the ability to claim outright deductions for prepaid expenses of $1,000 or more for items such as services, interest and lease payments etc, is only
available to businesses that are in the SBE. Alternatively, the prepaid amount is to be written off over the period to which it relates. At this stage
the prepayment provisions do not apply to prepayments made under timber plantation managed investment schemes.
INCOME FROM LONG-TERM CONSTRUCTION CONTRACTS
In respect of long-term construction contracts that may apply to certain industries, the
Some of the industries to which this applies include:
- Building industry
- Major refurbishment projects
- Civil engineering
- Ship building
It is imperative that the method chosen is applied consistently, both during the years for which the contract runs and also to all similar contracts that
are entered into by the taxpayer.
The two allowable methods are:
- Billings Method/Basic Method
This requires all progress and final payments received in a year (including amounts billed or entitled to be billed in the year) to be included in assessable
income.An income tax deduction is allowed for losses and outgoings as they are incurred; and
- Estimated Profits Method
The taxpayer is permitted to spread the ultimate profit or loss over the term taken to complete the contract, provided that the basis is reasonable and
is in accordance with accepted accountancy principles.
The ultimate profit or loss is required to reflect the anticipated profit on the project. This profit or loss may be adjusted from year to year to reflect
any changes that may have been caused by price increases in material, labour and other costs, industrial disputes and delays caused by other factors
for example, weather.
TR 2018/3 makes it clear the completed contract method, where profits or losses are deferred until the completion of the contract, is not accepted by the
TRADING STOCK
Trading stock is defined as including any item that is produced, manufactured or acquired, and which is held for the purpose of manufacture, sale or exchange
in the ordinary course of a taxpayer’s business.
This definition also specifically includes livestock used in primary production activities (section 70-10 ITAA 1997).
In addition, land that is owned by a developer or land trader may be considered to be trading stock depending upon the intention for that property.
Note that work in progress forms part of trading stock for a manufacturer but are not considered as trading stock under a long-term construction project.
Materials obtained by service providers (tradesmen) for supply to customers as part of the provision of their services are considered to be trading stock
unless they are considered to be of a minor or incidental aspect of the services (refer Taxation Ruling TR98/8).
Consumables stored, however, are not trading stock and generally are deductible upon purchase (Taxation Ruling IT 333). Note that the computer spare parts
of a computer supplier are generally deemed to be trading stock (Taxation Ruling TR93/20).
Materials such as containers, packing materials, labels etc, that are sold with the goods are considered to be trading stock for manufacturers and not
consumables, whereas returnable packaging items are not considered to be trading stock.
Trading stock on hand at the beginning and at the end of a financial year together with the costs of purchasing trading stock during the financial year
are taken into account in the calculation of taxable income (section 70-35 ITAA 1997).
As previously stated an adjustment needs to be made for any stock taken for private purposes.
A physical stocktake should be undertaken at least once a year even if a perpetual inventory system is in operation. An exception to this is in respect
of taxpayers in the SBE.
Trading stock is considered to be on hand if you have the power to dispose of it (Taxation Ruling IT2670). This can still be the case where you may not
necessarily have physical possession of it, such as where the stock may be held on consignment by another party or it is in transit.
It is possible to convert an item from a capital asset to trading stock, or from trading stock to a capital or personal asset.There are specific provisions
in ITAA 1997 that deal with these circumstances. In effect section 70-30 will deem that there has been a disposal of the item as a capital asset and
a subsequent purchase of it as trading stock at either cost or market value.
The appropriate treatment of discounts, rebates and other trade incentives offered by sellers to buyers is outlined in TR 2009/5.
VALUE OF TRADING STOCK
Section 70-45 provides the alternatives available to be used in the valuation of each item of trading stock on hand.
These alternatives are:
- Cost;
- Marketing selling value; or
- Replacement value.
The valuation of trading stock at cost relates to the full absorption cost of each item.This includes costs such as freight, insurances, customs
and excise duties, and delivery charges.
For any work in progress and manufactured goods the valuation also includes a component for the cost of labour and materials and an appropriate proportion
of variable and fixed overheads. No GST is included unless it has not been claimed as an input tax credit. The cost of infrastructure land and expenses
forming part of the cost of land is considered trading stock for a land developer.
The following methods are acceptable to the
- First In First Out (FIFO) –The cost of trading stock on hand is deemed to be the cost of the items most recently acquired.
- Average Cost – The cost of an item is based on the weighted average cost of all those items, whether purchased during the year or
on hand at the beginning of the year. This method is an alternative where you cannot ascertain the actual cost of stock. - Standard Cost – A predetermined standard cost per unit is used.This is acceptable where standards are reviewed regularly to equate
with current prices. - Retail Inventory – Goods are priced at their retail selling price at the time of stocktake, but then are subsequently reduced by the
amount of the mark-up to produce the cost of the goods on hand. This is only acceptable where old stock has not been previously marked down.
You may choose either cost, market selling value or replacement value for each item of trading stock. In addition, the method used for the valuation of
closing stock can be varied from year to year.
The only requirement of the
method used to value the trading stock must be shown on the taxpayer’s income tax return.Documentary evidence should be retained to support the
valuation method used for closing stock.
Where the market selling value or replacement value are chosen for valuing stock, a higher assessable income will result as closing stock will be higher
in value. This should be considered in instances where a business has low profitability in a particular year. Alternatively, it may be prudent to revise
the closing stock valuation methods where there are to be changes in the tax rates in the ensuing year.
In the event of obsolescence or other special circumstances, a trading stock valuation using either of the above methods may result in an unreasonable
value (section 70-50, ITAA97). The taxpayer can provide his own valuation in these circumstances. Where a taxpayer wishes to avail himself of this
option he must apply the general guidelines as provided for in Taxation Ruling TR93/23.
Full absorption costing must be used when opting for the cost method for valuation of closing trading stock. That is, the manufacturer needs to include
the indirect costs of operating the manufacturing facility (including light and power, administrative expenses, wages, etc.) as part of the cost of
goods.
Full absorption costing requires the following costs to be absorbed into the value of trading stock on hand at year end:
- The purchase price;
- All costs incurred to the extent they are directly related to the purchase of the trading stock;
- Operating distribution centres;
- Operating warehouses or storage areas not forming part of the selling location;
- Freight from the supplier’s premises to the retailer’s or wholesaler’s selling outlet, warehouse or distribution centre; and
- Freight from the retailer’s warehouse or distribution centre to the retail outlet.
The Tax Office has issued Practice Statement PSLA 2003/13 relating to taxpayers or consolidated groups with operating turnovers in excess of $10 million.
The Practice Statement provides guidance as to the types of costs to be included in the valuation of closing trading stock. These costs include, but
are not limited to, the following:
- Purchase costs;
- Costs of operating distribution centres;
- Costs of operating on or off-site warehouses or storage areas, including wages, electricity, cleaning, security etc;
- Inwards freight to the warehouse or distribution centres;
- Freight from the warehouse or distribution centre to the retail outlet.
For SBE taxpayers simplified trading stock rules apply. Generally, where the difference between the value of trading stock at the beginning and the end
of a year does not exceed $5,000, the taxpayer does not have to value each item or account for any change in the value of trading stock on hand. However,
it is necessary that the estimate for the difference is based on reasonable assumptions or circumstances by the taxpayer.
LAY-BY SALES
Income from lay-by sales is derived and therefore assessable when the buyer pays the final instalment for the goods, and the goods are delivered to the
buyer.
All amounts that are received while the goods are being held by the seller are not considered to have been earned by the seller and are therefore not considered
assessable income for income tax purposes.However, where a non-refundable deposit is paid that amount is assessable (refer Taxation Ruling TR 95/7).
Note that goods that are in the possession of the seller at the end of the year of income are required to be taken up as trading stock on hand for tax
purposes, even though they may not be available for resale at that point in time.
Where an early termination of the lay-by sale occurs, any refund to the buyer is not tax deductible as those amounts would not have initially been included
as income of the seller – having been shown as a liability in the accounts of the seller.Any amount forfeited to the seller is considered to be taxable
income.
PROFESSIONAL
For many years a serious problem existed for professionals selling or retiring and disposing of Work In Progress (WIP).
In effect, an amount of WIP received by a partner upon retirement was assessable income to the partner but was viewed as a capital payment by the partnership
and therefore not tax deductible to the partnership. When the Work In Progress was subsequently invoiced by the partnership it became assessable income
to the partnership.In effect the WIP amount was subject to double taxation.
This issue has since been resolved by the retiring partner receiving a WIP advance from the partnership and continuing to be entitled to his share of the
WIP as it is received. The collection of the WIP is used in paying the advance.
The law has been amended to prevent this double taxation of professional WIP. The amendments allow a deduction for payments made to a retiring partner
for WIP. If the work will be completed within 12 months the deduction is available at time of payment for the WIP. If the work will not be completed
within 12 months the deduction will be available in the following year. The retiring partner must pay tax on the amount received for the WIP. These
amendments have applied since 23 September 1998 (the date of withdrawal of Taxation Ruling IT 2551).
COMMERCIAL DEBT FORGIVENESS
Division 245 of the ITAA 1997 contains the commercial debt forgiveness provisions.Commercial debts are defined as being debts upon which the interest payable
is deductible under section 8-1 or, if no interest is payable, it would have been deductible if it had been charged.
It is imperative that the amount forgiven is actually a debt and not an unenforceable disputed claim.Forgiveness entails the release, waiver or extinguishment
of a debt and includes debts that are unable to be pursued due to the statute of limitations.
Where a creditor forgives all or part of a debt owing to it, the debtor would in effect have received a gain. However, as there is no asset involved there
can be no triggering of a capital gains tax event and therefore no capital gains tax issues arise.
To avoid the duplication of deductions, the net forgiven amount of a debt is used to reduce the following amounts in the relevant debtors’ accounts:
- Revenue losses;
- Any capital losses that have been carried forward from prior income years;
- The undeducted balances of other deductible expenditures that have been carried forward from prior years. This includes the reduction of the opening
taxation written down value of depreciable assets; and - The cost bases of capital gains tax assets.
PRIVATE USE OF TRADING STOCK
The value of trading stock that is used for private purposes must be included at its market value in the taxpayer’s trading statement.It is vital that
an accurate record of the value of any goods taken for private use is kept.
The
determined (TD 2018/10) for the 2017-18 income year by the
| Business | Adult or child aged over 16 years | Child aged 4 – 16 years |
| Baker | $1,350 | $675 |
| Butcher | $830 | $415 |
| Café/Restaurant (licensed) | $4,640 | $1,750 |
| Café/Restaurant (unlicensed) | $3,500 | $1,750 |
| Caterer | $3,790 | $1,895 |
| Delicatessen | $3,500 | $1,750 |
| Fruiterer/Greengrocer | $800 | $400 |
| Takeaway foods | $3,430 | $1,715 |
| Mixed businesses (includes milk bar, general store, convenience store) | $4,260 | $2,130 |
TIMING OF INCOME
The financial year for Australian income taxpayers is for the twelve-month period ending on 30 June of each year.
Substituted accounting periods are available but will need to be approved by the Tax Office.However, approval is only granted in exceptional circumstances.
METHODS OF TAX ACCOUNTING
Depending upon the taxpayer’s circumstances there are three main tax accounting methods that can be used to determine the taxable income of a taxpayer.
These methods are:
- The cash or receipts basis of accounting;
- The accruals or earnings basis of accounting; or
- Small Business Entity (SBE)
Whichever of the first two alternatives is chosen must be strictly adhered to.
There may be circumstances where monies are received for goods or services that are not to be rendered until a future time. Under the matching principle
these monies would not be income to the taxpayer and would therefore not be subject to tax until the goods or services are actually provided or performed.
However, expenses associated with the derivation of this income would need to be reviewed to ensure they are taken up in the correct period. An example
of this would be annual magazine subscriptions paid in advance to a business.
In addition, there are situations where monies not yet received for goods or services already provided or performed may or may not be assessable. This
depends upon the tax accounting method used by the taxpayer.
There are specific provisions and rulings relating to the valuing of work in progress (WIP). These provisions differ depending on the tax accounting method
used. Work in progress held at the end of the financial year is required to be brought to account by manufacturers. However, this is not generally
the case for service providers or professional partnerships.
Therefore, there is an opportunity for service providers and professional partnerships to defer income tax by not billing for uncompleted work at year
end.
Guidelines as to which method may be relevant to a taxpayer are set out in Taxation Ruling TR 98/1.
In particular the following factors are deemed to be relevant:
- The size of the business – the cash basis may be more appropriate for a small business taxpayer whereas the accruals basis may be more appropriate
for a medium to large business taxpayer, or where a trading or manufacturing business is evident.
- The type of the business – generally small businesses will opt for the cash basis whereas larger businesses, where a trading or manufacturing activity
is evident, will opt for the accruals basis. - Capital items – businesses with heavy reliance on the use of plant and equipment may determine that the accruals basis is more appropriate for their
needs. - Policy for recovery of outstanding debts – the accruals basis may be more appropriate where there are formal procedures for the extending of credit
and debt collection. - Method of accounting – the type of accounting records maintained may indicate which basis of accounting for tax purposes is to be used.
- Trading stock – where a trading or manufacturing business is evident the accruals basis of accounting may be appropriate.
It is necessary to have an understanding of the taxpayer’s business and to relate this to the alternative available accounting methods. The relative importance
of any individual factor is dependent upon the specific circumstances of a business. It is generally accepted that the smaller the business the more
likely it is that the cash basis should be used, whereas the accruals basis is appropriate where a trading or manufacturing business is conducted.
There are certain requirements that may assist in determining the accounting method to be used in the situation of the medium to larger businesses.
This method requires that income is brought to account only when it is physically received.
This receipt includes the situation where income is reinvested, accumulated or capitalised. However, expenses are deductible when they are incurred and
not necessarily paid, provided that no further claim is made when they are actually paid. This use of this basis of income is usually attributable
to individuals, including professionals, but excluding larger professional partnerships. In this instance, income such as wages, rent, dividends or
interest is generally calculated on a receipts basis…An exception to this is income from public unit trusts or discretionary trusts that are assessable
on a declared basis.
ACCRUALS OR EARNINGS BASIS
The accruals basis entails accounting for income as it is earned.Medium to large businesses are generally required to use this basis of accounting.
In effect, income is treated as earned when the entity has the right to receive it. This is when goods are delivered, or jobs are completed, and the relevant
invoices mailed. Notwithstanding the income may not have been received, the conditions pertinent to the right to receive it have occurred. In effect,
tax will be payable on the debts of the business.
The situation may arise where a debt has been taxed but is subsequently deemed to be irrecoverable.In this case a deduction for it should be made in the
period in which it is considered to be irrecoverable.
Under both the receipts and earnings basis, expenditure is claimable when incurred and therefore deductions are available on creditors at year end.
In summary, small businesses generally find that the cash basis of accounting is the most appropriate.However, there may be a time when as the business
grows and increases its turnover, employs more staff, and invests in more capital assets that a change to the accruals basis is required.
Where the change of accounting method takes place at the end of a financial year, a tax benefit may be obtained in respect of income that has been accrued
at the date (Henderson v FCT 70 – ATC 4016). This will not apply where the business has decided to be a Small Business Entity (SBE).