Explanation of Cash and Accrual basis accounting
The cash basis of accounting identifies the revenue on receiving the cash and the expenditure when they are paid. The cash basis of accounting does not records the accounts receivable or accounts payable. There are several small business that opts for the cash basis of accounting since it is easy to maintain. The cash method of accounting held as beneficial in identifying the amount of cash the business has during any given time period (Ato.gov.au, 2018). The accrual method of accounting on the other hand identifies the revenue and expenses when it is earned, irrespective of when the money is originally received or paid. The method is used more frequently than the cash method. The advantage of using the accrual method of accounting is that it provides the business with the more realistic understanding of income and expenditure at a particular time period. The accrual method of accounting provides the business with the long term picture which is not available under the cash basis of accounting.
The law court in “Carden v FCT (1938)” held that the tax accounting method should provide the substantially appropriate reflection of the taxpayer’s true income (Sadiq et al., 2018). While in “Henderson v FCT (1970)” held that for any particular taxpayer there are only one correct process of ascertaining the taxable income and stated that the accrual method of accounting as the correct method.
Factors affecting choice of cash or accrual basis:
There are certain factors in determining whether the tax accounting method that is selected provides the “substantially correct reflex” (Taylor et al., 2018). Below listed are factors that affects the choice of cash or accrual basis of accounting;
- The size of the business whether small or large
- Proportion of business earnings originating directly from the personal effort of the taxpayer
- Business complexity, and;
- Receivable of debts
The factors stated above affect the choice of a cash or accrual basis of accounting.
Choice of basis of accounting method:
As defined under the paragraph 8 and paragraph 9 of the taxation ruling of TR 98/1 the basis of choosing the accounting method is reliant on the size of the business (Ato.gov.au, 2018). A taxpayer can choose either cash or accrual basis of accounting. The existing situation of Frank states that he is carrying out a business which is relatively small in size. Frank can chose to account under any of the accounting method since the gross proceeds of the business is inside the threshold limit of $10 million. The court of law in “Carden v FCT” stated that the accounting method should give a true reflection of taxpayer’s income (Woellner et al., 2018). Similarly in “Henderson v FCT” it was held that the correct method of determining the assessable income is by using the accrual basis of accounting.
Factors to consider when choosing accounting method
Referring to the decision in “Henderson v FCT” in the current case of Frank, the accrual accounting method is right process of ascertaining the assessable income. Even though Frank can opt for selecting any of the available accounting method for identifying revenues, the accrual basis is the appropriate process of determining the taxable earnings.
Rights of Taxation Commissioner:
As defined under the “Taxation Ruling of TR 98/1” a business whose annual sales revenue or turnover is greater than the ATO prescribed limit of $10 million, the taxpayer should account for the accrual accounting method (Ato.gov.au, 2018). On noticing that the yearly turnover does not goes past the threshold limit of $10 million the taxpayer in such a situation can select any basis of accounting and the commissioner of taxation cannot force the taxpayer in such situation. The commissioner of taxation might put forward the request of selecting either the cash or the accrual accounting method for recording the revenue. On noticing any form of conflict between the taxation commissioner and the taxpayer, guidance of the tribunal can be sought by both the parties.
Basis of accounting for both the years:
Instances from the case of Frank provides suggestion that during the income year ended 2016/17 Frank earned a total revenue of $75,000. In the subsequent year of 2017/18 Frank reported a yearly sales turnover of $2.5 million. According to the evidence obtained the total sales turnover for the income year ended 2016/17 and 2017/18 accounted to less than $10 million limit. In “FC of T v Firstenberg (1976)” the taxpayer was the solicitor in sole practice and returned on cash basis (Woellner et al., 2018). The commissioner of taxation assessed the taxpayer on the accrual basis and held that the cash basis was the appropriate method.
Similarly in “FC of T v Dunn (1989)” the taxpayer was the accountant in sole practice and returned on cash basis (Caldwell, 2014). The commissioner of taxation assessed the taxpayer on cash basis and held that the cash basis was the appropriate method. The facts from the case of Frank suggest that the sales revenue of Frank did not exceeded the limit of $10 million in both 2016/17 and 2017/18. Referring to “FC of T v Dunn (1989)” in order to provide the correct taxable position of Frank along with the amount of earnings derived from the taxpayers personal efforts it is recommended that accrual basis of accounting should be followed by Frank. The accrual basis of accounting would provide assistance in portraying the substantially true reflex of Frank’s assessable income.
Case law and its implications for Frank
Use of accounting Software:
The traditional process of accounting particularly the accrual or the cash basis are not relevant anymore due to the availability of the present software packages. The electronic accounting method provides a glaring difference in traditional accounting method. The software packages is created for the accrual basis of accounting. Software packages such as MYOB and ZERO provides more accurate results under the cash method (Tan et al., 2016). The availability of the accounting software packages offers business with better long term business and easy maintenance of the cash flow. The traditional criteria of cash or accrual distinction is not relevant anymore as the present accounting software packages provides the business with the better picture of revenues and cash.
A.The “taxation ruling of R 97/23” provides an explanation to the circumstances where the expenses occurred by the taxpayer for repairs are allowed as deductions under “section 25-10 of the ITAA 1997”. In context of “section 25-10” the definition of repair represents the work that is done to the premises or a portion of the premises (Douglas et al., 2014). The ATO defines the ordinary meaning of the word repair as remedying or making the defects good arising out of damage or deterioration of the property and contemplating the continuous existence of the property. A taxpayer is allowed to claim deduction under “section 25-10” when the repair expenses are incurred during the income year when the property is entirely held by the taxpayer for producing income (Robin, 2017). The court in “BP Oil Refinery Ltd v FC of T (1992)” expressed its opinion that work would not constitute repair unless it includes some restoration of something that is lost or damage. Specific example of repairs includes replacing the guttering or window that is damage in storm.
According to situation of Ruby Pty Ltd, it is found that the company incurred expenses of $8,500 on replacing the old kitchen fittings together with the cupboard that was damaged through wear and tear. Citing the instance of “BP Oil Refinery Ltd v FC of T (1992)” the expenses occurred by Ruby Pty Ltd for repairs are allowed as deductions under “section 25-10 of the ITAA 1997” since the repair expenses are incurred during the income year when the property is entirely held by the company for producing income.
B.Certain legal expenses incurred in producing the rental income are allowed for deductions. This comprises of the cost of defending the claims for damages relating to injuries that is suffered by the third party on the rental property (Kenny, 2014). As defined under “section 8-1 of the ITAA 1997” a deduction is allowed to the taxpayer relating to all the losses or outgoings up to the extent to which they are occurred in producing or gaining the assessable income except during the circumstances when the expenses are domestic in nature or related to the earnings of exempted income. In “Herald & Weekly Times v FC of T (1991)” legal expenditure have been allowed as deductible expenses on the circumstances when the expenses has originated as the taxpayer consequences of revenue generating activities and the legal expenses are not capital in nature (Morgan et al., 2015). The court in “Hallstorms Pty Ltd v FC of T (1946)” expressed its opinion that legal expenses can be characterized as the outgoing based on the revenue account or the outlays of capital character depending upon the purpose of incurring the legal expenses.
Conclusion
The case facts suggest that Ruby Pty Ltd incurred legal expenses in defending the claims for injuries suffered by a visitor to their tenants. Referring to “Herald & Weekly Times v FC of T (1991)” the legal expenses incurred by the company in defending the claims for injuries was in the capacity of land owners (Blakelock & King, 2017). The expenses can be claimed as deductions under “section 8-1 of the ITAA 1997” since it originated because of letting the property to the tenants with the objective of producing taxable income. Quoting the expression of court in “Hallstorms Pty Ltd v FC of T (1946)” the legal expenses can be characterized as outgoing of revenue account and incurred in the course of producing taxable income.
C.According to the “section 26-5 of the ITAA 1997” a taxpayer is denied deductions for penalties and fines that are imposed as the result of breaches of Australian law (Fry, 2017). Certain examples of non-deductible penalties and fines includes the business fines for indulging in misleading and deceptive conduct. The federal court in “Sun Newspaper Ltd v FCT (1938)” held that outlays that are mainly incurred for structural improvements rather than occurring it for functional purpose are non-deductible outgoings.
Ruby Pty Ltd was found to have breached the business laws by selling defective batch of parts to an Australian car manufacturer. A claim for damages was subsequently lodged in the federal court and eventually led in paying $750,000. The amount of compensation that is ordered by federal court to Ruby Pty Ltd constitute a business penalty and the same is non-deductible under “section 26-5 of the ITAA 1997”.
D.As stated by the Australian Taxation Office expenses related to business provision are held as non-deductible expenses. “Section 63 of the ITAA 1997” allows a taxpayer from claiming deductions for expenses that are physically present (Miller & Oats, 2016). While “section 63 (1)” allows a taxpayer to claim deductions for expenses that are written off.
Ruby Pty Ltd annually set aside a provision in the accounts for any future claims for damages. The expenses will held be held as non-deductible under “section 63 of the ITAA 1997” since it is a general business provisions and no deductions are allowable.
E.Under the general provision of “section 8-1” preliminary outgoings relating to the start of revenue producing activities that are not in the course of revenue producing activities are not allowed for deductions. The taxpayer was denied deduction in “Softwood Pulp & Paper v FC of T (1976)” for incurring expenses on feasibility study of establishing a new paper producing mill (Kiprotich, 2016). The commissioner of taxation held that the expenses were not incurred in revenue producing activities and preliminary to the business.
Ruby Pty Ltd incurred investigation expenses on possibility of re-entering in the industry of car parts manufacturing. The amount of $220,000 incurred for market study will be held as preliminary to the commencement of business activities. Quoting the judgement of court in “Softwood Pulp & Paper v FC of T (1976)” no deductions will be allowed under “section 8-1 of the ITAA 1997” to the taxpayer as the expenses were not incurred in the course of income producing or business activities.
References:
Accounting methods. (2018). Retrieved from https://www.ato.gov.au/Business/Income-and-deductions-for-business/Assessable-income/Accounting-methods/
Blakelock, S., & King, P. (2017). Taxation law: The advance of ATO data matching. Proctor, The, 37(6), 18.
Caldwell, R. (2014) Taxation for Australian businesses.
Douglas, H., Bartlett, F., Luker, T., & Hunter, R. (2014) Australian Taxation Judgments.
Fry, M. (2017). Australian taxation of offshore hubs: an examination of the law on the ability of Australia to tax economic activity in offshore hubs and the position of the Australian Taxation Office. The APPEA Journal, 57(1), 49-63.
Kenny, P. (2014) Australian tax.
Kiprotich, B. A. (2016). Principles of Taxation. governance.
Legal Database. (2018). Retrieved from https://www.ato.gov.au/law/view/document?DocID=TXR/TR981/NAT/ATO/00001&PiT=99991231235958
Miller, A., & Oats, L. (2016). Principles of international taxation. Bloomsbury Publishing.
Morgan, A., Mortimer, C., & Pinto, D. (2015) A practical introduction to Australian taxation law.
Robin, H. (2017). Australian taxation law 2017. Oxford University Press.
Sadiq, K., Coleman, C., Hanegbi, R., Jogarajan, S., Krever, R., & Obst, W. et al. (2018) Principles of taxation law.
Tan, L. M., Braithwaite, V., & Reinhart, M. (2016). Why do small business taxpayers stay with their practitioners? Trust, competence and aggressive advice. International Small Business Journal, 34(3), 329-344.
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.
Woellner, R., Barkoczy, S., Murphy, S., Evans, C., & Pinto, D. Australian taxation law 2018.
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