Part 1: Accounting Method for Frank’s Architect Business

The cash and the accrual basis of accounting are regarded as two different method that is used in recording the accounting transactions. The central differences between the two methods is the time when the transactions are recorded (Bushman et al., 2016). When it is aggregated over the time, the outcomes of the two method is approximately the same. Under the cash method accounting the expense are recorded when the cash is paid to the suppliers and employees. Whereas in the accrual method of accounting the revenue is recorded when it is earned and the expenses are recorded when it is consumed.

According to the “taxation ruling of TR 98/1” it is explained that the taxpayer should record the revenues under the accrual method when the gross revenue exceeds the threshold limit of $10 million (Ato.gov.au, 2018). Despite the explanation if the taxpayer current year revenue does not exceeds $10 million during the accounting year the taxpayer can follow the cash basis of accounting. The court of law in “Carden v FCT” held that factors such as tax accounting method should provide the substantial correct view of the taxpayer’s true income (Barth et al., 2016). While the court in “Henderson v FCT” held that for any particular tax payer, there is one and only correct method of accounting the taxable income. There are certain factors that must be chosen in determining whether the accounting method provides a substantial correct reflex. This includes the following;

1. Size of the business
2. Proportion of business income that originates directly from the taxpayers personal efforts
3. Complexity of the business
4. Receivable of debts, and
5. Accounting method or practice evidenced by the actual accounting method.

Therefore, the above stated factors forms essential in deciding the appropriate method of accounting.

According to the paragraph 8 and 9 of the “taxation ruling of TR 98/1” accounting method can be chosen based on either the cash basis or under accrual basis of accounting (Ato.gov.au, 2018). As understood in the present case Scenario of Frank it is found that the taxpayer is operating small business. Frank in the current situation can opt to account for either of the accounting method as the gross revenue of his business does not exceed the threshold limit of $10 million. According to the court decision in “Carden v FCT” the accounting method must provide substantially a correct view of the taxpayer’s true income (Bankman et al., 2017). While in “Henderson v FCT” the court held that the accrual basis of accounting forms the correct method of ascertaining the taxable income.

Citing the reference of “Henderson v FCT” in the present situation of Frank, the accrual basis of accounting is the correct method of determining the taxable income. Though Frank has the liberty of choosing either of the accounting basis for recording the revenue however the accrual method of accounting is the only correct method of ascertaining assessable income.

Factors to choose the accounting method

According to the “taxation ruling of TR 98/1” a business whose yearly turnover exceeds the threshold limit of $10 million is required to follow the accrual method of accounting. Given that the annual turnover does not goes past the threshold limit of $10 million, the taxpayer in such situation has the right of choosing either of the accounting method and the taxation commissioner has no right to force (Ato.gov.au, 2018). The taxation commissioner may request the taxpayer follow either one of the accounting basis of recording revenue. In case of any conflict of interest between the taxation commissioner and the taxpayer both the parties can seek the guidance of tribunal.

Evidences from the case study suggest that in the accounting year of 2016/17 frank reported total revenue of $75,000 whereas in the following accounting year of 2017/18 the annual turnover of company amounted to $2.5 million. As understood the annual turnover of the business for both the accounting year remained inside the threshold limit of $10 million. Therefore, Frank has the authority of adopting either the cash or the earnings method for tax accounting purpose. The court of law in “FCT v Dunn (1989)” held that the taxpayer was using the accrual basis of accounting however switched to cash basis (Ato.gov.au, 2018). An evidences can be bought forward in the current case of Frank for the year ended 2016/17 by stating that the taxpayer should be held liable for assessment under the cash basis. This is because it is assumed that Frank has maintained accounting records based on the cash method.

Similarly, the law court in “FCT v Firstenberg (1976)” stated that the taxpayer returned on cash basis but the court assessed the taxpayer on the accrual basis (Murphy & Higgins, 2016). The commissioner continued to assess the taxpayer on the accrual basis and held that the cash basis was the appropriate method.

In the following year of 2017/18 it is noticed that the Frank has indulged in the constructing activities and has also generated trading income. Citing the case of “FCT v Firstenberg (1976)” to reflect the correct assessable position of Frank and proportion of business income originating from the taxpayer’s personal efforts it is advisable to account under the accrual basis of accounting (Ato.gov.au, 2018). Frank has also hired the administrative staffs to aid into the day to day business activities. A recommendation can be made in this regard is that Frank must account under the accrual method must be adopted. This is because the accrual basis of accounting would help in reflecting substantially a correct reflex of the taxpayer’s true income.

The availability choosing the basis of accounting

The availability of the current software packages makes the traditional method of accounting namely the cash or the accrual method of accounting irrelevant (James & Nobes, 2016). The use of electronic method of accounting helps in creating differences between the traditional methods of accounting. The accounting software packages are created for accrual basis of accounting. The cash basis of accounting can be followed under the software packages of ZERO and MYOB. The present availability of the software packages offers business with easy to maintain cash inflow and outflow. The software packages offers the taxpayer with better business scenario of total cash in hand and at bank.  

Answer to A:

With respect of “section 25-10 of the ITAA 1997” the term repairs is related to the work done to the premises or the part of the premises (Fleurbaey & Maniquet, 2015). The term repair represents that remedying the defects or making the defects goods or deterioration of property to be repaired which contemplates the continuous existence of the property. Repairs performed for restoring the efficiency and the functions of the asset without changing or improving the character of the property. As defined by the ATO repairs constitutes replacing the guttering or the window which is damaged in storm and repairing electrical appliances or the machinery (Sikka, 2017). Maintenance can take the form of constant painting and keeping the items on the property in good conditions.

The facts obtained from Ruby Pty Ltd reveals that the expenses were incurred by the taxpayer in replacing the cupboards and the fittings of the kitchen on their rental property which was deteriorated by wear and tear. According to the “section 25-10 (1) of the ITAA 1997” the taxpayers are permitted to claim for deductions relating to the expenses which is incurred in repairing the rental property or any form of depreciating that is wholly employed for generating assessable income (Simmons et al., 2017). Citing “section 25-10 (1) of the ITAA 1997” Ruby Pty Ltd is entitled to claim an allowable deduction for the expenses incurred in repairs of kitchen fittings and cupboard of the residential property. The expense incurred were mainly to remedy the defects or damage on the residential rental property without changing or improving the character.

Answer to B:

As stated under the “section 8-1 of the ITAA 1997” a taxpayer is allowed to claim deductions for certain legal expenses which is incurred in generating the rental income (Barkoczy, 2018). These comprises of the costs occurred in defending the claims for damages relating to injuries suffered by the third party on the rental property. Referring to “FC of T v Snowden & Wilson Pty Ltd (1958)” an individual taxpayers are entitled to deductions for losses or outgoings till the extent that these expenses are incurred in producing the chargeable income (Grange et al., 2014). An exception to section 8-1 is that a taxpayer is not allowed to claim deductions for losses or outgoings that are capital, private or domestic in nature. According to the court judgement in “Herald & Weekly Times Ltd v Federal Commissioner of Taxation (1991)” legal expenses are allowed for deductions if the expenses have originated as the outcome of assesse revenue producing activities given the legal expenses are not domestic, private or capital in nature.

Rights of Taxation Commissioner

Ruby Pty Ltd incurs a legal expenses in defending the suit for the injuries suffered by one of the visitors of tenant. Citing the law court judgement in “Herald & Weekly Times Ltd v Federal Commissioner of Taxation (1991)” legal expenditure were occurred in producing the rental income. The legal expenses that was incurred was the outcome from the risk which is ever present for a land lord (Sadiq, 2018). Quoting the reference of court in “FC of T v Snowden & Wilson Pty Ltd (1958)” legal expenses can be claimed as deductions under “section 8-1 of the ITAA 1997” by Ruby Pty Ltd since it arouse because of letting out the rental property to the tenants for generating the assessable income.   

Answer to C:

“Section 8-1 of the ITAA 1997” enables a taxpayer for an entitlement to deduction relating to the expenses that are occurred for outlays that is incurred in producing the taxable income. According to the “section 26-5 of the ITAA 1997” a taxpayer is denied deductions for expenses that is occurred as business penalties (Taylor et al., 2018). The law court in “Hallstroms Pty Ltd v FCT (1946)” explained that the character of the expenditure should be determined at the time of claiming deduction under “section 8-1 of the ITAA 1997” (Woellner et al., 2018). The case study provides that Ruby Pty Ltd incurred compensation payment following a claim for damages was filed by the car manufacturing in the federal court. A settlement was finally reached where the taxpayer was required to pay $750,000 for supplying the defecting products.

Denoting the decision in “Sun Newspaper Ltd v FCT (1938)” it was held that outgoings which is aimed for structural improvements instead of occurring it for operational purpose then such expenditure is held as non-deductible (Caldwell, 2014). Similarly the compensation damages that is paid by the Ruby Pty Ltd constitute business wrong-doings and penalties. Therefore under “section 26-5 of the ITAA 1997” no deduction is allowable to the taxpayer.

Answer to D:

According to the ATO business provision expenses are treated as non-deductible expenses. The taxpayer is only allowed to claim deductions under “section 63 of the ITAA 1997” where the expenses are physically present before claiming for deductions (Ato.gov.au, 2018). An individual taxpayer is only permitted to claim for allowable deductions where the expenses are written off under “section 63 (1)” of the Act. 

Ruby Pty Ltd reports a provision for accounts for future claim for damages. Therefore, the taxpayer would not be allowed to claim deductions for the expenses because the general provision expenses are non-allowable for deductions under “section 8-1 of the ITAA 1997”.

Basis of accounting for both the years

Answer to E:     

According to the general provision stated under “section 8-1” a deduction is denied to the business relating to the expenses that are preliminary in the beginning of the revenue producing activities. The court in “Softwood Pulp and Paper v FCT” held that feasibility expenses incurred by the company for establishing new paper producing mill were non-deductible (Sadiq, 2018). The commissioner of Taxation stated that costs were non-deductible because everything that was done by the taxpayer was preliminary in revenue generating activities. In another example of “Goodman Fielder Wattie v FCT” a deduction was denied to the company for expenses incurred in initial research and development since the activities were provision in nature and non-deductions were allowable.

Ruby Pty Ltd reports an expense $220,000 paid to the consultants for investigating the possibility of re-entering in car manufacturing industry. Citing the case of “Softwood Pulp and Paper v FCT” the expenses does not qualifies for deductions as they are preliminary to commencement of revenue producing activities and non-allowable as deduction under “section 8-1 of the ITAA 1997”. 

References:

Accounting methods. (2018). Retrieved from https://www.ato.gov.au/Business/Income-and-deductions-for-business/Assessable-income/Accounting-methods/

Bankman, J., Shaviro, D. N., Stark, K. J., & Kleinbard, E. D. (2017). Federal Income Taxation. Wolters Kluwer Law & Business.

Barkoczy, S. (2018). Australian Tax Casebook 2018 14e ebook. Melbourne: OUPANZ.

Barth, M. E., Clinch, G., & Israeli, D. (2016). What do accruals tell us about future cash flows?. Review of Accounting Studies, 21(3), 768-807.

Bushman, R. M., Lerman, A., & Zhang, X. F. (2016). The changing landscape of accrual accounting. Journal of Accounting Research, 54(1), 41-78.

Caldwell, R. (2014) Taxation for Australian businesses.

Fleurbaey, M., & Maniquet, F. (2015). Optimal taxation theory and principles of fairness (No. 2015005). Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).

Grange, J., Jover-Ledesma, G., & Maydew, G. 2014 principles of business taxation.

James, S. R., & Nobes, C. (2016). Economics of Taxation: Principles, Policy and Practice. Fiscal Publications.

Legal Database. (2018). Retrieved from https://www.ato.gov.au/law/view/document?DocID=TXR/TR981/NAT/ATO/00001&PiT=99991231235958

Murphy, K. E., & Higgins, M. (2016). Concepts in Federal Taxation 2017. Cengage Learning.

Sadiq, K. (2018). Australian taxation law cases 2018. Pyrmont, NSW: Thomson Reuters.

Sikka, P. (2017, December). Accounting and taxation: Conjoined twins or separate siblings?. In Accounting forum(Vol. 41, No. 4, pp. 390-405). Elsevier.

Simmons, D. L., McMahon, M. J., Borden, B. T., & Ventry, D. J. (2017). Federal Income Taxation. Foundation Press.

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.