Question

1-Firm B uses the calendar taxable year and the cash method of accounting. On December 31, 20x6, Firm B made certain cash payments. To what extent can it deduct the payment in 20x6? (Please note: payments for assets to be consumed in the following year are fully deductible in the year of payment if the expenditure results in a benefit with a duration of 12 months or less and is consumed by the end of the following year.)

a) $3,000 compensation to a consultant who spent three weeks in January 20x7 analyzing B’s internal control system.
b) $500,000 to purchase a new piece of manufacturing equipment. The equipment was delivered on January 8, 20x7 and has a useful life of 5 years.
c) $16,900 property tax to the local government for the first six months of 20x7.
d) $50,000 for a two-year lease beginning on February 1, 20x7.
e) $23,700 of inventory items held for sale to customers.

Answer 1

a) $3,000 compensation to a consultant who spent three weeks in January 20x7 analyzing B’s internal control system.

• $3,000 recognized in 20x6

Cash basis accounting doesn't recognize prepaid expenses that last less than 12 months, therefore, this expense will be recognized in the year that it was paid for regardless if the actual expense took place on a later date. The same applies for rent, insurance, etc.

b) $500,000 to purchase a new piece of manufacturing equipment. The equipment was delivered on January 8, 20x7 and has a useful life of 5 years.

• $0 recognized in 20x6

If you use modified cash basis accounting, you must capitalize fixed assets and depreciate them. You would recognize depreciation expense during the following 5 years.

c) $16,900 property tax to the local government for the first six months of 20x7.

• $16,900 recognized in 20x6

Since you paid your taxes in 2016, you must recognize them.

d) $50,000 for a two-year lease beginning on February 1, 20x7.

• $0 recognized in 20x6

The 12 month rule doesn't apply, therefore, you must recognize rent during 20x7 and 20x8.

e) $23,700 of inventory items held for sale to customers.

• $0 recognized in 2016

Even for cash basis accounting, inventory is a permanent account in the balance sheet and it cannot be expensed until sold.