SE Machinery Pty Ltd - Case Study Example

SE Machinery Pty Ltd [SEM] I. Advices to SEM A. When the contributed $500,000 as capital contribution to SEM in May it appeared in thebooks as part of the Equity or Capital Account and reported as part of the gross profit by yearend which ended June 2012.. In such a transaction wherein actual cash was received and SEM chose to recognize the cash inflow as capital, the tax law provides that this be considered as ordinary income. Division 6 – Assessable Income and Exempt Income, Section 6.5, states that Australian residents’ ordinary income are assessed whether derived from within Australia or outside, including those derived indirectly or directly “from all sources” (Australian Parliament 1997, Section 6.5). As Flynn, M.(2009, p.171) had stated, “The second test is to ask whether the receipt represents a flow produced by an item of capital. If it does, the receipt is revenue.” B. However, the Arthur Murray principle will apply for the prepayment. According to Kater, E. (2009), under that principle, income is generally not derived until after services or products have been delivered, except in a situation wherein there may not be a refund of prepayment according to a contract. There was no contract which specifically stated there can be no refund under certain conditions. Income was recognized in June 2012 even though products were yet to be delivered in August 2012. The prepayments were recognized as revenue so that the gross profit includes the value of that prepaid order. But requirements for such a capital contribution to be considered an Income of SEM were not yet completed although prepaid. The goods (Teftoffelex) were delivered only in August 2012. Since there is no contract stipulating that the prepayment was not refundable, the Arthur Murray principle will allow for the delay in payment of Income Tax corresponding to the $ 1,200,000 worth of orders. SEM has received payment and delivered the orders only in August 2012. Thus, this will result in having unearned income as of yearend, June 2012. The Arthur Murray Principle will be applicable because income should be recognized only after the fulfilment of an order and after payment had been received. But this only means that in the next income declaration, income tax would have to be paid for the $1,200,000. The book entries should have been as follows (Appendix 1) It is only after the delivery of goods that the liability account, Unearned Revenues, amounting to a total of $ 1,200,000 should be reversed to consider the entire $ 1,200,000 as Sales. Thus, the proper advice to SEM is to adjust the Sales by $ 1,200,000 because it is in fact still a liability (as Unearned Income) and will remain that way until the goods are delivered. II A. Explanations for Revenue and Expense Accounts 1. Bad Debt Deduction After Write-Off = $8,000 Section 63 paragraphs 34-39 allows for deductions of bad debts only after they have been written off. (AG/ATO 2012, TR 92/18). The Australian Taxation Law under Act No. 55 as amended, in Division 21-5. 2. Interest Expense on Working Capital = $ 25,000 Borrowed @ 8% Interest From February 1, 2012 to end of June 2012 which is 5 months, SEM should recognize the accrued interest expense. This would amount to 25,000 x 0.08 x 5 mos. / 12 months = $ 833. According to the AASB 123 Core Principle (AG/AASB 2009, p. 7 & 9), “Borrowing Costs that are directly attributable to the acquisition, construction, or production of a qualifying asset form part of the cost of that asset. All other borrowing costs are recognized as an expense.” This should include interest (Section 6a p. 9). Usually, interest expenses are prepaid upon release of borrowed money. And based on the Principle of Profit Determination of the AASB(AAT & Willis, D. 1997, p.7), the expense should be matched with the revenue given a certain period. Thus, upon receipt of the loan, interest expenses should have been treated as Prepaid Interest. And the Prepaid Interest asset account should be reduced by the accrued expense value which would amount to $ 833. Under the Accrual Concept of Acccounting (p.8), “…revenue is recognised when it is earned and expenses recognised as they are incurred…” So far, only $300 was expensed at the time of borrowing. Since it does not mention that the amount is part of the 8% interest per year, the $300 must be the Finance Charges other than the interest on loan. (AE 3) An adjustment entry will be needed to recognize the accrued interest expense worth $833. June 30, 2012 Interest Expense Debit - $ 833 Accrued Interest Expense Credit - $ 833 Note that there are no Balance Sheet accounts disclosed in this case of SEM. If there was a recognized Prepaid Interest, the credit entry should be Prepaid Interest. 3. Depreciation In the guide made available by the ATO (2012 [b]) for the purpose of depreciating assets, the general rule is that the life of an asset to be depreciated depends on the estimated useful life. For cars in general, the guideline shows 8 years based on the specification of TR 2011/2 (p.36). The depreciation expense recognized in June 2012 will have to be clarified since the usual building allowance for depreciation used to be only $15,000. The case implies that the difference of $160,000 worth of depreciation expenses is made up of Motor Vehicles’ depreciation and Furniture’s depreciation within the year. . The new car for a Managing Director should likewise be depreciated since it was purchased in January 7, 2011 or 1.5 years up to June 30, 2012. Thus the additional unrecorded depreciation expense can be computed as follows: (AE 4) 1.5 years/ 8 years x $ 65,466 = $ 12,274. And the corresponding adjusting entry will be June 30, 2012 Depreciation Expense Debit - $ 12,274 Accumulated Depreciation Credit - $ 12,274 Thus, the adjusted total Motor Vehicles depreciation expense should be $160,000 + $ 12,274 = $172,274. Also considering the adjustments in Part II-H, the corresponding totals of depreciation expenses will then have to be increased by these adjusting entries. (Note D – Summary of Depreciation Expenses. See Appendix 2.) 4. Fixed Assets Disposed Of & Additions to Fixed Assets (Notes AE-CG & AE-CL) To recognize the sale of furniture with cost of $ 4,000 and adjusted value= $ 2,926, which was sold for $ 5,526 in June 20, 2012, income from the sale would appear as follows: (See Appendix 3.) (AE-CG) Capital gains by companies are taxed at 30% along with the income tax earned (Global Property Guide 2012). (AE-CL) For the machinery sold at a termination value lower than the adjusted value, wherein cost = $5,000; adjusted value= $ 3,277; and termination value = $2,277, the accounting records will show the following entry (See Appendix 4.). In connection with the building extension constructed at a value of $100,000 and which was occupied in Jan. 4, 2012, there should be a capital allowance for depreciation by June 30, 2012 amounting to 1/50 years x 6/12 months x $100,000 assuming the useful life is 50 years, given that the older building is already 30 years old and still being depreciated at the rate of $15,000 per year. The books should show the following entries: (See Appendix 8.) The motor vehicle for a Managing Director should likewise show a corresponding capital allowance for depreciation. As earlier mentioned, the ATO has listed the life of vehicles to be usually 8 years. Since the new vehicle was purchased in Jan. 7, 2011, its capital allowance should now be good for 1.5 years/ 8 years x $ 65,466 = $ 12,274. Additional depreciation expenses were recognized. See Repairs and Maintenance 5. Education Expenses, Entertainment Expenses, Overseas Travel Expenses The education for Board of Directors’ children was taxable as Fringe Benefits. Both Entertainment and Overseas Travel should be treated as Fringe Benefits as well. Even the newly purchased car for the Managing Director is subject to FBT. The rate of FBT is 46.5% according to the ATO website. See Fringe Benefits computation in Appendix 5. It is either SEM calls the new vehicle a company car or, if reported as a car for the Managing Director, the Australian government will tax SEM for the Fringe Benefit involving the car. For purposes of conservatism, the higher value of FBT is applied. Fringe Benefits Tax should then be adjusted from the original $ 43,000 to the conservative figure of $ 70,897. (AE 6) June 30, 2012 Fringe Benefits Tax Debit - $ 30,897 Fringe Benefits Tax Payable Credit - $ 30,897 6. Legal Expenses - $ 4,600 All the disclosed legal expenses in the case of SEM are part of the business operations. Therefore, they should be considered as part of operating expenses. Section 8.1(b) of the 1997 Income Tax Assessment Act (ITAA) says that such a deduction is allowed because “it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.” (Australian Parliament 1997, Section 8.1 ) 7. Long Service Leave Paid (Note LSL) The Treasury (2012, p.2) described the accounting treatment of Long Service Leave for those companies ending the year in June 30, 2012. All current LSLs “must be presented as a current liability. . . in accordance with AASB 101”. But since the major amount was paid within the year, the entry should be directly to the expense account while the balance not yet paid should be the remaining liability account. (See Appendix 7 for corresponding entries.) 8. Repairs & Maintenance - $ 42,500 (Note R&M) That part of Repairs and Maintenance consisting of the furniture purchase for the lunch room, amounting to $ 5,000 should be reclassified under Furniture. Replacement of the building roof worth $ 7,000 should be capitalized. Section 8.1 of the 1977 ITAA will apply for such a deduction. Details of what may be deducted under Repairs and Maintenance are also given in AG/ATO (2012 [e]). Out of the reported $64,500 appearing in the June 30, 2012 , the following adjustments (correcting entries) should be made: (See Appendix 6.) 9.Research & Development According to AG/ATO 2012 [g], SEM is not entitled to claim any incentive for the R & D expense incurred because it involves “core technology”. But it may be deducted as expenses for purposes of income tax computation. II B. Taxable Income 2011/2012 1.New Basis of Taxable Income (Notes R1 & R2) Any sale is subject to GST. As of the latest GST Law which took effect in June 2012, AG/OLDP (2012, Section 9-40) states that a company “must pay the GST payable on any taxable supply that you make”. And in Section 9-70, “the amount of GST on a taxable supply is 10% of the value of the taxable supply”. For purposes of taxation, the Income Statement should preferably reflect the payable Sales Tax in the form of an allocation. Section 9-75 defines the value of a taxable supply. It is price x 10/11 wherein the price includes the GST. In the reported revenue, GST can also be computed based on P x 10/11=Taxable Supply; that is also $3.035.000= 10%GST + Supply Value before tax. Applying the formula, P x 10/11 = TS, by substitution, $ 3,035,000 x 10/11 = $2,759,091 = Taxable Supply (R1) TS x 10% = 2,759,091 x10% = $ 275,909 = Goods and Services Tax (GST) (R2) Revenue (Note R1) $ 2,759,090 Provision for GST (Note R2) 275,910 Gross Revenue $ 3,035,000 However, because the products ordered were not yet supplied as of the period ended June 30, 2012 and the agreement stipulates that the products will be supplied in August 2012, the actual revenue should be adjusted to comply with the matching principle between revenues and expenses. Thus the Gross Revenue should be reduced by $ 1,200,000. (R3) $ 3,035,000 - $ 1,200,000 = $ 1,835,000 adjusted gross revenue (R4) P x 10/11 = Adjusted Taxable Supply = $ 1,835,000 x 10/11 = $1,668,182 (R5) 10% GST = 10% x 1,668,182 = $166,818 Therefore, the adjusted figures should appear in the final Income Statement as follows: 2.Adjusted Revenue & Expenses Statement SEM Pty Ltd. Revenue & Expenses Statement For the period ended June 30, 2012 Revenue (Note R4) $ 1,668,182 Provision for GST (Note R5) 166,818 Gross Revenue (Note R3) $ 1,835,000 Operating Expenses: Bad Debts Written Off (Section 63 paragraphs 34-39) $ 8,000 Cost of borrowing funds for working capital (AG/AASB 2009, p. 7 & 9) 300 Interest Expense (Note AE 3) 833 Depreciation Expenses (Note D) 189,023 Education Fees (AG/ATO 2012 [d]) 22,000 Entertainment Expenses (AG/ATO 2012 [d]) 15,000 Overseas Travelling Expenses (AG/ATO 2012 [d]) 24,000 Provision for Long-Service Leave (Note LSL) 26,000 Fringe Benefits Tax (Note AE6) 70,897 Legal Expenses (Section 8.1b) 4,600 Repairs & Maintenance (AG/ATO 2012 [e]) & (Note R&M) 42,500 Research & Development (by CSRIO) – (AG/ATO 2012 [g]) 20,000 Superannuation Contribution – (AG/ATO 2012 [h]) 76,000 Other Expenses (all tax deductible) 200,000 Sales Tax (Note R5) (Act No. 55 2012 Division 33-5) 166,818 Total Operating Expenses $ 1,814,621 Net Operating Income Before Income Tax $ 20,379 Other Income/ (Losses): Capital Gain from Sale of Furniture (Note AE-CG) $ 2,596 Capital Loss from Sale of Equipment (Note AE-CL) ( 1,000) $ 1,596 Net Income for the period ended June 30, 2012 $ 21,975 Income Tax @ 30% $ 6,592 References AAT & Willis, David 1997. Accounting and Bookkeeping Principles and Practice. Association of Accounting Technicians. Viewed September 5, 2012 @ AG/AASB 2009. Borrowing Costs. Australian Government – Australian Accounting Standard Board Compiled Accounting Standard AASB 123. November 2009. Viewed September 5, 2012 @ AG/ATO 2012[a]. Tax Ruling: TR 92/18. Australian Government Taxation Office Legal Database. AG/ATO 2012 [b]. Guide to Depreciating Assets 2012. Australian Taxation Office NAT 1996-6.2012. Viewed September 5, 2012 @ AG/ATO 2012 [c]. Legal Database: Legislations and Regulations – Part III Fringe Benefits. Australian Government Taxation Office. AG/ATO 2012 [d]. Fringe Benefits Tax – A Guide to Employers. Australian Government Taxation Office Legal Database. Viewed September 6, 2012 @ AG/ATO 2012 [e]. Guide To Claiming Business Deductions: Repairs, Maintenance, and Replacement Expenses. Viewed September 6, 2012 @ AG/ATO 2012 [f]. Guide To Claiming Business Deductions: What You Can Claim & How To Claim. Viewed September 6, 2012 @ < http://www.ato.gov.au/businesses/PrintFriendly.aspx?ms=businesses&doc=/content/00266008.htm&page=29&page=29&page=3#P66_5159> AG/ATO 2012 [g]. Research and Development Tax Incentive: Amounts You Can Claim. Viewed September 6, 2012 @ AG/ATO 2012 [h].Employer Guide for Reportable Employer Super Contributions. Viewed September 6, 2012 @ < http://www.ato.gov.au/content/00189411.htm> AG/OLDP 2010. A New Tax System (Goods and Services Tax) Act 1999. Australian Parliament 1997. Income Tax Assessment Act 1997. Commonwealth Consolidated Acts. Flynn, Michael 1999. ‘Distinguishing Between Income and Capital Receipts’. Journal of Australian Taxation.May-June 1999 Issue 3. pp.155-171. Viewed September 4, 2012 @ Gilders, F et al (2011) Understanding Taxation Law 2012. LexisNexis/Butterworths. Global Property Guide 2012. Taxes Are High in Australia. Viewed September 5, 2012 @ Kater, Emily 2009. When is Income Tax Derived? Legal, Tax & Accounting Australia: Tax & Accounting Insight. March 2009. Viewed September 4, 2012 @ The Treasury 2012. Accounting for Long Service Leave and Annual Leave. NSW Government of Australia Treasury Circular NSW TC 12/06 March 14, 2012. Viewed September 5, 2012 @ Bibliography L. Nethercott, et al 2012. Australian Taxation Study Manual 21st Ed.). CCH Sydney.  R. Deutsch, et al (2012). Australian tax handbook. Pyrmont, Thomson S. Barkoczy (2011). Core Tax Legislation 2012 (15th ed.). CCH Sydney. Woellner, et al, (2011). Australian Taxation Law 2012 (22nd ed.). CCH Sydney Appendix 1.To recognize that the goods were not yet delivered in June 2012. The agreement was for the products to be delivered in August 2012. Sales should take place after supply of goods is completed. May 1, 2011 Cash Debit - $ 1,200,000 Capital Credit - $ 500,000 Sales Credit - 700,000 June 30, 2011 Sales Debit - $ 700,000 Unearned Revenue Credit - $ 700,000 June 30, 2011 Sales Debit - $ 500,000 Unearned Revenue Credit - $ 500,000 2. Summary of Depreciation Expenses (Note D) Old Building Annual Depreciation $ 15,000 New Building Annual Depreciation (1/10/11) 1,000 (Note AE 5) Old Building Improvements Depreciation 82 (Note AE 7) Depreciation Expenses (Vehicles & Furnitures) 160,000 Depreciation Expense (New Vehicle 1/711) 12,274 (Note AE 4) (Also see Part II-H.) Depreciation Expense (New Furniture 10/31/11) 667 (Note AE 7) (Also see Part II-H.) Total Depreciation Expenses $ 189,023 3. Entry for the Sale of Furniture June 20, 2012 Cash Debit - $ 5,526 Allowance for Depreciation 1,074 Furniture Credit -$ 4,000 Capital Gains 2,596 4. Entry for the Sale of Equipment June 20, 2012 Cash Debit - $ 2,277 Allowance of Depreciation 1,723 Loss on Sale of Equipment 1,000 Equipment Credit - $ 5,000 5. Fringe Benefits Computation Education Fees $ 22,000 Entertainment Expenses 15,000. Overseas Travelling Expense 24,000 Provision for Long Service Leave 26,000 Motor Vehicle for Managing Director 65,466 $ 152,466 FBT rate x 46.5% FBT payable $ 70,897 (AE 6) If Motor Vehicle is excluded, FBT payable $ 40,455 6. Entries for the Building Improvements & New Furniture + Depreciation June 30, 2012 Building Improvements (11/2011) Debit - $ 7,000 Repairs and Maintenance Expense Credit - $ 7,000 Furniture (10/31/2011) Debit - $ 5,000 Repairs and Maintenance Expense Credit - $ 5,000 (Note AE 7) June 30, 2012 Depreciation Expense – Building Debit - $ 82 Accumulated Depreciation – Bldg. Credit $ 82 ($ 7,000 x 7/12) / 50 years Depreciation Expense – Furniture $ 667 Accumulated Depreciation – Furn. $ 667 ($5,000 x 8/12) / 5 years 7. Entry for LSL Provision June 30, 2012 Provision for Long Service Leave Debit $ 26,000 Cash Credit $20,395 Long Service Leave Payable 5,605 8.The books should show the following entries to recognize a corresponding depreciation expense as follows: (AE 5) June 20, 2012 Depreciation Expense Debit - $ 1,000 Allowance for Depreciation Credit - $ 1,000 Read More