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Chapter Objectives Be able to: Explain how profit is determined. Apply the four main concepts from GAAP in determining profit. Apply the six limitations from the ITA in determining profit. Identify and apply the various exceptions to the general rules in determining profit.
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Chapter Objectives Be able to: • Explain how profit is determined. • Apply the four main concepts from GAAP in determining profit. • Apply the six limitations from the ITA in determining profit. • Identify and apply the various exceptions to the general rules in determining profit.
Business Income Defined • Broadly defined as a profession, calling, trade, manufacture or undertaking of any kind whatever and an adventure or concern in the nature of trade. • Notice that there is no reference to size or the ongoing nature of the activity. • In deciding whether a transaction is to be treated as a capital transaction or a business transaction, the principal factor to be considered is the intended use of a property on acquisition. • Property acquired for the purpose of providing the owner with a long-term or enduring benefit is capital property and its disposition will be a capital gain (loss). • Property acquired for the purpose of reselling it at a profit is inventory and its disposition will be a business income (loss).
General Rules for Determining Business Income • Profit comprises the revenues earned in a taxation year less the expenses incurred for the purpose of earning such revenues. • The fundamental starting point in determining profit is well-accepted business principles along with Generally Accepted Accounting Principles (GAAP) and the provisions of the Income Tax Act (ITA). • The four fundamental concepts from GAAP for profit determination are revenue recognition, accrual, matching and conservatism. • However, in spite of well-accepted business principles and GAAP, the ITA includes six limitations on the deduction of expenses. They are income earning purpose test, capital test, exempt income test, reserve test, personal expense test and reasonableness test.
Exceptions to the General Rules - Specific Income and Expense Exceptions • The exceptions that will increase income are listed in sections 12, 13 & 14 of the ITA. The exceptions that limit certain expenses are listed in sections 18 & 19 of the ITA. The exceptions that permit certain expenses are listed in section 20 of the ITA. • The common limited expenses are: use of recreational facilities, club dues, political contributions, advertising expenses, allowance for an automobile, interest & property taxes on vacant land, certain costs during the construction period, work space in a home, meals & entertainment and costs of an automobile. • Additional permitted expenses are: capital cost allowance, interest, expenses of borrowing money or issuing shares, landscaping, reserves for doubtful debts, reserve for delayed payment revenues, expenses of representation, investigation of a site, convention expenses, utilities service connection, private health services plan and CPP contributions.
Exceptions to the General Rules - Treatment of Inventories • There are two acceptable methods for valuing inventory: 1) Value each item of inventory at the lower of its cost or market value 2) Value all items of inventory at their market value • Cost values may determined using the first-in, first-out (FIFO) method or the average cost method but not the last-in, first-out (LIFO) method. • Market value is the realization value of an item which would include the expected selling price less direct selling costs. • Any change in the inventory valuation method must be approved by the CCRA.
Exceptions to the General Rules - Other • Typically, a taxation year for an individual is the calendar year. However, for certain businesses, individuals can elect to use an alternative fiscal period. This election would include a complex formula in estimating calendar year income. • Although scientific research and experimental development are capital in nature, they may be deductible under certain circumstances. • Professionals can elect to exclude income from work in progress. However, any change in this election must be approved by CCRA. • The two types of reserves permitted are for doubtful debts and for income when there are extended payment terms. • In order for unpaid salaries to be deductible, they must be paid within 180 days of the business’s taxation year. • Farmers can elect to use the cash basis of accounting and hobby farmers are restricted in the amount of losses that can be claimed.
