Welcome back. After having discussed
the concepts behind what trade and business expenses are deductible,
in this video we'll examine when an expense is deductible.
So generally speaking, the timing of deductions
is determined by the taxpayer's accounting method.
Recall that four accounting methods are acceptable to the IRS:
cash, accrual, special, and hybrid.
Here we'll discuss cash and accrual since they are
the dominant accounting methods used by business taxpayers.
First, the cash method.
When is an expense deductible under the cash method?
Here an expense is deducted when it's paid, with either cash, or property, or services.
Also even under the cash method,
a current deduction for a capital expenditure is not allowed.
That is, generally, a business taxpayer cannot immediately deduct
the entire value of business equipment or machinery in the first year of use.
Instead, the taxpayer must capitalize the equipment as an asset, then depreciate it.
Therefore, over time, the entire cost of the asset will be deducted.
There are some exceptions that do allow for
immediate deduction of capital expenditures, but we'll
look at those issues later in the course, when we
discuss property transactions and depreciation.
Under the cash method,
it's also important to note that prepaid expenses are not deductible currently if they
expire or can be consumed beyond the end of the year following payments.
In simpler terms, there's a one year rule for prepaid expenses.
For example, if in December of the current year,
a business taxpayer prepays for the next year subscription to a business database,
then the prepayment is fully deductible because the use of that database
will not extend beyond the end of the year following the payments.
Any prepaid items that fail the one year rule must be
prorated and deducted when they apply.
Therefore, to the extent the prepayment is for expenses to be incurred in the next year,
they are deductible this year.
But, to the extent the prepayment is for expenses
to be incurred in the year after next year,
then the expenses are deductible in the year after next year.
That is, when the product or service is consumed.
Another general exception is that the tax law
restricts the use of the cash method to small businesses,
farms, personal service corporations, and certain partnerships.
The second widely used accounting method is the accrual method.
Here the general rule is that expenses are deducted when they're incurred,
not necessarily when cash is paid, or property is delivered, or services are rendered.
So what does this mean, to incur an expense for it to be deducted?
Well, there are two tests,
the all events test and the economic performance test.
Both tests must be met for the expense to be deductible under the accrual method.
First, the all events test states that a deduction is allowed
when all events have occurred to create the taxpayer's liability,
and the amount of the liability can be determined with reasonable accuracy.
For example, let's say a machine breaks and I call a service repair person to fix it.
The person fixes my machine and bills me $500, and I pay the bill in three months.
What does the all events test say as to when the business taxpayer gets the deduction?
Well under the accrual method,
once the repair person fixes the machine and billed for $500,
it means that all the events have occurred to create a liability to
the business owner and the liability can be determined with reasonable accuracy.
Here, the bill is $500.
In this case, the business owner can claim a deduction for $500 on the day
the service person bills the business owner, and not when the actual cash payment is made.
Note that under the cash method,
the $500 deduction will only occur once the bill is paid.
That is, the deduction can only be claimed in three months.
The second test here is the economic performance test.
This says that the accrued services, property,
or use of property giving rise to the liability can only be deducted when the service,
property, or use of property, has actually been performed, provided, or used.
So back to our service repair example.
Because the service repair person fixed the machine,
the service that gave rise to the $500 bill has actually been performed.
Therefore, under the economic performance test,
the $500 bill is deductible to
the accrual business owner when the repair person bills the owner.
Importantly, note here that both the all events test and
the economic performance test must be met in
order for the accrual basis taxpayer to deduct an expense.
For example, if the repair person begins working on
the machine, but does not yet know the final cost,
the all events test has not been met.
If the service repair person must come back later to actually fix the machine,
the economic performance test has also not been met.
Both of these tests must be met in order for
the expense to be deductible to the accrual basis taxpayer.
There is an exception here for accrual basis taxpayers.
If there's a recurring expense,
a deduction is allowed even if there's no economic performance, at least not yet.
So if the item is recurring, and treated consistently year over year,
the accrued item is immaterial,
or accruing results in better reflection of income,
the all events test is met and
economic performance occurs within a reasonable period of time,
but not to exceed eight and a half months after the year end,
then the expense can be deducted by the accrual basis taxpayer.
A final important item to note with
accrual method taxpayers is regarding reserves for estimated expenses.
Here the tax law does not allow a deduction for
reserves, or for estimated amounts, because principally
the economic performance test has not been met.
For example, a company that builds washing machines might estimate that 1% of
its washing machines may need repairs, and they value the repairs at $100,000 per year.
Can the washing machine company deduct the $100,000 on its current year tax return?
The answer here is no, because the company has
not actually yet repaired the washing machine.
That is, economic performance has not occurred.
In fact, the actual expense might only be $75,000 this year,
in which case the company would be over deducting $25,000.
The IRS does not want these types of estimates to creep into the tax return for fear that
taxpayers will have the incentive to overestimate
the deductions and, thus, under report their income.
Therefore, the business has to wait until they incur the cost of fixing
the washing machine before deducting the known exact amount.
In all, we discussed when an expense is deductible.
Under the cash method,
an expense is generally deductible when it's paid in cash, property, or services.
While under the accrual method,
an expense is generally deductible when it's incurred.
That is, when the all events test and the economic performance test are both met.
Matthew HutchensLecturer of Accountancy
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
