yy ce / / /// // Ly f Q LEARNING oBJECTIVEs At the end of the chapter, the student shall be able to: 1. describe the concept of income from business and exercise of profession; 2. identify the accounting methods of reporting business income; and 3. determine how to compute gross taxable income based on the nature of a business. DEFINITION OF TERMS Business income represents gain or profit derived from the investment of money, goods, services, or their equivalent. | Professional income refers to the earnings of individuals who publicly exercise their profession. For example, a physician that provides medical services in his/her clinic, a certified public accountant who offers accounting and auditing services, and a lawyer who provides legal services are all professionals with income from exercising their profession. Gross income derived from business shall be equivalent to gross sales less sales returns, discounts and allowances, and cost of goods sold In the case of taxpayers engaged in the sale of services, gross income means gross receipts less discounts. Cost of goods sold shall include all business expenses directly incurred to produce the merchandise and to bring them to their present location and use.the cost of goods sold shall include the in transporting goods tg e while the goods are in __ For trading or merchandising concerns, g invoice cost of the goods sold, plus import duties and freight i the place where the goods are actually sold, including insurance transit. ods manufactured and sold shall include For manufacturing concerns, the cost of g direct labor irect labor ang all costs of production of finished goods, such as raw materials, manufacturing overhead, freight cost, insurance premiums, and other costs incurred to bring the raw materials to the factory or warehouse. ACCOUNTING METHODS OF REPORTING BUSINESS INCOME There is no prescribed method of reporting business income. A taxpayer shall adopt an accounting method or system of recording business income that is best suited to his/ her purpose and will reflect the true results of operation. The accounting methods of recognizing business income are as follows: . Accrual basis . Cash basis . Hybrid method 1 2 3, 4. Crop-year method 5. Installment method 6. Deferred payment method 7. Percentage of completion method 8. Completed contract method of Spread-out method 10. Outright method Accrual Basis The income, profits, and gains are included in the gross taxabl. e when le income w earned, whether received or not, and expenses are included i : when incurred, whether paid or not. led in the allowable deductionsAt the end of 2019, Polo Company reported the following Sales on account 3,500,000 Cash sales 1,800,000 Cost of sales 11,600,000 Salaries and wages paid during the year 250,000 In 2019, the Company collected 40% of the sales on account. Determine the gross income using the accrual method. The gross income under the accrual basis of accounting is computed as follows: Sales (3,500,000 + 1,800,000) 5,300,000 Less: cost of sales Gross income The following income, however, should not be reported under accrual basis even if it pertains to a future period: 1. Deposit on rent without restriction. Unrestricted deposit on rent shall be reported as income in the year it was received. 2. Income, gains, or profits on an installment basis. The amount of income reported shall be based on a certain percentage of the collection, f 3. Income collected through the completed contract method. The amount of income collected every year shall be recognized upon the completion of the contracts. Cash Basis The income, profits, and gains are reported as gross income when received, and expenses are deductible when paid. The following individuals usually report their income under the cash basis: 1. Taxpayers who do not keep books of accounts and other accounting records 2. Taxpayers who employ the cash receipts and disbursement method 3. Taxpayers with inadequate accounting recordsKalbo Barber Shop maintains incomplete records. The available records reflected the following information at the end of the year Total in the cash receipt book Later Collectibles from customers en Payables to various suppliers i Total in the cash disbursement book a Rent payable to the owner of the building oa Unpaid utilities on 6,900 Payable to barbers and attendants GMD Determine the gross income using the cash basis method. . ENS The gross income under the cash basis method of accounting is computed as follows: Totals in cash receipts 386,900 Less: total cash disbursement 245,600 Gross taxable income £141,300 Hybrid Method The hybrid method is the combination of the accrual and cash basis methods of reporting income and expenses. This method employs the practi ce of reporting income using the cash basis method and recording expenses using the accrual basis method of the other way around. Crop-year Method Farmers, such as those who engage in rubber, coconut, or mango planting, adopt the crop-year method of computing gross income when the gestation period of the crop is more than one year. Gestation period refers to the span of time from planting ® harvesting. Alll operating and production expenses incurred are deducted when an ins" is realized.JJ, a licensed agriculturist, has engaged in 35-hectare coconut farming. His records provide the following information: Cumulative Data Data on First Five Years the Sixth Year Land and land improvements 6,500,000 - Planting materials and other costs 480,000 - Operating expenses 260,000 P 60,000 Revenue from crop sales 480,000 Determine the gross income using the crop-year method: 1. During the first five years . 2. On the sixth year As there is no coconut production made on the first five years, the gross income for the period is nil. However, revenue has been realized already on the sixth year; hence, the gross income is determined as follows: Revenue from crop sales 480,000 Less: operating expenses (260,000 + 60,000) 320,000- Gross taxable income In an agriculture business, some costs incurred during the gestation period are ) capitalized. Installment Method The amount of income to be reported under the installment method is a portion of the collection received during the year. The following may teport their income under the installment method: 1. A taxpayer who regularly sells personal properties in installments 2. A taxpayer who makes a casual sale of personal property, other than inventory, on an installment basis, provided that the selling price exceeds P1,000 and the initial payments do not exceed 25% of the selling price 3. A taxpayer who sells or disposes a real property on an installment basis provided that the initial payments do not exceed 25% of the selling priceThe taxpayer, however, has the option to report the whole amount of gains or prog, wn the Year of sale instead of reporting on an installment basis. The formulas that follow for computing the income using the installment methog May be used subject to the following conditions: 1. The property sold is without a mortgage. 2. The property is with a mortgage to be assumed by the buyer, but the mortgag. does not exceed the cost to the seller Gross profit Amount of installment collection received » 5 -Contract price However, if there is a mortgage assumed by the buyer and the mortgage exceeds the Cost to the seller, the following formulas may be used to compute for the income under the installment method: i 1. On the date of sale Gross profit Initial Contract price payment Income “Gross profit ; ' Sto 'he Broly, x Atount of installment al Contract price collection received @ Gross profit is the excess ofthe selling price over cost or adjusted value Initial payment represents the payment received in evidence of indebtedness for the purchases during the t or other disposition is made. cash or property other than th ‘axable period in which the 9Initial payment may include the following 1. Down payment during the year of sale 2. Additional payment made during the taxable year 3. Excess of the mortgage assumed by the buyer over the cost to the seller Contract price may refer to the following: 1. The gross selling price 2. The gross selling price minus the mortgage assumed by the buyer 3. The gross selling price minus the mortgage assumed by the buyer, plus, if in case, the excess of the mortgage assumed over the original cost of the property The property sold may be either of the following: 1. Without a mortgage to be assumed by the buyer 2. With a mortgage to be assumed, but the mortgage does not exceed the cost to the seller 3. With a mortgage to be assumed but the mortgage exceeds the cost of the seller Computation of the Initial Payment 1. There is no mortgage on the property sold, or the mortgage assumed by the buyer does not exceed the cost to the seller. Down payment 20000 Add: additional payments during the year 2000 Initial payment 200K ! 2. The mortgage assumed by the buyer exceeds the cost to the seller. Down payment 2000 ‘Add: additional payments during the year 20000 Excess of the mortgage over the cost to the seller 200Xx__2xxxx Initial paymentC ‘Omputation of the Contract Price 1 Mere is no mortgage on the property sold Contract price = Selling price The mortgage assumed by the buyer does not exceed the cost to the seller. Selling price XXX Less: mortgage assumed by the buyer XXXXX ntract price 5. The mortgage assumed by the buyer exceeds the cost to the seller. Selling price fata Add: excess of the mortgage assumed by the buyer over the cost to the seller 2000, Total XXXXX Less: mortgage assumed by the buyer ee Contract price eee In 2019, Bike Company, a dealer of motorcycles selling through an installment scheme, sold 20 units at P80,000 each. The cost of the product was 50,000, The customers were required to make a 15% down payment, and the balance was payable in four equal annual installments. Compite the amount of income to be reported using the installment method for five years starting 2019. ELE The g105s profit on installment is computed as follows: Sales (P80,000 x 20) P 1,600,000 Less: cost of sales (P50,000 x 20) ‘000,000 Gross profit ® eo0000 The annual collection would be: Selling price P- 80,000 Less: down payment (P80,000 x 15%) 12,000 Balance P 68,000 Multiply by a Total : 1,360,000 Divide by the number of installment payments 4 Annual collections P__340,000_The annual income to be reported would be: 2019 [(P600,000/1,600,000) x (12,000 20)] P 90,000 2020 [(600,000/1,600,000) x 340,000] 127,500 2021 [(P600,000/1,600,000) x 340,000] 127,500 2022 [(P600,000/1,600,000) x 340,000] 127,500 2023 [(P600,000/1,600,000) x 340,000] _127,500_ Total income : P.600,000 In 2019, a real estate dealer sold for P3,750,000 a fully developed 500-square-meter lot with a cost of 3,000,000. The property is mortgaged for P1,500,000 which will be assumed by the buyer. The buyer made a down payment of P600,000, and before the end of 2019, he made an additional payment of 250,000. The balance is payable in two equal annual installments. Compute the income under the installment method. ~ mn E The gross profit under the installment method is computed as follows: Selling price 3,750,000 Less: cost 3,000,000 Gross profit The initial payment is computed as follows: Down payment 600,000 Additional payment during 2019 250,000 Initial payment The taxpayer may report the income of P750,000 on an installment basis because the percentage of the initial payment to the selling price is only 22.67% (P850,000/ 3,750,000). The contract price is computed as follows: Selling price 3,750,000 Less: mortgage assumed by the buyer 1,500,000 Contract price 2,250,000Slows: The collection in two installments is computed as follow: ‘3,750,000 Selling price 600,000 Less: down payment 7 0,000 additional payment ae 2,350,000 Balan assumed ——— "1,400,000 e Divide by the number of installment 2 Payments “P 700,000. Annual collection rm The annual income under the installment method will appear as follows: 2019 [(P750,000/2,250,000) x 850,000] 283,333.33 2020 [(P750,000/2,250,000) x 700,000] 233,333.33 2021 [(P750,000/ 2,250,000) x 700,000] 233,333.34 Total income 750,000.00 1 In 2019, a real estate dealer sold for P4,300,000 a fully developed commercial lot with a cost of P1,900,000. The property is mortgaged for P2,000,000, which will be assumed by the buyer. The buyer made the following payments: {Down payment : 600,000 Additional payment before the end of 2019 200,000 The balance is payable in two equal annual installments, Compute the income under the installment method. exp ‘The gross profit is computed as follows: Selling price 4,300,000 Less: cost ‘000 oni Gross profit 2,400,000The initial payment is computed as follows: Down payment Add: additional payment in 2019 excess of the mortgage over the cost (2,000,000 - 1,900,000) Annual collection ‘The percentage of the initial payment to the selling price is 20.93% (P900,000/ 4,300,000); hence, the taxpayer may report the income using the installment method. The contract price is computed as follows: Selling price Add: excess of the mortgage over the cost Total Less: mortgage assumed by the buyer Contract price ‘200,000 100,000 {600,000 4,300,000 100,000 ‘4,400,000 2,000,000 The collection in two equal installments is computed as follows: Selling price Less: down payment 600,000 additional payment 200,000 mortgage assumed 2,000,000 Balance =e Divide by number of installment Payments Annual collection 74,300,000 The annual income under the installment method will appear as follows 2019 [(P2,400,000/2,400,000) « 900,000] 2020 [(°2,400,000/2,400,000) x 750,000] 2021 [(P2,400,000/ 2,400,000) x 750,000) Total income P 900,000 000Deferred Payment Method The deferred payment method of recognizing income is a vane ascunas method because Properties are also sold on an installment basis, but the initial payment exceeds the selling price by 25%. If the initial payment, therefore, is not more than 253, Of the selling price, then the installment method shall be used __ The amount of income usually recognized in the deferred payment method is the difference between the selling price and the cost of the property. In 2019, a real estate dealer sold a real estate costing P1,800,000 for 4,500,000 on an installment plan. The buyer made a down payment of 2,000,000, and the balance is Payable in two equal annual installments. Determine if the taxpayer is eligible under the installment method or deferred payment method, and compute the income to be reported. The sale is without a mortgage to be assumed by the buyer; hence, the selling price is equal to the contract price. The percentage of the initial payment to the selling price is 44.44% (P2,000,000/94,500,000); hence, the taxpayer is not eligible for the installment method. The gross profit is computed as follows: Sales © 4,500,000 Less: cost {Gross profit The annual installment collection will be: Selling price P4500,000 Less: down payment 2,000,000 Balance Sena 2,500,000 Divide by number of installment payments Annual collection poets 1,250,000The income to be reported under the deferred payment is computed as follows: 2019 (2,000,000 ~ 1,800,000) P 200,000 2020 collection 1,250,000 2021 collection 1,250,000 Total income 2,700,000 The cost of P1,800,000 was fully deducted in 2019 against the down payment. In case the cost exceeded the down payment, there should be no income that would be recognized in 2019, and the excess of the cost over the down payment would be deducted from the 2020 collection. The taxpayer, however, is not prohibited from reporting the whole amount of 2,700,000 as the gross income in year 2019, Percentage of Completion and Completed Contract Method These are two methods used in a long-term construction contract. The percentage of completion method reports income based dn the progress of work. The completed contract method, on the other hand, reports income only upon the completion of the project. Examples of both methods are given in the succeeding pages of this chapter. Spread-out Method and Outright Method The spread-out and outright methods are used to report income earned from leasehold improvements where the lessee introduced such improvements, and these improvements have formed part of the property of the lessor at the end of the lease term. The two methods are clearly illustrated in the next topic of this chapter, COMPUTATION OF GROSS BUSINESS INCOME The basic rule is that the taxpayer shall adopt a method of computing income that best suits his/her purpose, provided that the method employed reflects the true results of the operation. One factor that determines the mode of computing the gross income of the business or profession is the nature of the business.follows: Business entities are cording to their nature as ities are classified according buying and selling of goods op 1. Merchandising - a business entity engaged i" ine of the product. An example ig Products without changing the form or appearans Shoe Mart Manufacturing - a business entity engaged in by changing the form of the product through The Coca-Cola Company. i . Service - a business establishment engaged in providing services. An example is the Philippine National Bank ; 4. Farming or agriculture - a business entity engaged in agriculture, farm operation, or livestock. An example is Dole Philippines. 5. Construction ~ a business entity engaged in the construction of roads, bridges, buildings, and other permanent structures. An example is Philrock Construction Company. the buying and selling of goods a certain process. An example ig Nv Merchandising and Manufacturing (All Amounts are Assumed) : Gross sales 3,500,000 Less: sales discounts 150,000 sales returns and allowances 200,000 Net sales Less: cost of sales Gross income Cost of Sales Computation 1. For merchandising business (all amounts are assumed) Merchandise inventory, beginning =e ‘Add: purchases 1,900,000 u freight in 150,000 Total 2050000" Less: purchase discount 80,000 . purchase returns 70,000 ———= + — 150,000 _ 1,900,000 Total goods available for sale Less: merchandise inventory, end Cost of sales 2,500,0002, For manufacturing business (all amounts are assumed) Raw materials inventory, beginning P 200,000 Add: raw materials purchases (net) 1,000,000 Raw materials available for use ‘1,200,000 Less: raw materials inventory, ending 500,000 Raw materials used 700,000 Direct labor Factory overhead 1,400,000 Total manufacturing 2,100,000 Add: work in process, beginning 500,000 Total work in process 2,600,000 Less: work in process, ending, 700,000 Cost of goods manufactured 1,900,000 Add: finished goods, beginning 900,000 Total goods available for sale 2,800,000 Less: finished goods, ending 1,000,000 Cost of sales 1,800,000 Service/Professional Income (All Amounts are Assumed) Gross receipts 1,800,000 Less: sales discounts 180,000 Net sales 1,620,000 j Less: cost of services 820,000 Gross income P__ 800,000 The cost of services may be computed as follows: Salaries of personnel 400,000 Cost of supplies 120,000 Honorarium of specialist 150,000 Depreciation of equipment 80,000 Rental 70,000 Cost of services P820,000Farming or Agriculture deter A business entity engaged in farming may de following methods: 1. Cash basis, mine its gross income using the ss income shall be used if the business ee aot als ok commpating I does not take into account the value of entity does not maintain an inventory oF the inventory. x Accrual basis i : sidering « Under the accrual basis, the gross income is computed by considering the value of the inventory. 3. Crop-year basis ; aie The crop-yesr basis of computing the gross income is usually ee when the time to produce the crop or its gestation period is more th = mn Us For instance, farming engaged in rubber production has five to eight years of gestation period. eR (All amounts are assumed) Accrual Basis Cash Basis Ending inventory P 400,000 7 Cash sales: livestock 1,000,000 1,000,000 rice/corn 800,000 800,000 {farm equipment 150,000 Ps 150,000 Share on rented area 80,000 80,000 Total 2,430,000 ‘P 2,030,000 Less: beginning inventory 600,000 a Cost of livestock/rice 850,000 850,000 BY ~ equipment 80,000 1,530,000 000 Gross income ~— Esonnag” ——22200. __930,000 =e. P1,100,000 ‘The difference between the gross income under the accrual and cash basi n ; h basis methods amounting to 200,000 (F1100,000 - 900,000) is atributabie ve tihecaitieecseaet the beginning and ending inventory (600,000 - 400,000 = 200,000)Construction Business The gross income of a business entity engaged in the construction of permanent structures such as buildings, roads, or bridges is computed using the following: 1. Completed contract method, This method only recognizes income once the project is fully completed. 2. Percentage of completion method. The percentage of completion, as the title Suggests, recognizes income based on the progress of the work completed. San Dig Construction Company has entered into a contract with Northern College for the construction of a P40,000,000 gymnasium. The project is expected to be completed within four years after the signing of the contract. Based on engineering studies, the following are the estimates: Cost Incurred Percentage | to Date of Completion First year 11,500,000 30% Second year 21,000,000 55% Third year 30,000,000 80% Fourth year 36,000,000 100% EMD: Compute the gross income from the first year to the fourth year if the / company uses the following: 1. The completed contract method 2. The percentage of completion method 1st Year 2nd Year 3rd Year 4th Year Contract price ™ - - ‘40,000,000 Cost Gross income The income on the construction was only recognized on the fourth year upon the completion of the project.ss i GEIB Using the percentage of completion method, the gross income ig computed as follows: 1st Year Contract price ‘40,000,000 % of completion 30% Contract earned "P12,000,000 Cost incurred to date 11,500,000 Gross income to date "500,000 Less: prior year gross income - Gross annual income “P _ 500,000 2nd Year 40,000,000 55% "22,000,000, 21,000,000 "> 1,000,000 500,000 3rd Year "P40,000,000° 80% "P32,000,000° 30,000,000 "P 2,000,000 1,000,000 4th Year ‘40,000,000 100% ‘40,000,000 36,000,000 — P 4,000,000 2,000,000 P 2,000,000 The income under the percentage of completion method is recognized as the work on the project progresses. Accordingly, an income of 500,000 was recognized on the first year with 30% completion stage and so on until the completion of, the project. Regardless of the method used in a long-term construction project, however, the total amounts of gross income recognized will be the same.