DEFINING INCOMEFor tax purposes, corporate income is defined as revenue minus expenses. The problems arise in measuring these two elements. The most dramatic instance of this difficulty concerns depreciation of assets. If a corporation buys a computer for $1 million, it is entitled to eventually charge off this cost as a deductible expense when computing taxable income. On 46 per cent rate, this represents an eventual tax saving of $460, 000. The sooner the cost can be written off, the greater the benefit to the company. For the purposes of reporting corporate income to the IRS, assets are grouped into three broad classes. Automobiles and research equipment are considered three-year property most business equipment is considered five-year property, buildings are usually considered as fifteen-year property. Another vexing problem associated with the measurement of corporate income concerns the cost of inventory sold during the year. This arises when prices are changing fairly rapidly and a company holds inventory for long periods. To take a fairly simple case, imagine a retailer of sailboats. At the start of the year he has 100 in stock, all purchased for $10, 000 each. During the year he takes delivery of 100 more but must pay $11, 000 each, ending with 90 in stock. The boats are sold for $15, 000 each. What was his income? The question concerns the relevant cost of the 110 boats that were sold and of the 90 that remain. The firm may have sold all the 'old' boats first (the LIFO method), or all the 'new' boats (the FIFO method), or a mixture of the two(the average-cost method). An accountant may assume any of the above combinations without regard to the actual facts of the situation. Let’s discuss the influence of the impact of different inventory valuation methods on the company’s decision making. When prices have been rising, the LIFO method will permit a corporation to charge more to cost in the present and less in the future. This will lower taxes in the present and raise them in the future. However, before 1970 many companies used the FIFO method, suggesting that in times of moderate inflation many managers were willing to sacrifice some real benefits to improve the appearance of their company's financial statements.
Vocabulary
Exercise 3
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