Interest received in advance: Company A received $300,000 in advance. The interest is taxed because tax regulators recognize interest to accrue to the company (part of taxable income) on date of receipt.
The book asks us to determine the carrying amount and tax base. I had initially thought the carrying amount = $300,000 (which it does) and that the tax base = $300,000 (it actually is $0) but I’m not 100% sure as to why.
The book goes on to say that interest is deemed to accrue to the company on the date of receipt, and that it must be included in taxable income in the financial year it is received. If that is the case, why isn’t the tax base $300,000? The book also says that it was not included on the IS because the income relates to a future financial year. That seems contradictory to the question, which says that the interest is taxed when received. Finally, it states that because the full $300,000 is included in taxable income in the current fiscal year, the tax base = $300,000 - $300,000. I’m totally lost. Any help would be much appreciated. Thank you.
P.S. one more thing. The book states that the tax base of a liability = the carrying amount - the amount that will be deducted for tax purposes in the future while the tax base of revenue received in advance = the carrying amount - the amount that will NOT be taxed in the future. I’m not sure how that makes sense.
Accounting can be a bit confusing when you’re differentiating between accounting for book purposes (read: financial statements) and tax accounting. They’re two separate beasts.
Normally, a company would make the following journal entries when it’s accruing interest income for book purposes:
Accrued interest receivable (debit); Interest income (credit) - to accrue interest as it’s earned.
Cash (debit); Accrued interest receivable (credit) - to record receipt of accrued interest receivable.
In your example, the company received interest in advance - that is, before it was accrued (earned), so it would make the following journal entries:
Cash (debit); Unearned revenue (credit) - to record interest received in advance. Note that Unearned revenue is a liability account, not an income account.
Unearned revenue (debit); interest income (credit) - to recognize interest income as it is earned.
For book accounting purposes, no interest has been earned; hence the use of the unearned revenue account in entry 1. The interest received in advance hits the balance sheet (cash = asset; unearned revenue = liability). It won’t hit the income statement until it is earned and recorded with entry 2.
Use of the unearned revenue account gives rise to a deferred tax asset - which you’ll get to soon.
You answered your own question regarding the tax basis of the revenue received in advance = carrying amount (300,000) - amount that will not be taxed in the future (300,000)(because it’s all getting taxed now) = 0.