The Accruals Method

[Mike]

Hi Folks,

This is a recent discussion I'm having on another forum. My knowledge can't take me any further so I'm hoping to be shown the light by some good samaritan on this forum. I think the main issue is whether tax can be deferred by reducing the gross profit in the financial year by offsetting the costs of property not yet sold against other property sales. What happens when a property is purchased in one year but sold in the following year? I thought the costs must be claimed in the year that they were incurred. How does the accruals method work in this instance? Thanks in advance for your help.

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Mike

Can you be clever with property trading to defer your tax payments? For example:

You buy and sell five houses and your net profit is £50K can you before the end of the tax year invest the £50K net profit in another house that you are refurbishing and therefore have no trading profit for that year and pay zero corporation tax?

Regards, Andy

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Yes. Property bought to refurb and onsell would be considered as trading stock. Every year the trading stock gross profit must be calculated. At the beginning of the financial year you may have a refurb in progress. The cost price of that stock is the value of the opening stock on hand. Example: £100,000. After refurb let'e say you sell for £150,000. Your gross profit is £50,000. You do this again with same results so your gross total profit is £100,000. End of financial year is looming so you purchase third property for £100,000. You don't sell so the cost of your closing stock on hand is £100,000. In total your sales receipts amounted to £300,000. Your costs for the year also amount to £300,000. Therefore your gross profit is zero.

Let me add that you don't necessarily have to buy a property to minimize the gross profit. You can also purchase materials to use in the next refurb.

Regards, Mike

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Mike, I find your illustration confusing because you have ignored the accruals concept ie when you sell a property you can only offset the costs relating to that property. In your example you have allocated costs of 3 properties against the sales revenue of 2 properties. Im sure the tax authorities would disallow this practice. In other words your costs from property 3 would be disallowed.

Felicity

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Hi Felicity,

I was going to comment further on my example because in year two there would be no costs to offset the first property sale because that property's costs were used in the preceding year. So what seemed like an advantage in year one becomes a problem in year two - a larger gross profit to be taxed.

Thanks for bringing the accruals method to my attention. I believe it is the accepted method of accounting for trading income. However, there is a big difference between a supplier of widgets making a delivery to a store and a property trader undertaking a refurbishment. In the case of the supplier, the widgets are sold although receipt of payment may be sometime later. In the case of a trader, who knows how long the refurb will take and what price it will sell for?

Now, in the case of the widget supplier, since the sale price is already known, the supplier must return that income as though it was received in the same year the expenses occurred. That is the critical point, the expenses must be declared in the same year that they were incurred. You are suggesting to offset the costs in the following year when the property is sold because you say the costs must be offset against the property to which the costs relate to. I think we need to get some expert advice on this one.

Most accountants, I'm sure would do what you suggest as long as the costs don't necessarily have to be offset in the same year they were incurred. However, if the IR holds firm to the view that costs must be offset in the year they were incurred then my scenario in the previous post is still valid if somewhat problematic.

Regards, Mike

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[Lotana]

Hi Mike,

I am not an accountant so what I say is only my humble opinion. I don't think there is a benefit.

In Australia business accounting has to be done on accruals basis (you don't have any other alternatives). But please note that GST liability may be calculated on a cash basis if you elect so.

From an accounting textbook: “In accrual-basis accounting, income is realized in the accounting period in which it is earned (e.g., once contracted services are provided, grant provisions are met, etc.), regardless of when the cash from these fees and donations is received. Expenses are recorded as they are owed (e.g. when supplies are ordered, the printer finishes your brochure, employees actually perform the work, etc.), instead of when they are paid.”

For a property trading business this should mean that a contract exchange date, not a settlement date, should be used. So, based on the example from your post:

Stock on hand 1/7/2002 $100K
Stock sold 1/8/2002 amount $150K
P1 bought (exchanged) 1/9/2002 for $100
P1 sold 1/12/2002 for $150K
P2 bought (exchanged) 1/1/2003 for $100K
P2 sold 1/3/2003 for $150K
P3 bought (exchanged) 1/6/2003 for $100K, deposit $10K
----
P3 settled 15/7/2003

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Profit and loss:

Sales $450K

Opening Stock (on hand 1/7/2002) $100K
Purchases $300K
Closing Stock (on hand 30/6/2003) $100K
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Cost of sales
= (Opening Stock + Purchases - Closing Stock) = $300K

Profit / loss = Sales - Cost of sales = $150K

If you decided no to buy P3, your profit and loss would look like this:

Sales $450K

Opening Stock (on hand 1/7/2002) $100K
Purchases $200K
Closing Stock (on hand 30/6/2003) $0K
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Cost of sales
= (Opening Stock + Purchases - Closing Stock) = $300K

Profit / loss = Sales - Cost of sales = $150K

The figure is the same. The problem is that when you buy P3 it cannot be classified as an expense, its value is added to both sides of the equation. But the actual expenses, such as insurance, inspections, QA reports for P3 can be deducted in the current financial year.

Say cheese

Lotana

 

[Mike]

Thanks Lotana,

My confusion was with claiming costs and claiming expenses. The cost of the property ie $100,000 can only offset the sale of the property in the same year of the sale. However, the expenses to purchase the property can be claimed in the year they were incurred. Thanks heaps.

Regards, Mike

 

[Mike]

Hi Folks,

As some of you know I'm in the UK and I have been reliably informed that while the accrual method is applicable to property trading in Oz it is NOT applicable to property trading in the UK so Andy's example in my first post apparently does work in the UK.

Now I'm hoping to get some opinions as to whether people here see that as a great advantage or not. To my untrained eye it does indeed seem like a great advantage. It seems to me that you can keep reinvesting the profits to buy more stock and pay little tax as long as the profits are put straight into capital expenditure. If you can manage it you could have multiple renovations/conversions/developments going at the same time. At some point, however, there will be a tax reckoning. This strategy only defers the inevitable but it seems like a great way to eventually build a large buy to hold portfolio. What do you think?

Regards, Mike

 

[brains]

Isnt it referred to in the States as "deferred tax payment"
where if you keep rollong the profits from sold IPs into the purchase of new IPs, you dont pay CGT. It is paid when you stop buying IPs and actually take the profit .