Economic performance

There are a few special rules that have been formulated with regards to handling advance payments regarding agreement for future sales. Under normal considerations the payments are recorded when they are received but this is not so in this alternative system. Under the alternate system the advance payments in earlier years and the recordings include payments in gross receipt according to the rules of the method used. Furthermore, it is advisable to record the advance payments in the years that any part of the advance payments has been included.

Under the accrual system expense are reported when liability has been fixed, the amount involved has been determined clearly and economic performance has occurred. If expense is incurred in receiving a service, economic performance is considered to have been incurred when the service is provided. When property has been delivered, economic performance is said to have been incurred (Pratt & Niculita 102 ). For expenses that are related to interest, the passage of time marks economic performance. In areas of compensation of services, economic performance is said to have occurred when the contractors are rendering their services.

Moreover, under the accrual system expenses are only deductible in the years they apply though they can still be charged on the years they are paid if the benefits they generate are applicable for a time of over one year. If business expenses or interest are owed to persons related as per the definition of related in income tax, and the related person handles his finances on a cash basis, the expenses are only deducted when they are paid and must be included in the related persons gross gains (Pratt & Niculita 21 ).

Related persons as per the definition for income tax purposes include the following: Family members or all those in the same lineal descent Professional service relations regardless of the amount of stake involved in the relationship. Individuals and corporation relationship is where the individual owns over half of the corporation's stock either directly or indirectly. Two S corporations are considered to be related if one person owns more than half of the stake in each.

A corporations and a partnership are defined to be related if over 50% of the stake in each case is owned by one person. In case of contested liability, when the accrual method is being used, the expenses can either be deducted in the years that it is paid or when the contest is settled. For the expense to be deducted when it is paid the following conditions must be met: Liability must have been contested. The contest liability must be in existence after payment has been transferred.

Property or money must be transferred to pay for the liability. The nature of the liability should be deductible even if it were not contested. Economic performance should have occurred. Income tax rules allow for the application of both cash and accrual methods provided that the method brings out a clear reflection of the income and is used in a consistent manner. Consistency is also required and the hybrid method if adopted should be used continuously and in all the financial transactions.

However, this is in theory since practical application is impossible as the tax rules require that the same method be used for revenues and expenses. Liability recorded on the balance sheet is a result of income that has already been earned and is recognized by accounting principles but not taxation authorities. Differences in the taxations principles and accounting principles may result in differences in the amount of income tax that an entity is expected to return. The differences due to the varied application of these two principles is referred to as deferred income tax.

In other words a deferred income tax is realized when income has been generated though the tax on that income is yet to be experienced. The deferred tax has to be paid either way and if they are not paid in the current year due to differential tax laws the company will be forced to pay in the next years. The main cause of the difference is that the GAAP calculate income tax expenses before taxes and this result is displayed in the income tax statement whereas the tax return results are calculated on the basis of the taxable income (Pratt & Niculita 43 ).