The Concorde Theatre Ltd., a local company owned by J. Bleet, operates a small neigh-bourhood cinema. The business is usually profitable, but this year, because of unusual events, a net loss has occurred. The income statement for the year ended December 31, 20X1, is summarized in the table below.
The company does not usually invest in real estate. The land and building that was sold for a gain of $70,000 was acquired seven months before its sale. An acquaintance of Bleet who ran into some serious financial difficulties required immediate cash to stop bankruptcy proceedings and asked Bleet to purchase his real estate. Bleet had no money to invest in real estate and was not in the market for such an investment.
However, the acquaintance pleaded with Bleet to help him out and kept reducing the purchase price to provoke an immediate cash sale. Bleet, watching the price drop to below what he felt was the fair market value, finally gave in. Concorde Theatre borrowed 100% of the purchase price and bought the property. The loan from the bank was payable on demand.
Sales ………………………………………….. $ 600,000
Cost of sales ……………………………… 400,000
Gross profit………………………… 200,000
Operating expenses ……………………… 170,000
Operating income……………………. 30,000
Other:
Gain on sale of land and building………… 70,000
Loss on sale of land…………………. (110,000)
Net loss …………………. $ (10,000)
Four months later, the company received an offer from a local real estate investor to buy the property for $65,000 above the original purchase price. The same day, the original owner, who had improved his financial situation, asked if he could buy the property back. He was upset when Bleet agreed only if the price was $70,000 above the original price. Reluctantly, the acquaintance agreed to pay that much, provided that the closing date was delayed to three months hence.
The land, the sale of which resulted in an $110,000 loss, had been purchased three years earlier. The land was across the road from the theatre, and Bleet had intended to turn it into a parking lot for theatre patrons. However, because of the traffic patterns on the street, the city refused to grant vehicle access for the property. After a long battle, Bleet gave up and posted the land for sale. After six months without an offer, he finally accepted a reduced price to free up needed cash.
Bleet has just met with his accountant, who has informed him that the company will have to pay income tax of $25,000 for the year ended December 31, 20X1. Bleet knows that the corporate tax rate is 25% on income but cannot believe that a tax of $25,000 is payable on a net loss of $10,000.
Bleet asks his accountant to explain how such a result is possible and asks whether there is any possibility of a more logical result.
Required:
As the accountant, outline your response to Bleet.