The indirect method uses net income as a starting point, then makes adjustments for all transactions for non-cash items.

SUNK COSTS

In managerial accounting sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree. A traditional understanding is that sunk costs are allocated as what are known as ‘fixed’ costs and then are added to variable cost to obtain total cost, in the long and short runs.

Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action. Economics proposes that a rational actor does not let sunk costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own merits. It is important to note that the decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

For example, when one pre-orders a non-refundable movie ticket, the price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back the money he originally paid.

The sunk cost is distinct from the economic loss. For example, when a car is purchased, it can subsequently be resold; however, it will certainly not be resold for the original purchase price. The economic loss is the difference. The sum originally paid should not affect any rational future decision-making about the car, regardless of the resale value: if the owner can derive more value from selling the car than not selling it, it should be sold, regardless of the price paid. In this sense, the sunk cost is not a precise quantity, but an economic term for a sum paid, in the past, which should no longer be relevant; it may be used inconsistently in quantitative terms as the original cost or the expected economic loss. It may also be used as shorthand for an error in analysis due to the sunk cost fallacy, non-rational decision-making or, most simply, as irrelevant data.

Economists argue that sunk costs are not taken into account when making rational decisions. In the case of the movie ticket, the ticket buyer can choose between the following two end results:

1. Having paid the price of the ticket and having suffered watching a movie that he does not want to see, or;

2. Having paid the price of the ticket and having used the time to do something more fun.

In either case, the ticket-buyer has "paid the price of the ticket" so that part of the decision should cancelitself out. If the ticket-buyer regrets buying the ticket, the current decision should be based on whether he wants to see the movie at all, regardless of the price, just as if he were to go to a free movie. The economist will suggest that since the second option involves suffering in only one way (spent money), while the first involves suffering in two (spent money plus wasted time), option two is obviously preferable.

Sunk costs may cause cost overran. In business, an example of sunk costs may be investment into a factory or research that now has a lower value or no value whatsoever.

The idea of sunk costs is often employed when analyzing business decisions. A common example of a sunk cost for a business is the promotion of a brand name. This type of marketing incurs costs that cannot normally be recovered. It is not typically possible to later "demote" one's brand names in exchange for cash (except perhaps as an exit strategy from a market). Decisions about future investments, sales or more advertising should be made based on future possibilities, not biased by the recent large investment in the advertising that the company made last year (or even last week).

INCOME TAX

Tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state.

An income tax is a tax levied on the financial income of persons, corporations, or other legal entities. Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income tax, or corporation tax. Individual income taxes often tax the total income of the individual (with some deductions permitted), while corporate income taxes often tax net income (the difference between gross receipts, expenses, and additional write-offs).

The "tax net" refers to the types of payment that are taxed, which included personal earnings (wages), capital gains, and business income. The rates for different types of income may vary and some may not be taxed at all. Capital gains may be taxed when realized (e.g. when shares are sold) or when incurred (e.g. when shares appreciate in value). Business income may only be taxed if it is significant or based on the manner in which it is paid. Some types of income, such as interest on bank savings, may be considered as personal earnings (similar to wages) or as a realized property gain (similar to selling shares). In some tax systems, personal earnings may be strictly defined where labour, skill, or investment is required (e.g. wages); in others, they may be defined broadly to include windfalls (e.g. gambling wins).

Personal income tax is often collected on a pay-as-you-earn basis, with small corrections made soon after the end of the tax year. These corrections take one of two forms: payments to the government, for taxpayers who have not paid enough during the tax year; and tax refunds from the government for those who have overpaid. Income tax systems will often have deductions available that lessen the total tax liability by reducing total taxable income. They may allow losses from one type of income to be counted against another.

For example, a loss on the stock market may be deducted against taxes paid on wages. Other tax systems may isolate the loss, such that business losses can only be deducted against business tax by carrying forward the loss to later tax years.