Heads I Win Tails You Lose

Lehman Brothers tax expert Robert Willens explains the tax accounting conventions for reporting of income.
Robert WillensJuly 24, 2001

Although the overriding goal of financial accounting is to properly match expenses with the revenues of the period to which such expenses relate, the objectives of tax accounting are markedly different.

With respect to advance payments, such receipts are almost always recorded as income in the period in which the payments are received, even though for financial accounting purposes such payments, where they relate to inventory, are deferred and reported as a reduction in the cost of goods sold in the period the inventory is disposed of.

These principles were recently on display in a case entitled Westpac Pacific Foods v. Commissioner. There, a taxpayer entered into an agreement with GTE Sylvania, which had the effect of making the latter the taxpayer’s exclusive supplier of lamps.

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Pursuant to the agreement, the taxpayer committed itself to purchase some $17 million worth of lamps during the term of such agreement. In turn, GTE Sylvania agreed to pay the taxpayer some $1.1 million and, in addition, $200,000 annually, provided that the taxpayer established an “adequate” warehouse distribution arrangement.

For accounting purposes, the advance payment was “set up” as a liability, a “deferred credit,” and was taken into account as a reduction in the cost of inventory purchased at the time such inventory was purchased. Moreover, the agreement provided that upon its termination the taxpayer was required to reimburse GTE Sylvania for any “unearned” payments and, in fact, at the time the agreement concluded, the taxpayer repaid approximately $800,000.

Deferred credit treatment of advance payments is, practically, unheard of in the world of tax accounting. Under the accrual method of tax accounting, income is included when all events have occurred which fix the right to receive such income and the amount thereof has been determined with reasonable certainty. For this purpose, the right to receive income becomes fixed at the date the payment is made.

Accordingly, the taxpayer was required to record the advance payment as income, upon its receipt, unless it was able to convince the court that the “discount” was, properly, a cost of inventory. The court rejected this claim.

While it is true that inventory cost includes the net amount paid for inventory, including discounts, the court concluded that the discount to which the regulations refer is that variety of discount that “arises contemporaneously” with the purchase of goods. The term does not include–in the court’s judgment–payments that the seller pays in exchange for an agreement—like the one at issue here—to purchase goods in the “indefinite future.”

Accordingly, these discounts–or as they were termed in the agreement Advance Payment Allowances–were not properly a part of the cost of inventory. Further, the court made short shrift of the taxpayer’s argument that accrual was improper because of the agreement’s repayment obligation which, as indicated, was honored.

The court concluded, based on well-established precedent, that contingent repayment obligations do not operate to defer the reporting of income. (See, in this regard, Jelle v. Commissioner.)

Accordingly, the taxpayer was required to account for these advance payments in a different manner for tax purposes versus “book” purposes; another example of how the matching principle is virtually unknown in the field of tax accounting, except, perhaps, when it comes to recording expenses. In those cases, it is frequently the case that outlays must be deferred (not expensed) in instances where the expenditure creates or enhances a separate and distinct additional asset or, more broadly, produces a benefit that extends beyond the close of the year in which the expenditure takes place.

Thus, at the end of the day, tax accounting accelerates income and, frequently, defers expenses giving it, we suppose, a “heads I win tails you lose” quality.

Robert Willens is a Managing Director and Tax & Accounting Analyst at Lehman Brothers.

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