Updated 3/27/13 to correct footnote
Discussion Memorandum #1
Net Operating Losses
The Dam Tubing Company has been in business for approximately 15 years operating a tubing business along the Guadalupe River near a local dam. By 2009, the business had been growing steadily was generating approximately $1,200,000 in sales and $180,000 of taxable income each year. The pattern changed in
2010
when, due to a two year drought, the company saw its taxable income reduced and then turn into a taxable loss in
2011
. In
2012
, because there was more rainfall, the company experienced something of a recovery resulting in taxable income for 2012. Unfortunately calendar year
2013
was another record dry year and the company experienced a large taxable loss due to the severity of the drought and to incurring certain extra drought-related safety measures the company implemented in that year. The pattern of taxable income and loss since prior to 2010 is shown below:
|
Year |
Taxable Income (Loss) |
|
Years Prior to 2010 |
$180,000 a year |
| 2010 |
$ 90,000 |
| 2011 |
($150,000) |
| 2012 |
$100,000 |
| 2013 |
($294,000) |
As company controller, you have already explained to Mr. Rite, the company’s owner and CEO, that the company will likely choose to carryback part of the 2013 loss to prior years to obtain a quick recovery of taxes previously paid the IRS. Besides any receivable from the IRS that may be recorded, Mr. Rite would like see no allowance recorded on any deferred tax asset that may be recognized related to any unused 2013 net operating loss (NOL) that is carried forward. He wants to see an improvement in the company’s financial position in preparation for borrowing funds to do additional maintenance on the tubing facilities due to damage caused by the rains in 2012 followed by drought in 2013. Mr. Rite has informed you that in his opinion it is not only probable but highly likely that the company will return to profitability soon allowing the company to fully use the NOL carryforward, especially since the weather forecasters are predicting El Niño conditions that are expected to result in periodic heavy rains for 2014.
The company has some excess property located near its tubing business currently used for storage that could be sold to generate approximately $40,000 of net gains. Assume the company would be able to treat the gains as ordinary income taxable at 30% for tax purposes should the property be sold. Although the company does not want to sell the property because it may need it to expand the business, the company would sell the property, if necessary, to avoid losing a tax benefit from the NOL’s.
The owner has asked you as the controller for The Dam Tubing Company, if you could do some research on whether the company will be able to show a tax benefit from the NOLs generated in 2013, either by routine loss carrybacks or carryforwards or through other means, if necessary. For the purposes of the analysis, at the end of 2013 the company has $15,000 of deferred tax liabilities (related to depreciation) classified as noncurrent liabilities and the currently enacted tax rate is 30% and is the same for all past and future years.
In preparation for further discussion of this issue, you should prepare a memo that:
(a) Explains the facts, i.e., describes the circumstances in which The Dam Tubing Company finds itself regarding the NOL.
(b) Explains the accounting guidance that applies to this situation. You should cite the appropriate paragraphs of the codification in your memo
and include the text of such paragraphs in the memo near where you are discussing how the guidance would be applied. Only include the relevant paragraphs, i.e., the codification guidance included should be relatively short. YOU MUST DISCUSS HOW THE CODIFICATION GUIDANCE SHOULD BE APPLIED TO THIS SITUATION TO RECEIVE FULL CREDIT.
(c) Provides your conclusion on whether and how much of a tax benefit the company will be able to recognize in 2013 from the NOL arising in 2013. The discussion should include
all possible sources of taxable income that could be used to recognize a tax benefit from
the NOL (taxable income in carryback years, future taxable income, etc., and discuss whether any valuation allowance is necessary for any deferred tax asset that may be recorded with respect to any NOL carryforward.
(d) In regard to (c) above please provide your estimate of the
amount of any receivable
due from the IRS arising from the loss in 2013 and the
amount of any deferred tax asset
that will be recorded in 2013 related to any unused operating loss carryforward and then give your
estimate of the amount of the valuation allowance
, if any, that will be required on that deferred tax asset based on the guidance in the FASB’s Accounting Standards Codification.
(e) Discuss whether Mr. Rite’s belief that it is likely that the company will soon return to profitability is sufficient to avoid setting up an allowance on a deferred tax asset related to NOL carryforwards or other tax-book differences?
The memo should be in plain English to the extent possible (except for quotes from the codification) since as company controller you will have to explain the situation and conclusions in the memo to the company’s owner and ultimately to the audit committee. The discussion memo should be from 2-5 pages long, exclusive of the citations from the FASB Accounting Standards Codification. You should be sure to give the section numbers for the Codification and to the extent you utilize other sources you should include footnotes referencing such sources, whether you use a direct quote or paraphrase.
PLEASE DRAFT THIS AS A MEMO AND NOT AS RESPONSES TO ITEMS A-E ABOVE.
For academic access to the FASB Codification database through the American Accounting Association, you may log in at the following website:
http://aaahq.org/ascLogin.cfm
using the following login information:
STUDENTS: User ID AAA51855
Password sJTh4TD
� The loss in 2011 was carried back to prior years with no remaining carryforward for that loss.
� Include the full code section number not just the paragraph number in referencing the paragraph.
Background
The members of the Board of Directors and the Audit Committee have asked me to conduct some research on an accounting issue regarding the presentation of certain cash flows in the statement of cash flows. The question relates to what is the appropriate classification of an advance payment that our company, Business Services, Inc, a management consulting firm, has received from a large customer for services to be purchased in the future under a long-term contract arrangement. We negotiated this advance payment arrangement with our largest customer because the customer is requiring us to devote a large amount of resources to providing future services to them and this would require us to ramp up our hiring to accommodate their service needs. As you are aware, we are considering how to best reflect in the cash flow statement this material customer advance received during the fourth quarter of this year. As we previously have discussed, some concerns have been raised regarding whether such a customer advance for future services should be treated as and operating or a financing cash flow under generally accepted accounting principles (“GAAP”).
The concerns are that because the contract is longer term (two years), the customer advance is not typical of the relatively the short-term advances one often sees from customers, that these advance cash flows are distant in time from when the services will be provided, and also that the advance bears interest. These aspects make the customer advance seem more like a company borrowing under a debt agreement, which would be classified as a financing transaction, than a cash flow collected from a customer in the ordinary course of business. Also, because it is material, there is some concern that treating the advance from the customer as an operating cash flow in the current period would distort the typical pattern of cash flows from customers in the cash flow statement, perhaps giving the impression that the company’s cash flows from customers are higher than they typically are on a recurring basis.
Research Results
Based on the research I have done it appears that the classification of the customer advance as operating appears to be an appropriate treatment under GAAP applicable to cash flows collected from the sales of a company’s product or services. I believe a key factor in the classification decision to treat the advance as an operating cash flow is that the advance in this case must be repaid in services rather than cash.
As defined in the FASB’s Accounting Standards Codification (ASC) glossary, operating activities include:
“all transactions and other events that are not defined as investing or financing activities. Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.”
Thus, operating cash flows is something of a residual category, including cash flows that are not appropriately classified in either of the other two classifications.
However, ASC paragraph 230-10-45-16(a) indicates that cash inflows from operating activities include:
Cash receipts from sales of goods or services, including receipts from collection or sales of accounts and both short-and long-term notes receivable from customers arising from those sales.
On the payments side, ASC paragraph 230-10-45-17(b) indicates that cash outflows from operating activities include”
Cash payments to acquire materials for manufacture or goods for resale, including principal payments on accounts and both short- and long-term notes payable to suppliers for those materials or goods.
While not included in the ASC and so not part of the authoritative literature, the Basis for Conclusions (“Basis”) of Statement of Financial Accounting Standards (SFAS) No. 95, which is the source of the codification guidance above, provides some insights into the FASB’s decisions regarding which cash flows from customers to include in operating cash flows, when they are not received at approximately the time of the sale. As discussed in paragraphs 93 through 95 of the Basis, the exposure draft for SFAS No. 95 rejected treating cash flows stemming from installment sales and purchases as operating under the view that only cash flows occurring “soon before or after” the time of sale or purchase should be operating cash flows. Under the Exposure Draft, “[s]ubsequent principal payments on the related notes would have been investing cash inflows or financing cash outflows.”
Commenters on the exposure draft felt that all cash flows related to the purchase or sale of inventory should be operating cash flows regardless of when they were received or paid. The Board ultimately agreed with those commenters and thus SFAS No. 95 provided that all cash collected from customers or paid to suppliers from the sale or purchase of inventory should be classified as operating cash flows.
While the paragraphs in the Basis above discuss purchases and sales of inventory, it seems to be a reasonable interpretation to extend the application of the guidance to a service company, whose primary operations are the sale or purchase of services. As cited above, ASC paragraph 230-10-45-16(a) actually indicates that cash receipts from sales of goods
or services
, including receipts from collection or sales of accounts and both short-and long-term notes receivable should be treated as operating. If the arrangement were an installment purchase of services, then the answer would appear clear, that is, the principal cash flows received on the installment notes would be treated as operating cash flows. In the company’s situation, the opposite is occurring, the cash flows are occurring in advance of the sale, but the services are not provided until sometime later.
Based on the authoritative guidance in the ASC and the further insights provided by the nonauthoritative guidance in the Basis for Conclusions, I believe that the accounting for advance payments would follow the same principles in the cash flow statement as deferred payments on installment sales. That is, a company that is in the business of selling services should treat cash inflows associated with the sale of services as operating cash inflows “regardless of when they were received or paid.”
The fact that the company received the cash payments for customer services in advance of delivery of the services is not relevant, if the cash payments are in fact payments in advance for services. The fact that the company is also required to pay interest on the advances is similar to installment receivables from the sale of inventory and services. In that case, the fact that the cash is collected years later and with interest does not change the cash flow categorization of the cash received on receivables arising from the sale of goods or services. By similar logic the cash received in advance, although repayable with interest at a later date, if in fact repayable in services and expected to be paid in services, should be treated as an operating cash flow.
In this regard, I believe that it is a very important part of the classification decision that our customer contract provides no alternative mechanism for repaying the advance except for the company’s providing the services required under the contract, except in an event of default on the contract. An event of default is defined as our company being unable to provide the required services to the customer under normal operating conditions. If the contract permitted us to repay the advance in cash or allowed the customer to demand cash absent a default by us, then I think that the classification of the advance as a financing cash flow may be more warranted.
While I believe the accounting guidance in the codification supports treating the customer advance as an operating cash flow, the guidance in the ASC does require another treatment for seller financing arrangements for purchases property, plant and equipment. The guidance cited below suggests that the separation in time of the cash flows from the transfer of the property, plant and equipment may lead to a financing cash flow presentation (rather than investing treatment in that case). ASC Paragraph
230-10-45-13(c)
states:
Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets, including interest capitalized as part of the cost of those assets. Generally, only advance payments, the down payment, or other amounts paid at the time of purchase or soon before or after purchase of property, plant, and equipment and other productive assets are investing cash outflows. However, incurring directly related debt to the seller is a financing transaction (see paragraphs
230-10-45-14 through 45-15
), and subsequent payments of principal on that debt thus are financing cash outflows.
These paragraphs appear to suggest that for purchases of property, plant and equipment (as opposed to inventory) the treatment from the purchaser’s standpoint for payments made after the purchase are financing. The seller financed portion of that transaction would not even appear in the cash flow statement of the purchaser as an investing transaction because it is a “noncash” portion of the investment, but the subsequent cash payments would be treated as financing. I believe that these paragraphs are not relevant to the company’s situation because they relate to transactions involving seller financing of a long-term asset not inventory or services. Also, the guidance provided appears to relate to a purchaser not a seller, the latter of which is what we are.
Summary and Conclusion
To summarize, based on the guidance in the ASC, my conclusion is that that the classification of the cash advance associated with the customer service contract as an operating cash flow is appropriate under GAAP, by analogy to installment sales arrangements for inventory sales. However, I think it is a key point that our customer contract provides no alternative repayment mechanisms, absent default by ourselves, to satisfying the contract, and hence repaying the advance, in services. While I believe this is the appropriate treatment under GAAP, I believe we should discuss this issue with our outside auditors prior to finalizing the decision on how to present these cash flows in the cash flows statement. I look forward to discussing this issue with you further.
1
