Silver Appliance Company operated a large retail appliance store in San Diego. The store sold all sorts of household appliances, plus auto and home sound equipment. The company’s owner, Brian Silver (known by his customers as "Big Brian" because of his rather ample proportions), had for many years been an extremely productive salesman in a San Diego store of the Highland appliance chain. Having built up a large personal clientele during those years, Mr. Silver felt he could easily shift customers to a new store, were he to open one. In 1986, he did just that, and the store had rapidly achieved an annual sales volume of over $5 million.
In 1989 Mr. Silver decided he could increase the volume, plus earn interest revenue, if he established an installment credit program to assist customers in financing their major purchases. The program was a success, with the amount of installment receivables growing in each successive year (except for 1993).
In early 1994 Mr. Silver decided the firm had outgrown its sole-practitioner accounting firm. He therefore retained a national public accounting firm to provide Silver Appliance with various auditing, tax, and consulting services. The accounting firm’s partner assigned to the Silver account was Suzi Chung. After reviewing Silver’s accounting practices, Ms. Chung met with Mr. Silver to review these practices. Of particular interest to Ms. Chung was the fact that Silver used the typical sale method (formally, the “delivery method”) to recognize sales— and hence cost of sales and gross margin—on all sales, irrespective of whether the sales were for cash, were charged to a Visa or Mastercard account, or were financed on Silver’s installment credit plan. Although she felt this made good sense for preparing income statements for Mr. Silver’s use, Ms. Chung pointed out that the federal income tax laws permit the use of the installment method of revenue and gross margin recognition on installment plan sales.
With the installment method, a retailer recognizes revenues as installment payments are made and then applies the store’s normal gross margin percentage to them to determine the gross margin for tax purposes. For example, suppose a customer bought a $700 refrigerator having a cost of $490; then the gross margin percentage is 30 percent ($210÷$700). If the customer’s first installment payment were $50 (ignoring interest), the store would at that time recognize $15 (30% * $50) gross margin for tax purposes 1. The effect of using this method for calculating taxable income is that it delays, relative to the delivery basis, the reporting of gross margin, and hence defers the taxes on that margin until the margin is realized through the customer’s cash installment payments.
After Ms. Chung’s explanation of the installment method, Mr. Silver expressed a definite interest in changing to this method for tax purposes.
However, I want to keep using the regular basis for our monthly and annual income statements because I really feel we earn the margin when the customer signs the installment agreement and we deliver the . . .
Assignment
- If Silver Appliance Company had used the installment method for tax purposes in the years 1989-93, how different would its tax payments have been in each of those years? What would the year-end balance in deferred taxes have been in each of those years? (Round calculations to the nearest $10.)
- How would you respond to Mr. Silver’s questions concerning (a) interpretation of the amount of deferred taxes, (b) tax payments in a period of declining sales, and (c) double taxation of installment sales made in 1993?
1 The formal accounting treatment is to recognize $50 of revenues, match with that $35 cost of goods sold, and thus recognize $15 gross margin