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 companys 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 2003, he did just that, and the store had rapidly achieved an annual sales volume of over $5 million.

In 2006 Mr. Silver decided he could increase the stores 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 2010).

In early 2011 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 firms partner assigned to the Silver account was Suzi Chung. After reviewing Silvers 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 salesand hence cost of sales and gross marginon all sales, irrespective of whether the sales were for cash, were charged to a Visa or MasterCard account, or were financed on Silvers installment credit plan. Although she felt this made good sense and was in accord with GAAP for preparing income statements for Mr. Silvers 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, the retailer recognizes revenues as installment payments are made and then applies the stores normal gross margin percentage to these payments 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 customers 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 customers cash installment payments.

After Ms. Chungs explanation of the installment method, Mr. Silver expressed a definite interest in changing to this method for tax purposes. However, he said, 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 appliances. But before we change, Id like to see how much weve been overpaying in taxes the past few years by not using the installment method. To address this question, Ms. Chung gathered the data shown in Exhibit 1.

EXHIBIT 1: Installment Sales Data (thousands of dollars)

Notes:

1. All installment sales contracts were for periods of one year or less.

2. The companys effective federal income tax rate in each year was approximately 34 percent.

Mr. Silver raised several other questions with Ms. Chung. I understand in general the impact that this method would have on our tax payments; but its not clear to me what the impact would be on our balance sheet, given that I dont want to change methods on our income statement. Ive seen an item called deferred taxes on balance sheets in the annual reports of some companies that I own stock in. I know this is somehow related to using different accounting for shareholder and income tax reporting. Would we have such an account if we make this change? If so, you will have to explain to me how I should interpret the balance in that account.

Also, I have a friend who owns an architectural firm that reports on the cash basis for tax purposes. She was telling me the other day that her billings have really dropped this year because of the downturn of local construction activity, and yet she is still having to make tax payments as big as last years. Could this happen to us if we change our method for reporting installment sales for tax purposes?

Finally, it occurs to me that we have already paid taxes on the installment sales profits we recognized in 2010, even though many of those sales have not yet been collected. If we change methods for 2011, are we going to end up paying taxes twice on those uncollected 2010 installment salesonce in 2010 and again in 2011?

Questions

1. If Silver Appliance Company had used the installment method for tax purposes in the years 20062010, 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.)

2. How would you respond to Mr. Silvers 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 2010?

2008 $526.2 478.2 2009 $559.4 492.5 2007 2010 Installment receivables as of December 31 Pretax profit as reported Gross margin percentage 2006 $190.1 332.6 $351.9 415.3 $489.1 461.3 34.6% 35.1% 34.2% 33.4% 32.2%