4.43.1  Retail Industry (Cont. 1)

4.43.1.3 
General Accounting

4.43.1.3.6  (07-23-2009)
Vendor Allowances

  1. Retailers receive allowances from vendors through a variety of programs and arrangements. Vendor allowances are generally intended to offset the retailer’s costs of selling the vendors’ products in its stores. These allowances can be grouped into the following broad categories: buying allowances and promotional allowances.

  2. Most vendor allowances are accounted for as a reduction of the cost of the merchandise inventory and recorded at the time the allowances are earned. The allowances are generally recognized as a reduction in cost of goods sold at the time the related inventory is sold.

  3. Some vendor allowances are accounted for as other income or as a reduction to a particular expense at the time the retailer incurs the expense eligible for reimbursement. For example, a retailer may record the receipt of a cooperative advertising allowance for a qualifying advertising or similar promotional expense as a credit to advertising expense.

  4. An examiner's primary focus should be the tax treatment given to promotional allowances.

  5. See also IRM 4.43.1.8 for further information on vendor allowances.

4.43.1.3.7  (07-23-2009)
Tangible Property

  1. Property owned by retailers generally consists of stores, warehouses, distribution and fulfillment centers, and corporate offices. For most retailers, stores are owned outright, leased, or operated under arrangements where the retailer owns the building and leases the land. The tangible property generally consists of land, buildings, leasehold improvements and furniture, fixtures, and equipment (FF&E).

  2. Tangible property owned by retailers is stated at cost less accumulated depreciation.

  3. For financial reporting purposes, depreciation is generally recorded using the straight-line method and, in certain circumstances, accelerated methods over the shorter of estimated asset lives or related lease terms.

  4. For financial reporting purposes, retailers review long-lived assets for indicators of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

    1. The evaluation is performed at the lowest level of identifiable cash flows, which is typically at the individual store level.

    2. A retailer’s review of factors present and the resulting appropriate carrying value of long-lived assets are subject to judgments and estimates that the retailer is required to make.

  5. An examiner's primary focus is with the classification assigned units of property and the resulting cost recovery.

  6. See also IRM 4.43.1.9 for further information on tangible property.

4.43.1.3.8  (07-23-2009)
Goodwill and Other Intangible Property

  1. Intangible property owned by retailers generally consists of goodwill, trademarks, trade names, package design and software (purchased and developed).

  2. Intangible property owned by retailers is stated at cost less accumulated amortization. Intangible property identified as "amortizable IRC 197 intangibles" are amortized over 15 years. Other acquired intangible assets are amortized under IRC 167 on a straight-line basis over the periods during which the particular asset may reasonably be expected to be useful to the taxpayer in its business.

  3. For financial reporting purposes, goodwill and other intangibles with indefinite lives that are not amortized are evaluated for impairment annually or more frequently when triggering events or changes in circumstances occur. Important factors, which can trigger impairment, include significant:

    1. Under-performance relative to historical or projected operating results

    2. Changes in the use of the acquired assets or the overall business strategy

    3. Negative industry or economic trends

    4. Decline in stock value for a sustained period

  4. For financial reporting purposes, retailers review intangibles for indicators of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

    1. If a potential impairment is identified, the amount of the impairment loss recognized would be determined by estimating the fair value of the assets and recording a loss if the fair value was less than the book value.

    2. Fair value will be determined based on appraisal values assessed by third parties, if deemed necessary, or a discounted future cash flows analysis.

    3. A retailer’s review of factors present and the resulting appropriate carrying value of goodwill and other intangibles are subject to judgment and estimates.

  5. An examiner's primary focus is the classification assigned to units of property and the resulting cost recovery.

  6. See IRM 4.43.1.10 for further information on intangible property.

4.43.1.3.9  (07-23-2009)
Lease Accounting

  1. The retail industry is an asset-intensive business. Retailers may own and/or lease the property needed to operate in the normal course of business.

  2. Retailers often finance their property by operating leases. More frequently than other industries, retailers make leasehold improvements on top of leased property. This practice is not as common in other industries.

  3. Retailers generally estimate the expected term of a lease by assuming the exercise of renewal options where an economic penalty exists that would preclude the abandonment of the lease at the end of the initial non-cancelable term and the exercise of such renewal is at the sole discretion of the retailer. This expected term is used in the determination of whether a store lease is a capital or operating lease and in the calculation of straight-line rent expense.

  4. Rent abatements (i.e. holidays) and escalations are considered in calculating straight-line rent expense for operating leases. Consequently, rent expense is recognized for financial reporting purposes at the earlier of the first rent payment or the date of possession of the leased property. The difference between the amounts charged to rent expense and the rent paid is recorded as deferred lease incentive and amortized over the lease term.

  5. As part of certain lease agreements, retailers receive construction allowances from landlords. A construction allowance is used to defray the cost of constructing a store the retailer intends to operate. Historically, for financial accounting purposes, retailers recorded construction allowances as a reduction to the cost of the leasehold improvements and depreciated the credits over the useful life of the leasehold improvements. Due to SEC guidance issued in 2005, retailers now record construction allowances as a deferred liability and amortize the allowances on a straight-line basis over the life of the lease as a reduction to rent expense.

  6. For financial accounting purposes, the useful life of leasehold improvements is generally limited by the expected lease term. If significant expenditures are made for leasehold improvements late in the expected term of a lease, judgment is applied to determine if the leasehold improvements have a useful life that extends beyond the original expected lease term or if the leasehold improvements have a useful life that is bound by the end of the original expected lease term.

  7. See IRM 4.43.1.11 for further information on leases.

4.43.1.3.10  (07-23-2009)
Liabilities and Reserves

  1. Retailers regularly set up reserves to cover contingent liabilities that arise in the ordinary course of business.

  2. Retailers generally accrue for estimated sales returns and allowances. The estimate may take into consideration the retailer’s historical experience, current sales trends and other factors in the period in which the related products are sold.

  3. Retailers regularly establish reserves for self-insured liabilities such as worker's compensation and general liability risks. These estimates may be based on the results of an independent study and may consider historical claim frequency and severity as well as changes in factors such as its business environment, benefit levels, medical costs, and the regulatory environment.

  4. See IRM 4.43.1.12 for further information on liabilities and reserves.

4.43.1.3.11  (07-23-2009)
Advertising

  1. Advertising costs are expensed as incurred (i.e., under the all events test). Advertising costs consist primarily of print costs, point of sale advertising and marketing promotions.

  2. Direct response advertising costs, which may consist of catalog production and postage costs, are generally deferred and amortized over the period of expected direct marketing revenue. This period is typically less than one year.

  3. Costs associated with the production of television advertising may be expensed over the life of the campaign.

  4. Advertising costs are net of cooperative advertisement allowances.

4.43.1.3.12  (07-23-2009)
New Store Opening

  1. The opening of new stores is dependent upon, among other things, the availability of desirable locations, the negotiation of acceptable lease terms and general economic and business conditions affecting consumer spending in areas targeted for expansion.

  2. Generally, no deduction is permitted for the cost of start-up activities, including organizational costs and store openings. However, a taxpayer may elect to deduct start-up expenditures incurred after October 22, 2004, in the year in which the active trade or business to which the expenditures relates begins. The amount that may be deducted in that year is the lesser of the amount of the start-up expenditures or $5,000, reduced (but not below zero) by the amount by which the start-up expenditures exceed $50,000. Any start-up expenditures that are not deductible may be deducted by the taxpayer ratably over the 180-month period beginning with the month in which the active trade or business begins. All start-up expenditures incurred by the taxpayer that relate to the active trade or business are considered in determining whether the start-up expenditures exceed $50,000.

  3. For start-up expenditures incurred on or before October 22, 2004, a taxpayer may only elect to amortize these expenditures over a period determined by the taxpayer that is at least 60 months.

  4. For start-up expenditures paid or incurred after September 8, 2008, a taxpayer is deemed to make an election under IRC 195 to deduct start-up expenditures for the taxable year in which the active trade or business to which the expenditures relates begins. Therefore, a taxpayer is no longer required to attach a statement to the return or specifically identify the deducted amount as start-up expenditures for the IRC 195 election to be effective. A taxpayer may choose to forego the deemed election by clearly electing to capitalize its start-up expenditures on a timely filed Federal income tax return (including extensions) for the taxable year in which the active trade or business begins.

4.43.1.3.13  (07-23-2009)
Accounting Records

  1. Accounting records maintained by most retailers include the basic journals and ledgers of any business. In addition, there are a number of different record systems maintained by retailers which deal exclusively with the acquisition, level, and disposition of inventory. Larger retailers should also have records detailing their compliance with the uniform capitalization requirements.

  2. IRC 7602 empowers the examiner to review any books, records, papers, records, or other data which may be relevant to determining a taxpayer’s tax liability.

  3. The IRS has generally exercised restraint in requesting tax accrual workpapers (TAW) and other audit workpapers. The examiner may request tax accrual workpapers and other audit workpapers in certain limited situations. See IRM 4.10.20. For technical questions for TAW, contact the TAW technical advisor team.

  4. This section describes many of the records maintained by retailers, although the names, format and content of these records may vary.

4.43.1.3.13.1  (07-23-2009)
General Records Maintenance

  1. A retailer should maintain the basic records required of any business. A number of these records are briefly described below.

  2. Year-End Trial Balance

    1. The taxpayer's year-end trial balance shows each general ledger account and its year-end balance. The content of this record will usually include the prior year's balance and sometimes the budgeted balance.

    2. A comparative trial balance including the current and several prior years will assist the examiner in identifying accounts which are unusual in nature or amount.

    3. In conjunction with the trial balance, the examiner should request adjusting and reclassifying entries including explanations, and the number of the income tax return line onto which each account was entered.

  3. Monthly Detailed Trial Balances

    1. The activity within any general ledger account can be analyzed by reviewing the monthly detailed trial balance or equivalent, which should show the detail of all entries made to each general ledger account

    2. The detail should identify the source journal and document number for each general journal entry. A limited description of the entry may also be included.

  4. If the detail is voluminous and computerized information is available, consideration should be given to using a Computer Audit Specialist (a CAS). The CAS can assist in obtaining:

    1. The monthly net activity of each account, with sub-totals by source of entry.

    2. The monthly total debit and credit entries for each account, showing the number of entries. The monthly totals should be scanned for accounts which contain entries which are abnormal in size or source. Unusual contra-entries or year-end entries can quickly be identified. The total year's activity detailed chronologically by entry, stratified by dollar amount and/or entry type.

    3. The details of all transactions over a certain dollar limit, or of every nth transaction.

    4. Statistical samples.

  5. General Ledger

    1. Some retailers include details of all entries in the general ledger, in effect combining ledger and journal into one document. Others show only net debits and credits for each month, with the specifics recorded elsewhere. Review of the ledger can provide a quick overview of the activity of the account during the year.

  6. General Journal

    1. Entries can include routine monthly accruals, standard journal entries, (computations made the same way each month on standardized journal entry forms), reversals, correcting entries, etc. Not all of these entries will necessarily flow through to the tax return.

    2. In many cases the transaction numbering system used will indicate the source and type of each entry. There will generally be a brief explanation of the entry shown in the journal.

    3. Taxpayers on computerized systems may use a combination general ledger/general journal.

  7. Accounts Payable Ledger

    1. This document has historically been very useful to agents during the examination of retail taxpayers. Most of the ledger entries reflect either the establishment of a payable for a future payment or the elimination of the payable when the subsequent payment is made.

    2. Most retailers utilize an automated system to record and monitor the payables since there are numerous products, vendors, discounts and payment terms involved in merchandise acquisition, plus many expenditures associated with operating and expanding the business.

    3. The payable entry will reflect substantial information, including vendor name and number, purchase invoice number, and amount. These records could be reviewed using a number of different techniques.

    4. The list of vendors with which the taxpayer conducts business can be analyzed. The examiner may identify certain vendors whose transactions with the taxpayer have significant audit potential. These transactions can be isolated by vendor.

    5. A discovery sample approach can identify expenditures which have been improperly classified.

    6. Selected accounts can be isolated, stratified by dollar amount, and statistically sampled.

    7. Some taxpayers will fragment an invoice by item or destination. Larger dollar expenditures may therefore have a higher probability of being improperly classified.

    8. See IRM 4.43.1.5.4.1 for related information regarding records involving the acquisition of merchandise.

  8. Accounts Receivable

    1. For retailers who do not have an in-house charge system, accounts receivable should not be unusual. The amounts reflected in the receivable could be monies due from third party credit cards; from banks on installment contract paper which was sold; from customers whose checks were not accepted by the bank; or from vendors as a result of overpayments, rebates, or renegotiated items.

    2. Retailers which utilize some form of in-house customer charge account will have much more extensive records and systems in place to record purchases and payments on account, to periodically send out bills, and to enforce collection.

    3. In conjunction with the review of these records, the examiner should consider reviewing the taxpayer's criteria for writing off receivables it considers totally or partially worthless. Depending on the number, nature, and amount, a barometer of the reasonableness of the taxpayer's current write-offs may be the collection history of previously written off accounts. See IRM 4.43.1.13.6.9 for additional information on audit techniques pertaining to bad debts.

4.43.1.4  (07-23-2009)
Gross Income

  1. This section provides general background information about gross income items reported by taxpayers in the retail industry and the general accounting practices for such items.

  2. Gross income recognition rules impact retail businesses every day. Gross income is generally the largest line item in the tax return. Gross income includes merchandise sales, leased department income and other income such as shipping and handling fees.

  3. The receipt of prepayments for goods and services is a common situation in retailing. Prepaid income transactions typically occur in the ordinary course of business rather than a result of a structured tax strategy.

4.43.1.4.1  (07-23-2009)
Potential Compliance Risks

  1. Is the item includible in gross income?

  2. If the item is includible in gross income, is the item included in the proper tax year?

  3. Did the retailer defer the income item improperly?

  4. If the item is includible in gross income and it is included in the proper tax year, is the amount of income reasonably accurate?

4.43.1.4.2  (07-23-2009)
General Tax Principles

  1. IRC 61 provides that gross income for purposes of calculating taxable income means all income from whatever source derived. IRC 61(a)(3) expressly includes gains derived from dealings in property. Treas. Reg. 1.61-3(a) provides that in a merchandising business, gross income means total sales, less the cost of goods sold.

  2. Treas. Reg. 1.61-1(a). provides gross income includes income realized in any form, whether in money, property, or services.

  3. Treas. Reg. 1.61-2(d)(1) provides that income paid in property or services is the fair market value of the property or services.

  4. Treas. Reg. 1.446-1(c)(1)(ii)(C) requires that the method used by a taxpayer in determining when income is to be accounted for generally be acceptable if it accords with GAAP, is consistently used by the taxpayer from year to year, and is consistent with the income tax regulations. Even if a taxpayer follows GAAP for financial reporting purposes, the IRS may require different treatment for tax purposes.

  5. Income is generally recognized at the point in time at which a sale occurs. The term "sale" is given its ordinary meaning for Federal income tax purposes and is generally defined as a transfer of property for money or a promise to pay money.

  6. IRC 451(a) provides that the amount of any item of gross income must be included in gross income for the taxable year in which received by the taxpayer, unless under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.

  7. Treas. Reg. 1.451-1(a) provides that items of income are includible in gross income in the taxable year in which all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy.

  8. Treas. Reg. 1.451-5(b) provides that advance payments for goods are to be included in income in the year of receipt, or in the earlier of:

    1. the taxable year the payments are accruable in income under the taxpayer's method of tax accounting, or

    2. the year the payments are includible in gross receipts on the taxpayer's financial reports.

  9. Treas. Reg. 1.451-5(c) provides advance payments for inventoriable goods must be included in income in the second taxable year following the year in which cumulative advance payments exceed the estimated cost of the goods to be delivered.

  10. Under both the general rule and the special rule for inventoriable goods, provision is made for offsetting the cost of goods sold. If the general rule is followed, and the advance payments are included in income in the year accrued either for tax or financial statement purposes, proper matching of revenue and costs will insure that the cost of goods sold has been taken into account. If the inventoriable goods rule is applicable, Treas. Reg. 1.451-5 has a specific provision for taking into account matching costs of goods sold under certain situations.

4.43.1.4.3  (07-23-2009)
Key Considerations

  1. The Internal Revenue Code provides a very general definition for the meaning of gross income. The Supreme Court has given a liberal construction to the term in recognition of the intent of Congress to tax all gains except those specifically exempted. Consequently, any statutory exclusion from income must be narrowly construed.

  2. In the retail industry, the primary consideration in the area of income is the tax treatment of prepaid income items received by accrual basis retailers. Specifically, when is income received in advance of selling goods or performing services includible in gross income? A common aspect of tax planning is a taxpayer’s effort to defer the recognition of income items. Deferring items of income provides an economic benefit to retailers from the time value of money. The longer the period between the date an item is received and the date the item is included in gross income, the greater the economic benefit.

  3. Under accrual basis accounting, the right to receive, not actual receipt, triggers the inclusion of an item in income. Rev. Rul. 84-31 provides the right to receive becomes fixed at the earlier of any of the following three events:

    1. Required performance happens

    2. Payment is due

    3. Payment is received

  4. An accrual basis retailer must report income in the year in which the right to such income accrues, despite the necessity for mathematical computations or ministerial acts. The fact that the retailer cannot presently compel payment of the money is not controlling. In applying the all events test, the various courts have distinguished between conditions precedent, which must occur before the right to income arises, and conditions subsequent, the occurrence of which will terminate an existing right to income, but the presence of which does not preclude the accrual of income. Consequently, a retailer that receives payment for goods or services must accrue the amount unless the receipt is subject to substantial limitations or restrictions, or is a deposit or a loan.

  5. The determination of when a sale occurs (and the right to receive income is fixed) requires consideration of all the facts and circumstances of a particular transaction or arrangement. The terms of a retailer’s sales agreement represent the legal rights and obligations of the parties and are relevant in determining when the all events test is met. Several factors are considered, but no single factor is controlling.

    1. Passage of title is perhaps the most conclusive circumstance.

    2. Transfer of possession is also significant.

    3. Other factors include the existence of conditions precedent or subsequent and whether the right to receive is contested.

    4. Certainty of receipt, however, has never been a requirement for the accrual of income. Otherwise, an accrual method taxpayer could shift at will the reporting of income from one year to another.

  6. Absent a specific provision authorizing deferral, prepaid income must be included in income upon receipt.

    1. Rev. Proc. 2004-34 provides specific rules for deferring prepaid income in some circumstances.

    2. Treas. Reg. 1.451-5(c) provides specific rules for deferring advance payments for the sale of goods.

  7. The facts, not actual bookkeeping entries, control the determination of whether an income item is includible in gross income.

  8. The examiner generally should not propose an adjustment which merely shifts an item of income from one year to the next or prior year if the amount is not material and the overall effect on the revenue is inconsequential.

4.43.1.4.4  (07-23-2009)
Industry Practices

  1. Gross income includes merchandise sold for cash or credit and services that are incidental to the sale of merchandise. Shipping and handling revenue is also included in gross income.

  2. Retailers generally record income at the time of sale when payment is made, delivery has occurred, and the sales price is fixed. In some situations (e.g. e-commerce and catalog sales), income may be recorded at the time of delivery (i.e. customer receipt).

  3. Retailers generally defer income recognition of advance customer payments for goods and services beyond the date of receipt. Common prepaid income items in retailing include gift card sales, layaway sales, club memberships, and extended service plans. Prepaid income items are typically credited to a current liability account at the time of cash receipt. Income is recognized at some later date, which may be a different tax year.

  4. Sales are generally recorded net of estimated and actual returns and allowances as well as sales incentives such as rebates, discounts, loyalty or reward points, coupons and other promotions. Reserves for these various sales deductions are often computed as a percentage of sales based on historical percentages.

  5. Sales taxes collected from customers may be considered revenue. Alternatively, sales taxes collected from customers may not be considered income and included in accounts payable or accrued liabilities until remitted to the taxing authorities.

  6. Retailers which have leased departments generally include sales from such departments in gross income (e.g. cosmetics, jewelry).

  7. Retailers have offered some form of store credit for many years (e.g. returned merchandise). Store credits for returned merchandise may be offered in the form of gift cards.

4.43.1.4.5  (07-23-2009)
Financial Reporting

  1. Income must be earned and realized (or realizable) before financial statement recognition.

  2. Revenue is earned when an entity has substantially performed the actions necessary to be entitled to the benefits of the revenue.

  3. Revenue is earned for merchandise when title and risk of ownership pass to the buyer.

  4. Revenue is earned for services when a single significant act is performed, when the final act is performed if a series of acts are required over a period of time, through the passage of time (e.g. rent, interest), or on collection if significant uncertainty exists.

  5. Revenue is realized when products (goods or services), merchandise, services, or other assets are exchanged for cash or claims to cash.

  6. Revenue is realizable when related assets received or held are readily converted to known amounts of cash or claims to cash.

  7. Revenue is recognized at the time of sale only if all of the following criteria are met:

    1. The price is substantially fixed or determinable at the date of sale.

    2. The buyer has paid the seller or is obligated to pay the seller and the obligation is not contingent on resale of the product.

    3. The buyer’s obligation would not change in the event of theft or physical destruction or damage of the product.

    4. A buyer acquiring the product for resale has economic substance apart from that provided by the seller.

    5. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer.

    6. The amount of future returns can be reasonably estimated.

  8. The Securities and Exchange Commission ("SEC" ) criteria for revenue recognition include:

    1. Persuasive evidence exists of an arrangement determined by customary business practices and processes.

    2. Delivery has occurred or services rendered.

    3. Seller’s price to buyer is fixed and determinable.

    4. Collectibility is reasonably assured.

  9. Advance payments generally are not recognized until the period in which the income is earned, for example when merchandise is provided (advance payments for goods), or when services are provided (prepaid fees for services).

  10. In the interim, prepaid amounts are treated as a liability until the revenue is earned, reflecting an obligation to provide something of value in the future.

4.43.1.4.6  (07-23-2009)
Retail Topics and Issues

  1. Payment prior to performance is common in the retail industry. Gift cards, extended service plans, and club memberships are just a few examples of items for which payment usually precedes performance.

  2. Tax accrual accounting generally results in an earlier reporting of income items and a later reporting of expense items than financial accrual accounting. Consequently, the IRS generally takes the position that prepaid income is includible in gross income in the year of receipt while retailers take the position that prepaid income is includible in a subsequent year or years when performance takes place.

  3. Historically, the IRS has been successful with its position that prepaid income is taxable in the year of receipt, notwithstanding that the amount may be refundable in certain circumstances or that the retailer is required to provide goods or services in the future.

  4. In some transactions, a retailer may effectively defer recognition of an income item by creating a current deduction or loss to offset a portion of the income item.

4.43.1.4.6.1  (07-23-2009)
Gift Cards and Certificates

  1. In the normal course of business, retailers have offered gift certificates for a number of years to increase their sales of goods and cash flow. In the 1990s, many retailers replaced their gift certificates with gift cards. For retailers, gift cards offer flexibility in promoting customer loyalty because they make it easier to track purchases and thus offer opportunities to enhance future sales. Gift cards are generally non-refundable unless required by state law.

  2. The sale of a gift certificate or gift card is recognized as income when redeemed for financial reporting purposes. Proceeds from the sale of gift cards are recorded at the time of sale as a liability. Gross income is reported and the liability is relieved when the holder redeems the gift card for merchandise. In some situations, gift card sales are recognized when the likelihood of redemption by the customer is remote (i.e. gift card breakage) and the retailer determines that it does not have a legal obligation to remit the unredeemed gift cards to the relevant jurisdiction(s) under escheatment rules.

  3. The sale of a gift certificate or a gift card is treated as an advance payment for tax purposes under Treas. Reg. 1.451-5(a)(2)(i).

  4. Unless a retailer complies with the deferral rules under Treas. Reg. 1.451-5 or Rev. Proc. 2004-34, gift card income must be reported when received.

  5. Under Treas. Reg. 1.451-5(c) gift card income may be deferred until the last day of the second taxable year following the year of sale.

  6. Under Rev. Proc. 2004-34, gift card income may be deferred until the last day of the first year following the year of sale.

  7. Under Treas. Reg. 1.451-5(b)(1)(ii), advance payments for tax purposes cannot be reported later than they are for financial accounting purposes.

  8. Audit Techniques may include the following.

    1. Scan the general ledger accounts for deferred income items.

    2. Review Schedule M to determine the existence of any adjustments reconciling book-tax reporting differences for income items.

    3. Ask the taxpayer to identify when gift card income is recognized for book and for tax purposes. If revenue recognition differs between book and tax, ask the retailer to address how such differences are reconciled and reported on the Schedule M.

    4. If the retailer indicates that gift card income is deferred, ask the retailer to identify: (1) the method used to defer gift card income for both financial and tax reporting purposes; (2) how the method was elected; (3) how unredeemed gift cards are tracked; (4) whether an estimate is used to record the liability for unredeemed gift cards at tax year end; (5) whether an outside service provider is used and to provide a copy of the service contract; and (6) whether an estimated cost of goods sold deduction is recognized to the extent unredeemed gift cards are recognized as income for tax purposes.

    5. Request a description of the accounting and record-keeping policies and procedures for the retailer’s gift card/certificate program.

    6. Request a list of the book and tax accounting entries the retailer makes to record gift cards, including sales, redemptions, expirations, escheatments, discounts, dormancy or other fees, and any other transactions.

    7. Obtain copies of the retailer’s accounting manual and all internal audit reports issued for gift cards. Inquire about the following: 1) whether the gift cards are issued in lieu of cash refunds; 2) whether the gift cards are reloadable and if so, how reloads are tracked; and 3) whether the retailer uses a separate legal entity to manage its gift card program and if so to provide details of the arrangement. The detail requested should include the name and the type (e.g., C-corp., LLC, S-corp.) of the entity created, when it was created, where it is chartered, if applicable, and generally how the program works.

    8. Ask the retailer to identify and describe any restrictions listed on the gift card.

    9. Obtain a photocopy of the front and back of the gift card(s) which the retailer and any of its subsidiaries issued for the tax years under audit. Ask if the retailer imposes any restrictions not otherwise listed on the gift card.

  9. Potential Compliance Risks

    1. Indefinite Deferral The examiner may encounter a situation whereby the retailer is deferring the recognition of gift card sales beyond the second year following the receipt of the cash. In this situation, the method used for tax reporting is the same method used for financial reporting (i.e. income deferral until redemption). The absence of a Schedule M adjustment reconciling reporting differences indicates the retailer may be using an improper method of accounting for tax reporting purposes.

    2. All Events Test Although Treas. Reg. 1.451-5(c) allows for the deferral of recognition for up to two years, the examiner must keep in mind that the all events test under Treas. Reg. 1.446-1 and Treas. Reg. 1.451-1 needs to be applied first. Gift card income is recognized when all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. The regulations do not permit deferral if the income has already been earned. If gift cards expire before the end of the second year following the year of receipt, the income may have to be recognized sooner under the all events test.

    3. Reloadable Cards When the holder of a gift card is able to add value or increase the worth of the gift card, it is commonly called reloadable. If a retailer’s gift cards are reloadable, the examiner should verify that the retailer’s accounting system and software takes into account the actual dates when money is added to the card for purposes of computing the limited deferral period.

    4. Service Charges or Fees Service charges or fees relative to gift cards, including dormancy fees, latency fees, or other administrative fees, that have the effect of reducing the total amount for which the holder of the gift card may redeem the gift card until the expiration date on the card has expired may not be properly reported as income by the retailer when charged against the gift card. The examiner needs to verify that the income is properly reported when dormancy fees, latency fees, or other administrative fees can be incurred relative to a taxpayer’s gift cards/certificates.

    5. Estimated Cost of Sales Treas. Reg. 1.451-5(c)(1)(ii) provides that a retailer must take into account the cost of sales, either on an actual or estimated basis, in the year in which the taxpayer is required to include the advance payments. However, Treas. Reg. 1.451-5(c)(1)(iii) provides that the reduction for cost of sales does not apply if the goods with respect to which the advance payment is received are not identifiable. Consequently, a deduction is allowed only when the merchandise is identified (i.e. when the gift card is actually redeemed).

    6. Bulk Sales Discounts Direct expenses are not deductible until the year in which the related income items are actually earned. Sales discounts on gift cards should be expensed in direct relationship to the recognition of income from the gift cards. A retailer which expenses discounts while deferring income from the related gift card sales is improperly accelerating a deduction..

4.43.1.4.6.2  (07-23-2009)
Layaway Sales

  1. A layaway sale is a sale of any goods in which the goods are offered for sale to the public on terms which permit periodic payment for the goods, and with respect to which delivery is deferred until completion of payment of the entire purchase price.

  2. Some retailers offer layaway sales to their customers. As a general rule, retailers that offer layaway sales do not require customers to enter into an installment note or other fixed payment arrangement when the down payment is received. Retailers retain the merchandise, set it aside in inventory and release the merchandise to the customer when the customer has paid the full purchase price.

  3. For financial reporting purposes, a layaway sale is not immediately recognized as income. The advance payments from customers are recorded as a liability at the time they are received even if the payments are subject to forfeiture. Gross income is reported and the liability is relieved when the customer pays the full purchase price and the merchandise is delivered to the customer.

  4. The advanced payments from layaway sales are reported as income at the time of receipt unless the retailer elects the deferral method under Treas. Reg. 1.451-5. Because IRC 453(b)(2)(B) revoked the installment sales method for dealers in personal property, layaway sales now are under the same general rules as gift cards. The deferral method is explained in IRM 4.43.1.4.6.1.

  5. Unlike gift cards, the merchandise sold under a layaway plan is usually identifiable before the customer takes possession. A substantial advance payment is therefore not deemed to have occurred until the last day of the taxable year in which layaway payments received equal or exceed the reasonable costs of the goods sold. The two-year deferral period provided by Treas. Reg. 1.451-5(c)(1)(i) begins on this date.

  6. For layaway sales, the retailer is allowed a deduction for the cost of goods at the time the income is recognized under Treas. Reg. 1.451-5(c)(1)(i) when the goods can be identified. This deduction (or estimate of cost of goods sold) must be claimed at this time even if no goods are on hand when the income is recognized. The deduction for the cost of goods sold is lost if it is not claimed at this time. Any variance between the actual costs and the deduction claimed is corrected at the completion of the installment obligation.

  7. The examiner should review the audit techniques for gift cards when examining layaway sales.

4.43.1.4.6.3  (07-23-2009)
Warranties and Extended Service Plans

  1. A manufacturer generally provides consumers with a limited warranty of product quality. Some retailers sell extended warranties or service contracts, such as electronics, which are in addition to the warranty provided by the manufacturer. The coverage provided is usually for a number of years and the consumer usually pays the entire cost of the coverage up-front.

  2. The mechanics of the agreements may vary from one retailer to another. Some retailers may perform the covered-service work themselves while others may have a third party perform the work. Some retailers are principals of the plan, retaining the contingent liabilities which arise from the coverage, or possibly paying a third party to assume total or partial responsibility. Other retailers are acting as the agents of a third party, which is the principal of the plan. As an agent, the retailer's involvement could be limited to selling the service contract to its customers, for which it would receive a commission. The third party, who is paid to assume the risk, increasingly involves a contract written with an off-shore insurance company.

  3. For tax reporting purposes, an accrual method retailer that receives payments for services to be performed in the future generally must include the payments in gross income in the taxable year of receipt. Consequently, any income received from the sale of extended warranties or service contracts is normally recognized in the year the contract is sold. Any expenses related to providing services under the warranties or service contracts are allowed only in the year in which incurred.

  4. Rev. Proc. 2004-34 allows an election to defer the service contract income to the next succeeding taxable year to the extent the prepaid income is not recognized in revenue in the taxable year of receipt.

  5. Rev. Proc. 92-98 allows retailers an election to defer the service contract income in certain situations where the taxpayer purchases an insurance policy to cover its service contract obligations. This method is known as the service warranty income method ("SWIM " ) and provides for a better matching of income and expenses. If this method is not elected, then the income is recognized when received and the costs of the insurance must be amortized over the life of the policy.

  6. SWIM is available to retailers of durable consumer goods with respect to qualified advance payment amounts received on service warranty contracts when:

    1. The service agreements are fixed-term agreements with respect to durable consumer goods purchased by a customer.

    2. The service agreements are separately priced, such that customers have the option to purchase the service warranty contract for an expressly stated amount separate from the price of the underlying durable goods.

    3. The service period begins in the taxable year the advance payment is received or upon expiration of a fixed-term manufacturer’s warranty beginning in the taxable year the advance payment is received.

    4. The retailer purchases a policy that constitutes insurance for federal income tax purposes from an unrelated third party to insure its obligation under the service warranty contract and

    5. The retailer makes payment to the unrelated third party insurer within 60 days after receipt of the advance payment for the entire amount of the insurance costs associated with the policy insuring its obligation under the service warranty contract.

  7. The primary audit consideration is when a retailer should report revenue from the sale of extended warranty or service contracts. The examiner is unlikely to encounter a reporting issue when the retailer is merely an agent which retains or receives commissions generated by the sale of extended product warranties or service agreements. Any potential issue would relate to the normal year-end timing issues. In situations where the retailer is the principal of the agreement sold to the customer, a number of potential issues may exist. The retailer may be improperly deferring income received for the sale of the agreement. The sale price may be reflected on the books as a prepaid liability recognized as income ratably over the life of the agreement. The possibility also exists that the retailer may defer income recognition, or even the inclusion as a prepaid, in situations involving multiple payments.

  8. The examiner should request and review all documents pertaining to the contracts and agreements. The examiner should also secure the procedural guide stating how the taxpayer accounts for these monies.

4.43.1.4.6.4  (07-23-2009)
Club Memberships

  1. Some retailers generate income from annual membership fees. A typical arrangement requires customers to prepay the entire membership fee. Customers have a unilateral right to cancel their membership at any time during the term and receive a partial refund of the fee paid.

  2. For financial reporting purposes, annual club membership fees are not immediately recognized as income. The advance payments from customers are recorded as a liability at the time they are received. Gross income is reported and the liability is relieved over the term of the membership. Most terms are for a period of 12 months and income is recognized ratably over this period.

  3. For tax reporting purposes, the advanced payments from club memberships are reported as income at the time of receipt unless the retailer elects the method under Rev. Proc. 2004-34. This revenue procedure allows retailers an opportunity to defer annual membership fees to the next succeeding taxable year to the extent the prepaid income is not recognized in revenue in the taxable year of receipt.

4.43.1.4.6.5  (07-23-2009)
Leased or Licensed Departments

  1. Retailers (e.g. department stores) might lease or license departments to unrelated parties. These retailers generally receive commissions based on a percentage of sales. The commissions are recognized as income at the time merchandise is sold to customers.

  2. Department stores and other retailers customarily include the sales of leased or licensed departments in the amount reported as total revenue. The SEC does not object to retailers presenting sales of leased or licensed departments in the amount reported as total revenue because of industry practice.

  3. Generally, this arrangement is not a lease but rather a service arrangement that provides for payment of a fee or commission. As such, a retailer should recognize the fee or commission as revenue is earned.

4.43.1.4.6.6  (07-23-2009)
Credit Card Fee Income

  1. Retailers have offered some form of store credit for many years. Some retailers operate a private label or an in-house credit card program to facilitate sales in their stores and generate additional revenue from fees related to extending credit. Retailers typically establish a federally chartered bank as a wholly-owned subsidiary to hold and service the card accounts. These captive banks act as the merchant bank and issuing bank with respect to the card transactions. Such store cards bear the insignia of the issuing chain. Other retailers form marketing arrangements with financial institutions that issue general purpose cards that bear the retailer’s name on the front of the card.

  2. Unlike cash or check payments, retailers do not receive the full selling price of transactions that customers make with general purpose credit or debit cards because the merchant bank subtracts a merchant discount fee for services rendered in connection with retailers accepting electronic payment from customers. Some of this discount reimburses the merchant bank for services provided to the retailer and some of the discount reflects the merchant bank’s interchange fee that is payable to the issuing bank. For a private label card, the retailer’s captive bank receives the merchant discount and the retailer’s retail operations pay the merchant discount.

  3. For financial reporting purposes, credit card fees are generally recognized at the time they are charged to a cardholder’s account.

  4. Prior to a 1997 tax law change, credit card fees generally were recognized at the earliest of when paid, due, or earned under IRC 446 and IRC 451. A 1997 tax law change added subsection (iii) to IRC 1272(a)(6)(C). The application of this change in law to those credit card fees that are properly treated as giving rise to original issue discount (OID) results in the recognition of the income attributable to the fees in accordance with the constant yield method described in IRC 1272(a)(6) for pools of loans.

  5. Many issuing and merchant banks have taken the position that interchange and merchant discount fees give rise to OID, relying on IRC 1272(a)(6) to defer income recognition for such fees. In addition to merchant discount, in-house card programs treat fees earned for late payment and insufficient funds as OID.

  6. The primary compliance risk is the deferral of merchant discount fees beyond the year of receipt because of the improper application of the OID rules. Merchant discount fees are a charge for services, which must be recognized in income currently. Alternative issues include the application of the matching rule for intercompany transactions and the methodology used to compute the amount of deferred income properly accounted for as OID.

  7. Audit Considerations include the following:

    1. Do merchant discount fees give rise to OID?

    2. If merchant discount is treated as OID, is it subject to the intercompany transaction rules of Treas. Reg. 1.1502-13?

    3. How should a credit card fee, if otherwise treated as OID, and not subject to the intercompany transaction rules, be included in gross income under IRC1272(a)(6)(C)? The deferral calculation must be examined as well.

  8. The examiner should request and review the following information to examine this issue:

    1. Credit card agreement, including all amendments

    2. Merchant agreement, including all amendments

    3. Processing agreement, including all amendments

    4. Sale of receivables agreement, including all amendments

    5. Detailed computation workpapers for any IRC 481(a) adjustment and current year adjustment related to fees treated as OID

    6. Schedule M book and tax reconciliation workpapers

    7. Standard journal entries for a credit card transaction

4.43.1.4.6.7  (07-23-2009)
Factoring Accounts Receivable

  1. Factoring transactions involve the sale of accounts receivable to a factoring company (or factor), which purchases all rights, title and interest in the accounts receivable and undertakes to assume the risk of their collection. A factor is a financial intermediary who purchases the accounts receivable. Factoring provides techniques for companies to manage their accounts receivable and/or provide financing.

  2. Factoring is a common business practice in the retail industry. Retailers generate accounts receivable by selling goods and services to their customers on credit and then sell or assign their accounts receivable to a factor in exchange for a cash advance.

  3. Numerous types of factoring arrangements exist. Some of the basic types vary the treatment of credit risk assumption and customer or debtor notification. In many arrangements, factoring agreements provide for accounts to be purchased on both a recourse and non-recourse basis depending on the credit worthiness of the customers or the debtors.

  4. The price the factor pays for the accounts receivable is discounted from the face amount to take into account the likelihood of uncollectibility of some of the receivables. For example, if receivables have a total face amount of $1,000, and the factor charges a 2% discount, the retailer receives $980 for the receivables. The discount rate represents the factor’s assumption of credit and other capital risks on the outstanding receivables. The discount represents an ordinary loss.

  5. Although valid economic reasons exist for factoring, the examiner should be aware of arrangements that may lack valid economic reasons:

    1. A domestic factor that is related to the retailer and that was created solely to factor the retailer’s receivables.

    2. A foreign factor where the retailer and factor have a common parent so that the retailer is a brother-sister corporation of the foreign factor. The factor is capitalized through a contribution by the parent.

    3. A pass-thru factoring entity (which is related to the retailer and which was created solely to factor the retailer's receivables), which is also purportedly owned in small part by foreign and/or tax exempt entities to which it allocates a large amount of income but a small amount of expenses, losses and/or deductions.

  6. The examiner should consult with a Financial Products Specialist when warranted.

4.43.1.4.6.8  (07-23-2009)
Sale on Approval

  1. A sale occurs for tax purposes when the seller relinquishes the benefits and burdens of ownership of the goods. The determination of when a sale takes place depends on the totality of circumstances including when title passes and when possession is transferred. The objective is to determine when the seller acquired an unconditional right to receive payment under the contract.

  2. A sale by an accrual basis retailer cannot be regarded as complete, or the consideration accruable, until the liability of the purchaser to make payment of the purchase price to the retailer has become fixed. If the sales contract contains a condition precedent, the sale is not complete or the purchase price accruable until the condition is satisfied.

    1. For example, a sales contract which makes acceptance of the subject matter dependent upon inspection or testing by the purchaser creates a condition precedent and prevents accrual of the purchase price by the seller until such tests and inspections have been made.

  3. Customer acceptance provisions may be included in a contract, among other reasons, to enforce a customer’s right to test the delivered product, require the seller to perform additional services subsequent to delivery (e.g. installation). The customer acceptance provision should be substantive and bargained for.

  4. Potential tax issues may include the following:

    1. Whether an item of gross income may be deferred on the theory that a defined acceptance period for product shipped to customers at the end of the tax year had not lapsed by the end of such tax year.

    2. For example, can a retailer defer the sale of merchandise that a customer has paid for and taken possession of at the time of sale because the sales invoice contains a stipulation that title and risk of loss do not pass to the customer until 30 days after the invoice date.

    3. In the situation of a sale on acceptance contract, the determination of when the right to receive income is fixed will depend on the importance of the acceptance provision in the standard sales contract.

4.43.1.4.6.9  (07-23-2009)
Sale with Unconditional Right to Return Merchandise

  1. If an unconditional right to return the merchandise to the taxpayer without penalty in conjunction with the fact that title did not pass to the buyer until a later year exists, a retailer may not be required to recognize income on the shipment date. The fact that customers rarely exercise this right is of no consequence. It is the existence of the right which controls.

  2. The examiner should determine if the buyer has the right to return the product and the buyer does not pay the seller at the time of sale and the buyer is not obligated to pay the seller at a specified date or dates.

  3. The examiner should also determine what happens in the event the product, while in the hands of the buyer, is stolen or damaged.

4.43.1.4.6.10  (07-23-2009)
Barter Transactions

  1. In a barter transaction involving barter credits, a retailer enters into a transaction to exchange a non-monetary asset (e.g. inventory) for barter credits (e.g. advertising). A barter transaction typically occurs directly between a retailer and the other party to the transaction. In some situations, however, a third party, such as a barter company may facilitate the barter transaction.

  2. A barter contract typically specifies the goods and services to be purchased. Barter credits may have a contractual expiration date at which time they become worthless.

  3. E-commerce retailers commonly enter into transactions in which they exchange rights to place advertisements on each others' websites. Traditional retailers may also enter into advertising barter transactions (e.g. inventory goods for advertising).

  4. A barter transaction generally results in recording an equal amount of income and expense. However, the recognition of income and expense may occur in different tax years. For example, a supermarket barters inventory for media credits. The retailer redeems the media credits in a year subsequent to the year the inventory is provided to the media company.

  5. For financial reporting purposes, the Emerging Issues Task Force (EITF) 93-11 and EITF 99-17 provide guidance for reporting advertising barter transactions.

  6. For tax reporting purposes, the fair market value of the barter credits are includible in gross income in the year of the barter transaction.

4.43.1.4.7  (07-23-2009)
Audit Techniques

  1. The examiner should scan liabilities reported on the balance sheet and supplemental schedules for deferral of income items. Consider the description of the entries and titles of the accounts.

  2. The examiner should scrutinize the accounts receivable subsidiary ledger for credit balances.

  3. The examiner should review Schedule M to determine if the retailer reported any book-tax differences associated with deferred income items.

  4. The examiner should obtain written agreements to determine the terms and conditions of the sales arrangement resulting in deferred income.

4.43.1.4.8  (07-23-2009)
Other Information

  1. Additional gross income information is included in this section.

4.43.1.4.8.1  (07-23-2009)
Sales Records

  1. Most retail transactions are made by cash, checks, or credit/debit card transactions.

  2. Most large retailers have a system in place which records the sale at the cash register as it occurs. In many cases the cash register is a computer terminal from which data is directly entered into the computer. This automated retail system is known as a Point of Sale (POS) inventory system.

  3. These electronic cash registers accumulate various sales data. They identify the type of transaction, the method of payment (including credit card types and numbers), authorization codes and employee codes. Sales detail by product, department, store, date, and time is immediately available to management personnel using these sophisticated systems.

  4. Promotional sale prices are recorded at the point of sale, thus eliminating the need for the retailer to physically remark price tags at the beginning and end of each sales promotion. When the product code is scanned, an immediate interaction with the product data base occurs, generating both the full retail price (net of prior permanent markups and markdowns) and the promotional markdown. The customer is charged the net reduced price. These price changes can be entered into the system in advance of the effective date. For example, the database can be programmed to reflect that product X, which carries a normal retail price of 99 cents, will be on sale for 79 cents for a specified seven-day period.

  5. In other less sophisticated systems, the retailer's sales personnel would enter the full price and then enter the promotional markdown separately. The recording of the complete sales transaction is more time consuming and generally contains less detailed information.

  6. The information from the sales journal may be analyzed by the examiner if there are indications that not all sales for a period, a specific product or a specific location have been reported. In addition, if a certain type of sale is being improperly deferred these records could be searched for data by transaction code. Before commencing a review of sales, the examiner should request and become familiar with the retailer's internal standard procedures for recording sales, including definitions of input codes.

4.43.1.4.8.2  (07-23-2009)
Taxpayer Exclusion Theories and Arguments

  1. Advance payments are loans.

    1. Borrowed money is not taxable income because of the corresponding obligation to repay.

    2. The examiner should request the note or other evidence of indebtedness if the retailer takes this position.

  2. Advance Payments are deposits.

    1. Like borrowed money, a deposit is not includible in gross income when received.

    2. The fact that an amount received may be refundable is not sufficient to make the payment a deposit. The rationale is that most items are refundable.

    3. The distinction between an advance payment and a deposit is one of degree rather than kind. An advance payment and deposit are similar in that both protect the seller (e.g. retailer) against the risk that it will be unable to collect money owed it after it has furnished goods. An advance payment and deposit are dissimilar in that an advance payment assures the seller that so long as it fulfills its contractual obligation, it can keep the money. The customer or supplier who makes an advance payment retains no right to insist upon the return of such funds. An advance payment essentially protects a seller (i.e. retailer) against the risk that the purchaser will back out of the deal before the seller (i.e. retailer) performs.

    4. An examiner should focus on the rights of the parties at the time payment is made if the retailer takes this position.

4.43.1.4.8.3  (07-23-2009)
Contested Amounts, Customer Disputes

  1. A right to income that is contested is not required to be accrued prior to resolution of the dispute concerning the amount. See Rev. Rul. 73-385.

  2. Treas. Reg. 1.451-1(a) provides that income is includible "when all the events have occurred which fix the right to receive such income..." . If a taxpayer's claim to income is being contested, and the controversy is unsettled at the close of the taxable year, the item of income is not includible in that year, since the taxpayer's right to receive the income is not fixed. Even when the other party to the transaction stands ready to pay the amount claimed it will not be income to the taxpayer if the funds are impounded or otherwise tied up so that they are not available to the taxpayer until the contest is settled.

  3. If some or all of the contested income is paid to the taxpayer, it is taxable at the time of receipt, even if the contest is not settled. The receipt of payment is one of the three basic events that may fix the taxpayer's right to receive, even if a contest is continuing.

  4. Contested income is includible in a taxpayer's income in the year in which the contest is settled. If the matter is litigated, the year of settlement is the year in which a court makes a decision that becomes final. A trial court's decision must become final, either through affirmation on appeal or through expiration of the right to appeal.

  5. If a taxpayer's right to income is contested, but there is no litigation, the income is to be accrued in the year in which the parties settle the controversy. Many taxpayers' claims for income under government contracts are contested administratively without any litigation, and these cases follow the general rule of income in the year of settlement.

  6. The IRS has taken the position that as long as the taxpayer's income from a contract is disputed by the obligor, all events have not occurred to fix the right to the income. The all events test is not satisfied until the dispute is resolved. Resolution of the dispute occurs when either the liability is acknowledged by the obligor, or the liability is finally determined by the court or other ''forum of last resort'' and is not subject to further appeal or contest. The IRS has adopted the rule of law first established in H. Liebes & Co. v. Commissioner, 90 F.2d 932 (9th Cir. 1937), that even when a claim has been reduced to judgment and no appeal has been filed, the right to receive proceeds or income does not accrue for tax purposes until the time to appeal expires.

  7. Admission of liability to the taxpayer is a necessary event to fix the taxpayer's right to receive income.

  8. In Rev. Rul. 2003-10, the IRS addressed the proper tax year in which a vendor using an accrual method should recognize gross income if the vendor's customer disputes its liability to the vendor. The ruling discusses three different situations.

    1. Situation 1. The taxpayer over billed a customer due to a clerical error. The customer discovered the error in the following year and disputed its liability for the over billed amount. The taxpayer should recognize income in the year of sale for the correct amount. The taxpayer had a fixed right to receive this correct amount

    2. Situation 2. The taxpayer shipped the wrong goods to the customer and during the year of sale the customer disputed its liability. In this fact pattern, the taxpayer does not recognize any income in the year of sale because the taxpayer did not have a fixed right to receive payment for the incorrect goods.

    3. Situation 3. The taxpayer shipped excess quantities of goods to the customer, but the customer agreed to pay for the excess quantities. The taxpayer must recognize all the income in the year of sale. There was never a dispute with the customer, so the taxpayer had a fixed right to receive the entire amount of income.

  9. Potential Compliance Risk

    1. If the dispute arises prior to tax year end, the income is adjusted in the year of sale.

    2. If the dispute arises after tax year end, the income is adjusted in the year of dispute. The rationale is that the dispute is a new event.

4.43.1.4.8.4  (07-23-2009)
Right to Receive

  1. Under an accrual method, it is the right to receive income and not the actual receipt of income that determines the inclusion of the amount in gross income. When the right to receive an amount becomes fixed, the right accrues. The right to receive rather than the earning of the income is important. The right to receive may often occur prior to the actual earning of the income, depending on the relevant agreement between the parties as well as other attendant circumstances. It is not necessary in all circumstances that the right to receive be legally enforceable. Enforceability of the right often pertains more to whether a debt may be collected than to whether the right to receive exists.

    1. Example 1. A retailer had the right to reimbursement of a portion of its advertising costs by vendors of advertised goods. The IRS ruled that the taxpayer should accrue the reimbursement when it placed the advertising, and not at a later date when it filed a claim.

    2. Example 2. The purchase of obligations, such as accounts receivable, at a discount from face value has been held not to result in the receipt of income. None of the three basic events fixing the right to receive occurs at the time of purchase merely because assets have been purchased for less than face value, and income is thus considered realized at the time of collection. See Rhodes-Jennings Furniture Co. v. Commissioner, 192 F.2d 1022 (6th Cir. 1951).

  2. Exceptions

    1. The receipt of payment does not always satisfy the all events test in fixing the right to receive. The IRS stated that the all events test is not satisfied when the payment received is in the nature of a deposit. The taxpayer received a payment from its customer at the end of Year 1 in exchange for the taxpayer's agreement to provide drivers for the customer's trucking operations for the first three months of Year 2. The memo stated that the payment received would be treated as a deposit and not taxable if the customer had the right to back out of the purchase and could get a refund of the payment. In this particular case, the service contract with the customer did not provide for the possibility of a refund, so the advance receipt had to be recognized as income in Year 1.

4.43.1.4.8.5  (07-23-2009)
Conditions Precedent

  1. In determining whether an accrual basis taxpayer has a right to receive an item, and whether the taxpayer must include it in income, the examiner must understand the distinction between a condition precedent and a condition subsequent.

  2. A condition precedent has been defined as a "condition that must be fulfilled before a party's promise becomes absolute." The condition precedes an absolute duty to perform. If a taxpayer does not have a duty to perform until the condition has been fulfilled, no right to receive occurs until the condition has been satisfied and, as a result, no accrual of income is required.

  3. A condition precedent to a sale or exchange leaves one or both of the parties to a transaction free to withdraw unless the condition is timely satisfied.

  4. Example. Merchandise shipped C.O.D. (i.e. cash on delivery) is not a sale until payment is made by the customer. For goods shipped COD, title does not pass (and a sale is not made) until the goods are delivered, accepted, and payment simultaneously rendered.

4.43.1.4.8.6  (07-23-2009)
Conditions Subsequent

  1. A condition subsequent has been defined as a condition that operates to terminate a party's absolute promise to perform. The condition arises after the fixing of the absolute duty to perform. The right to receive income arises even though that right may be reduced or eliminated by some subsequent event. Such contingencies are considered in the same light as anticipated losses, or estimated or contingent liabilities. None of these items result in current deductions, the approach under the tax law being to "wait and see" until the event occurs, and if it does, to give it some tax effect at that time.

  2. A frequently encountered condition subsequent is the possibility of a refund based on the occurrence of some future event. The possibility of refunds is a condition subsequent not affecting the accrual of income. The Supreme Court has ruled that unearned commissions are subject to refund if the related premiums are not paid because the possibility of a refund is a condition subsequent not affecting the accrual of income. See Brown v. Helvering, 291 U.S. 193 (1934).

  3. The possibility of a subsequent price adjustment is a condition subsequent much like the possibility of a refund and is treated similarly for tax purposes. The cases and rulings have uniformly held that the taxability of the sales price is not affected by the possibility of a subsequent price adjustment.

4.43.1.4.8.7  (07-23-2009)
Delivery of Goods or Services

  1. Generally, the delivery of goods or services is not very important in determining the accrual of income. Delivery is not listed as one of the three events giving rise to a right to receive.

  2. A number of cases have held that income accrued in the year before delivery, because there was transfer of title, or payment received, or both, so that one of the actions creating a right to receive had occurred. For example in Pacific Grape Products Co. v. Commissioner, 219 F.2d 862 (9th Cir. 1955) a shipment of goods was delayed at the buyer's request. However the seller billed for the unshipped goods and the buyer paid for such goods by year-end. The court held that it was proper to accrue income at year-end. On the other hand, in the case of Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988), the calendar year taxpayer delivered seasonal merchandise, such as Valentine's Day cards, substantially before the end of the calendar year in order to smooth out its production over the year and avoid warehousing the merchandise. The terms of the sale, however, were that title to the goods and risk of loss did not pass to the buyer until January 1. Although the customers were in physical possession of the merchandise at December 31, they did not own it, were not required to include it in year-end inventory, or pay personal property taxes on it. The court held that the all events test was not satisfied until January 1, and, therefore, the taxpayer could accrue income from these sales at that time.

4.43.1.5  (07-23-2009)
Inventory

  1. This section provides general background information about inventory in the retail industry and general accounting practices for such inventory as reported by retailers.

  2. In general, inventories can be defined as the goods held for sale to customers in the ordinary course of the retailer’s trade or business.

  3. For retailers, inventories play a significant role in the computation of taxable income. Goods in inventory generally represent the most significant asset on a retailer’s balance sheet. Similarly, the cost of goods sold (COGS) generally represents the largest single item of expense on a retailer’s income statement.

  4. Inventory is arguably the asset with the highest probability of being incorrectly valued because of the judgments and estimates involved in such determinations.

4.43.1.5.1  (07-23-2009)
Potential Compliance Risks

  1. Have all goods been included in inventory?

  2. Is the stated value of inventory correct?

  3. Has the inventory method employed been used consistently from year to year?

  4. Does the inventory method employed clearly reflect income?

  5. Has the taxpayer filed any change of accounting method requests relative to inventory?

4.43.1.5.2  (07-23-2009)
General Tax Principles

  1. Treas. Reg. 1.61-3 provides that gross income means total sales less cost of goods sold.

  2. IRC 471 provides that whenever the use of inventories is necessary in order to clearly determine the income of any taxpayer, inventories shall be taken on such basis as the Secretary may prescribe as conforms as nearly as may be to the best accounting practice in the trade or business and as most clearly reflects the income. To reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing factor.

  3. Treas. Reg. 1.471-2(c) states the bases for valuation of inventories most commonly used by business concerns and which meet the requirements of IRC 471 are:

    1. Cost

    2. Cost or market, whichever is lower.

  4. Treas. Reg. 1.471-2(d) provides that if the taxpayer maintains book inventories in accordance with a sound accounting system in which the respective inventory accounts are charged with the actual cost of the goods purchased or produced and are credited with the value of the goods used, transferred or sold, calculated on the basis of the actual cost of the goods acquired during the year (including the inventory at the beginning of the year), the net value as shown by such inventory accounts will be deemed to be the cost of the goods on hand. Treas. Reg. 1.471-2(d) further provides that the balances of the book inventories should be verified by physical inventories at reasonable intervals and adjusted to conform therewith.

  5. Treas. Reg. 1.471-2(e) provides that inventories should be recorded in a legible manner, properly computed and summarized, and should be preserved as a part of the accounting records of the taxpayer.

  6. Treas. Reg. 1.471-3(b) defines cost, in the case of merchandise purchased since the beginning of the taxable year, as the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. The transportation or other necessary charges incurred in acquiring possession of the goods should be added to this net invoice price.

  7. Treas. Reg. 1.471-3(d) provides that in any industry in which the usual rules for computation of cost of production are inapplicable, costs may be approximated upon such basis as may be reasonable and in conformity with established trade practice in the particular industry.

  8. Treas. Reg. 1.471-8 provides that retailers can use what is known as the "retail method" in ascertaining approximate cost of their inventories.

  9. Treas. Reg. 1.472-1(a) provides that any taxpayer permitted or required to take inventories pursuant to the provisions of IRC 471 and pursuant to the provisions of Treas. Regs. 1.471-1 to 1.471-9 inclusive, may elect with respect to those goods specified in the application and properly subject to inventory to compute the opening and closing inventories in accordance with the method provided by IRC 472 and Treas. Reg. 1.472-2.

  10. IRC 472 provides that a taxpayer may use the LIFO method in inventorying goods specified in an application to use such method at such time and in such manner as the Secretary may prescribe.

4.43.1.5.3  (07-23-2009)
Key Considerations

  1. What goods should be included in inventory for income tax purposes under Treas. Reg. 1.471-1?

    1. All goods that have been purchased and for which title has passed including in-transit goods

    2. Goods that are under contract for sale but have not yet been applied to the contract

    3. Goods that are consigned out to other locations for which title or ownership has not been transferred

    4. Goods that are sold cash on delivery (COD)

  2. While inventory rules cannot be uniform, they must give effect to trade customs which come within the scope of the best accounting practice in the particular trade or business. See Treas. Reg. 1.471-2(a)(1).

  3. In order to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation, so long as the method or basis used is in accord with Treas. Regs. 1.471-1 through 1.471-11.

  4. COGS is not treated as a deduction on an income tax return and is not subject to the limitations on deductions contained in IRC 162 and IRC 274.

  5. Any amount claimed as COGS must be substantiated and taxpayers are required to maintain records sufficient for this purpose. If a taxpayer does not have adequate records, but the record suggests that they are incurred as an offset to gross receipts, courts may estimate the offset based on the evidence.

4.43.1.5.4  (07-23-2009)
Industry Practices

  1. The following sections highlight and discuss the steps and practices commonly performed by retail taxpayers in obtaining their inventoriable goods. Key record- keeping documents will also be identified.

4.43.1.5.4.1  (07-23-2009)
Purchasing Process

  1. Retailers may have a centralized merchandise (or goods) purchasing department at its corporate headquarters with many buyers assigned to various product lines for the entire company, or decentralized buying procedures with buyers assigned to specific stores or geographical locales. Assistant buyers, administrative support, accounts payable clerks and inventory control personnel aid the head buyer in the purchasing process. Management and secretarial staff also are involved peripherally in the buying function. A company directory or a detailed organizational chart can be used to identify the taxpayer’s personnel involved in purchasing the goods for resale.

  2. The purchasing process includes the selection of vendors and merchandise/goods as well as the negotiation of cost. Vendor criteria include reliability and quality control. Merchandise selection addresses consumer demand, quality, color, size, quantity, and delivery date. Buyers negotiate wholesale cost including the various discounts (e.g., volume discounts) and allowances. Buyers also negotiate marketing allowances for performance by the retailer, including cooperative advertising and shelving allowances. Certain merchandise-based vendor allowances do not qualify as reductions to inventory value and include the following:

    1. Co-op Advertising

    2. Wage Reimbursement

    3. Slotting Fees

    4. Opening Order Discount

    5. Exclusivity Agreement

    6. Market Development Funds

    7. New Store Allowance

    8. Price Increase Allowance

    9. Product Placement Allowance

    10. Failure fee

    11. Others

  3. See IRM 4.43.1.8 for additional information on vendor allowances.

  4. The purchasing process generally consists of the five following steps:

    1. Identifying the various vendors

    2. Contacting the vendors

    3. Evaluating the vendors

    4. Negotiating with the vendors

    5. Purchasing from the vendors

  5. Buyers may also be responsible for the merchandising of the goods they purchase. Merchandising tasks include involvement in markups and markdowns, the display of the goods (planograms) and advertising.

  6. A more detailed overview of the steps involved in purchasing specific goods includes the following:

    1. Interest in the product

    2. Investigation of the product

    3. Decision to purchase the product

    4. Establishment of profit margin for the product

    5. Determination of quantities to be ordered

    6. Buyer/vendor negotiation for price and terms

    7. Establishment and maintenance of an item file for the product which includes purchase cost and retail selling price, payment terms, shipping location and arrangements, and vendor information

  7. To purchase goods, the following actions are generally taken:

    1. A purchase order (PO) is prepared.

    2. The PO is sent to the vendor, manually or electronically, with the record retained in the unfilled PO file.

    3. The receiving area is notified by the vendor or the retailer’s transportation agent to schedule dock time for delivery. An employee in receiving pulls a copy of the PO or a check-in document.

    4. The employee in receiving matches the product(s) received with the product(s) ordered. A confirmation is sent to the invoice processing department or entered into the computer system.

    5. The vendor submits an invoice, manually or electronically, to the invoice processing area where it is entered into the computer for an automated reconciliation with other document information.

    6. After the reconciliation, the invoice is recorded in the accounts payable system and subsequently paid.

4.43.1.5.4.2  (07-23-2009)
Vendor Database Information

  1. Because retail operations may require interaction with thousands of vendors, the taxpayer will usually set up a vendor database. The following information is contained in the vendor database:

    1. Vendor name and address

    2. Name and telephone number of vendor’s representative(s)

    3. Buyer(s) representing the taxpayer/ retailer

    4. Vendor number assigned by the taxpayer/retailer

    5. Product names, codes such as the Stock Keeping Unit (SKU) or the Universal Product Code (UPC) number and descriptions

    6. Desired minimum and maximum product inventory on hand

    7. Automated reorder point data

    8. Product purchase price by quantity

    9. Payment terms and discounts

    10. Shipping information, including carrier and origin

    11. Historical cost data

    12. Retail selling price as established by the buyer

    13. Historical retail pricing data

    14. Cumulative purchase information

    15. Schedule of markdowns for seasonal or fashion merchandise

    16. Cooperative advertising agreements

    17. Details of various other rebates or purchase incentives offered

  2. The factual development of various inventory issues such as the tax treatment of discounts, vendor allowances, rebates, purchase incentives, cooperative advertising, markdowns, shipping information, cost data, retail selling price data, and other similar information can be obtained from the vendor database.

  3. Other records such as the stock ledger system or merchandise record will detail all merchandise purchase orders. The unfilled order file is one of the records a buyer will use to determine an "open to buy" limit which is the budgeted amount a buyer is permitted to order for a specific period of time.

4.43.1.5.4.3  (07-23-2009)
Purchase Journal and Price Change Records

  1. The following sections discuss the purchase journal and price change records and categories.

4.43.1.5.4.3.1  (07-23-2009)
The Purchase Journal

  1. The taxpayer’s merchandise purchase journal will contain all of the entries related to the purchase of merchandise. This journal is a subsidiary of the accounts payable system. All documents entering the payables system are coded to reflect the nature of the transaction such as a regular merchandise transaction, a chargeback issued to a vendor, or a payment of an unearned discount.

  2. The purchase journal can be used to document the transfer of merchandise between the warehouse and a store or between two stores. Merchandise physically returned to a vendor is another type of transaction reflected in the purchase journal.

4.43.1.5.4.3.2  (07-23-2009)
The Price Change Records and Categories

  1. The retail price of a product is initially established at or before the time of purchase, usually as part of the overall purchase negotiation process between the buyer and vendor. If the buyer enters the original purchase price of the product into the retailer’s retained copy of the purchase order, that retail price would then become part of the internal data base for that item and that vendor.

  2. The original retail price of an item is subject to numerous changes and only certain employees within the organization, such as a buyer, have the authority to change the price of merchandise and only with the approval of another party. Such authorizations and procedures are contained in the retailer’s internal procedures manual which will also specify entry codes and descriptions used for the various price changes.

4.43.1.5.4.3.2.1  (07-23-2009)
Categories of Price Changes

  1. Markups. Markups increase the retail selling price of an item from the price at which it was initially marked.

  2. Markup cancellations. Markup cancellations reduce the selling price of an item that was previously marked up to a point not lower than the original retail price established for the item.

  3. Markdowns. Markdowns are the most common adjustments to the retail selling price of an item. A markdown reduces the original retail price established for the item on the purchase order or product database. There are numerous types of markdowns including:

    1. Temporary or promotional markdowns which are used to increase store traffic. These markdowns are taken at the sales register or Point of Sale (POS) terminal. Usually the marked price of the item is not changed.

    2. Competitive pricing markdowns which are used to keep the price of a high profile item in line with a competitor’s price.

    3. Soiled, damaged, or one of a kind merchandise markdowns which may be entered into a markdown log book by a store manager for subsequent entry into the retailer’s computerized records.

    4. Scheduled permanent markdowns on excess seasonal or trendy merchandise items. These markdowns initiated by the buyer are scheduled at the time of purchase of the goods to insure the items purchased will be off the shelves by an established date. These markdowns are tracked separately since the buyer may have an agreement with the vendor for a partial or complete reimbursement of the markdown.

    5. Other permanent markdowns which are taken to expedite the sale of certain merchandise items.

4.43.1.5.4.3.2.2  (07-23-2009)
Markdown and Markup Cancellations

  1. Markdown cancellations. After an item has been marked down (or reduced) from its original marked price, a markdown cancellation restores the item to a higher price. Only the increase back to the original retail price is considered a markdown cancellation. To the extent the price increase results in a new price which exceeds the original retail price, the excess portion which exceeds the original retail price is a markup.

  2. Both markup and markdown cancellations occur infrequently because most retailers have a computer system in place which records temporary or promotional markdowns at the point of sale making the practice of markup and markdown cancellations unnecessary.

4.43.1.5.4.4  (07-23-2009)
The Stock Ledger

  1. The stock ledger is the principal inventory record used by retailers. This can be called a variety of names, depending on the retailer. The stock ledger in a perpetual inventory system contains a roll-up of summary data from the purchases journal or accounts payable system, the price change records, and the sales journal. It also contains the original entry information reflecting the adjustment of the book inventory to the actual physical inventory. It can also reflect the entry, either manual or automatic, to accumulate an estimate of the shrinkage to date. It will usually show a roll-up of merchandise items which have been received but not yet charged to the stock ledger.

  2. The stock ledger contains information regarding each item of inventory at each location since a retailer needs to know the number of each item of merchandise in stock and the location at which the item of merchandise is available. Updating the vendor database at the time of purchase and receipt of the goods in conjunction with the use of scanning devices for transfers or sales allows for a detailed tracking system of the retailer’s goods.

  3. Generally the complete stock ledger detail is not printed often due to its size. Summary information from the stock ledger is printed periodically. The information contained in the stock ledger and the operation therefrom is as follows:

    1. Beginning inventory at both retail and cost

    2. Purchases at both retail and cost including freight, as rolled up from the purchases journal

    3. Retail markups, less cancellations

    4. Transfers of merchandise between the warehouse or distribution centers and store(s) or between stores are accounted for as an addition or subtraction (if not part of the purchases journal record).

    5. A cost complement percentage is determined by comparing beginning inventory at cost plus goods/merchandise received at cost to beginning inventory at retail plus merchandise/goods received at retail (including markups).

4.43.1.5.5  (07-23-2009)
Financial Reporting

  1. This section provides general information of the various financial reporting systems.

4.43.1.5.5.1  (07-23-2009)
Generally Accepted Accounting Principles (GAAP)

  1. The three accounting methods widely used by both public and private companies to determine the costs of inventory are:

    1. First-In, First-Out (FIFO)

    2. Last-In, First-Out (LIFO)

    3. Average Cost

  2. Under Generally Accepted Accounting Principles (GAAP), inventory is to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. The write-downs, however, cannot be reversed even if the inventory subsequently rises in value.

  3. Under GAAP, market valuation takes into account the quantity and condition of the inventory. Market means replacement cost. Market, however, should not exceed "net realizable value" defined as the estimated selling price minus the direct costs of disposing of the inventory. Market should not be less than the net realizable value reduced by an allowance for a normal profit margin. For tax purposes, however, only actual sales prices are considered.

  4. Under both GAAP and tax accounting, the LIFO inventory method is permitted. If LIFO is used for tax purposes, LIFO must also be used for GAAP.

  5. Accounting Research Bulletins (ARB) No. 43, Chapter 4, "Inventory Pricing," discusses the general principles applicable to the pricing of inventory for GAAP purposes. Under ARB 43, the primary basis of accounting for inventory is cost.

  6. Financial Accounting Standards (FAS) No. 151, issued in November 2004 and effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and thus applied prospectively, amended the guidance in ARB No. 43, Chapter 4, "Inventory Pricing," to clarify that the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) requires recognizing such items as current-period charges.

  7. Although a taxpayer’s inventory methodologies conform to GAAP principles and pronouncements and are acceptable for financial accounting purposes, unless such methodologies clearly reflect a taxpayer’s income, the Commissioner of the IRS (Commissioner) may challenge such methodologies for tax purposes. Treas. Reg. 1.446-1(a)(2) provides that no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. IRC 471 establishes two tests to which an inventory method must adhere:

    1. The method must conform as nearly as may be to GAAP.

    2. The method must clearly reflect income. (Treas. Reg. 1.471-2(a))

  8. The Supreme Court in Thor Power Tool Co. v. Commissioner , 439 US 522 (1979) noted the Commissioner is vested in accordance with IRC 446 and IRC 471 with "wide discretion" in determining whether a particular method of inventory accounting should be disallowed as not clearly reflecting income.

4.43.1.5.5.2  (07-23-2009)
International Financial Reporting Standards (IFRS)

  1. Many countries around the world, including the European Union, have adopted the International Financial Reporting Standards (IFRS) in support of global accounting standards. Although the United States’ accounting rules and regulations are based on GAAP, the Securities and Exchange Commission approved a plan in August 2008 to allow some U.S. companies to apply International Accounting Standards (IAS), beginning with their 2009 financial statements, and for all U.S. companies to follow by 2016.

  2. Relative to the differences in treatment of inventory under GAAP and IFRS, the following material is excerpted from Wiley IFRS 2008: Interpretation and Application of International Financial Reporting Standards:

    Inventory Treatment under GAAP Inventory Treatment under IFRS
    Allowable costing methods include:
    • FIFO

    • Average cost

    • LIFO

    LIFO costing is banned under IFRS
    There are no special rules for biological inventory (e.g., growing crops, livestock) IAS 41 on agriculture specifies use of fair value less estimated selling costs for biological assets, with changes in value reported in income
    Presentation is required at lower of cost or market Presentation at lower of cost or net realizable value
    Only in rare instances (mining of gold, etc.) is presentation at fair value in excess of cost permitted Certain defined situations, including agricultural products, for reporting at fair value in excess of actual cost
    Certain costs (idle capacity, spoilage) cannot be added to overhead charge in inventory cost, conforming to IFRS rule Certain costs (idle capacity, spoilage) cannot be added to overhead charge in inventory cost
    Lower of cost or market adjustment cannot be reversed Lower of cost or market adjustments must be reversed under defined conditions
    Recognition in interim periods of inventory Losses from market declines that reasonably can be expected to be restored in the fiscal year not required Recognition in interim periods of inventory Losses from market declines that reasonably can be expected to be restored in the fiscal year is required; guidance in the areas of disclosure and accounting for inventories of service providers offered

4.43.1.5.6  (07-23-2009)
Retail Topics and Issues

  1. This section covers specific inventory applications in the Retail industry.

4.43.1.5.6.1  (07-23-2009)
Valuation of Inventories

  1. Some retailers prefer to use the retail inventory method of accounting in determining the value of inventory rather than the cost method which requires inventory to be valued at its acquisition cost. The retail inventory method uses the relationship of cost to retail price to determine the cost of merchandise in inventory. This method is an averaging method and its use has historically been more convenient to compute for most types of merchandise, especially as volume increases.

  2. If a perpetual inventory is maintained in conjunction with the retail inventory method, a retailer can determine profits without taking frequent physical inventories.

  3. The use of the LIFO method in the Supermarket Segment is probably more common than for almost any other industry. Use of the LIFO method is high because of the consistency of inflation for supermarket merchandise over many years together with significant inventory balances (single store cost inventory balances ranging from $300,000 to $2,000,000).


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