Using APB opinion 21 and IRC Sec. 1274 to evaluate accounting and tax issues for an unusual loan.

Coffee, David ; Lirely, Roger

CASE DESCRIPTION

This case considers the financial accounting and tax issues associated with a loan made by a manufacturing company to the Atlanta Braves baseball team. The case has a difficulty level of four/five and is appropriate for an upper level financial accounting class or tax class. It is designed to be taught in one hour and requires two hours outside preparation by students.

CASE SYNOPSIS

A manufacturing company loans the Braves money at an interest rate below market. The Braves donate 20 season tickets to the company. Students are required to evaluate this transaction to determine: (1) how it should be treated for financial reporting purposes by the lender; and (2) the proper tax treatment of the transaction by the lender. The case demonstrates how financial accounting issues and tax issues can be similar as well as different in a business transaction.

INSTRUCTORS' NOTES

Introduction

This is an illustrative case. The subject matter concerns the lender's financial accounting and tax treatment of a transaction, which includes a loan, made at an unrealistic market rate and the receipt of 20 Atlanta Braves season tickets. The case has a difficulty level of four/five, appropriate for senior level or graduate courses and is designed to be taught in one class hour and is expected to require two hours of outside preparation by students.

Requirements

The case requires students to:

1. research authoritative accounting literature related to the proper accounting for notes receivable and make conclusions about the proper accounting treatment of the transaction.

2. research tax literature to identify tax issues and make conclusions about the proper tax treatment of the transaction.

CASE OBJECTIVES:

The case presents an accounting transaction, which becomes the basis for conducting financial accounting and tax research to identify how to properly treat the transaction.

The first objective of the case is to require students to conduct financial accounting and tax research.

A second objective of the case is to provide a financial accounting issue, which requires students to think critically and apply accounting logic and reasoning using the financial accounting model.

A third objective of the case is to illustrate the similarity and differences between tax issues and financial accounting issues.

APPLICABLE PROFESSIONAL PRONOUNCEMENTS AND TAX RESOURCES:

Financial Accounting:

"Interest on Receivables and Payables," Opinions of the Accounting Principles Board No. 21 (New York: AICPA, 1971)

"Interest: Imputation of an Interest Cost (Section 169)," Current Text, 1997/98 Edition, Volume 1, General Standards, Financial Accounting Standards Board, (New York: Wiley, 1997)

Taxes:

Internal Revenue Code of 1986 and Treasury Regulations (2003)

West United States Tax Reporter

RECOMMENDED TEACHING APPROACH:

We have tested this case in graduate accounting courses and found that it generates strong student interest and lively discussion. We have found a role playing scenario to be helpful in teaching the case. The case can be assigned to student groups of two, having one student in the group assume the role of Gary Gaines, the partner in charge of the independent audit, and the other assume the role of Phillip, the tax partner. This approach assigns one student responsibility for the financial accounting research and the other responsibility for the tax research. Each group can make a joint report to class.

CASE OVERVIEW

The case describes a $100,000 loan the Georgia Manufacturing Company has made to the Atlanta Braves Baseball team. The terms call for the return of the $100,000 principal in three years along with interest payments of 2% due at the end of each year. The Atlanta Braves, who are paying 10% for borrowed funds at the time of the loan, give the Georgia Manufacturing Company 20 season tickets in exchange for the favorable interest rates.

The Georgia Manufacturing Company has accounted for the loan by recognizing a note receivable for $100,000 on their books and crediting cash for $100,000. They recognized interest revenue of $2,000 for the interest payment received at the end of the first year, 12-31-03. Gary Gaines, the partner in charge of the independent audit, must decide if the accounting treatment of the note is acceptable. He must also determine the proper treatment of the transaction for tax purposes.

KEY ISSUES--FINANCIAL ACCOUNTING

1. What is the proper valuation of the note on the books of Georgia Manufacturing?

APB 21, Par 11 states that "when a note is received or issued for cash and no other right or privilege is exchanged, it is presumed to have a present value at issuance measured by the cash proceeds exchanged."

Since $100,000 was given to the Braves, a strict interpretation of this passage would assume that $100,000 would be the value of the note if it is concluded "no other right or privilege has been exchanged."

Even assuming for the moment that nothing was exchanged but cash and a note, it seems questionable to value the note at the $100,000 cash given the Braves because the interest rate on the note (2%) is so far below the indicated market rate (10%). The true present value of the note would be the present value of the cash flows ($2,000 +$2,000 + $102,000) discounted at the market rate of 10%. This would lead to a present value of:

Present value of $100,000 discounted 3 $75,132
periods @ 10%

Present value of the 3 interest payments of $4,973
$2,000 discounted @ 10%
 $80,105

2. Should the season tickets be recognized on the books of Georgia Products, and if so, at what value?

Georgia has given the Braves $100,000 cash for a note that has a value of $80,105. Is some other right or privilege involved in the transaction? Yes, the season tickets. They have an implied value of $100,000-$80,105 = $19,850. This equates to $992.50 ($19,850/20) each. Is this reasonable? Checking the Braves website at atlanta.braves.mlb.com indicates 2003 season ticket prices ranging from $850 - $3,735 per seat. It appears that the season tickets should be recognized as some type of asset on Georgia Products books as of January 1, 2003.

APB 21 par 7 states: "If cash and some other rights or privileges are exchanged for a note, the value of the rights or privileges shall be given accounting recognition by establishing a note discount or premium account. In such instances the effective interest rate differs from the stated interest rate. In this transaction, from Georgia Products perspective, they have exchanged cash for a note and a right or privilege (the season tickets). They use the 10% rate as the effective rate, which differs from the stated rate of 2%. As noted in APB 21, the difference between the present value of the note received and the cash given is appropriately regarded as the value assigned the season tickets, which are an asset on January 1.

3. How will interest revenue be recognized on the books of Georgia Products? An amortization table is constructed, recognizing interest at 10%

4. What are the appropriate journal entries on the books of Georgia Products?

KEY ISSUES--TAXES

1. Will Georgia Products recognize taxable income due to the below-market loan?

With some exceptions for de minimis loans between natural persons, between employers and employees and between corporations and shareholders, Section 7872 of the Internal Revenue Code (I.R.C.) requires interest to be imputed on certain below-market loans. A below-market loan is a loan for which the amount loaned exceeds the present value of the amounts to be received [[section]7872(e)(1)(B)]. This excess if referred to as foregone interest [[section]7872(a)(1)].

Section 7872 mandates that the present value of loan receipts be computed using the applicable federal rate (AFR), compounded semi-annually [[section]7872(b)(1)]. The IRS computes and publishes AFRs monthly using the life of the loan and the market rate of interest on marketable government securities with similar lives as criteria [[section]1274(d)]. For this case, we assumed that the applicable AFR was 5.47%. Instructors may want to vary rates to give students an opportunity to see both discount and premium scenarios and to examine the effect of varying interest rates on the present value of the bond. Using this procedure, the present value of the note for tax purposes is $90,444.33. Since the present value of the loan receipts is less than the amount of the loan, the loan is a below-market loan.

The tax treatment of the foregone interest depends upon whether the loan is (a) a gift or a demand loan or (b) a term loan. Section 7872(f)(3) defines a gift loan as one in which the foregoing of interest is in the nature of a gift. Generally, one thinks of gift loans as a loan between members of the same family--i.e., parents loan a child the down payment for the purchase of a home. Despite the apparent donative intent expressed by Roger, the CEO, it is unlikely that a loan made in a business setting as part of a business transaction could be construed as a gift [CIR v. Duberstein, 363 U.S. 378 (1960)]. In addition, although Georgia Products may not have made the loan with the express expectation of receiving anything in return, the Braves will mention Georgia Products as a supporter of the program and gave season tickets to the company. Based on these facts, we concluded that the loan was not a gift loan. A demand loan is a loan payable on demand [[section]7872(f)(5)]. Since the dates for the payment of principal and interest are specified in the note, the loan is a term loan.

Section 7872 presumes that the foregone interest is first transferred by the lender to the borrower then re-transferred from the borrower to the lender as interest [[section]7872(a)(1)]. Both parties should treat the foregone interest as original issue discount, that is a loan in the amount of $90,444.33 and original issue discount of $9,555.67 [[section]7872(b)(2)]. Georgia Products should recognize taxable interest income under the effective interest method using a constant semi-annual yield to maturity equal to its AFR as follows:

 Cash
 Interest Interest Discount Carrying
Period Received Income Amortized Amount

2003 $90,444.33
1st 6 months $0.00 $2,473.65 $2,473.65 $92,917.98
2nd 6 months $2,000.00 $2,541.31 $541.31 $93,459.29
 $5,014.96
2004
1st 6 months $0.00 $2,556.11 $2,556.11 $96,015.40
2nd 6 months $2,000.00 $2,626.02 $626.02 $96,641.42
 $5,182.13
2005
1st 6 months $0.00 $2,643.14 $2,643.14 $99,284.56
2nd 6 months $2,000.00 $2,715.44 $715.44 $100,000.00
 $5,358.58

2. How does Georgia Products handle the receipt of the tickets?

Georgia Products "tax" journal entry would be as follows:

Prepaid Expenses 9,555.67
Notes Receivable 100,000.00
Discount Notes Rec. 9,555.67
Cash 100,000.00

The interpretation of this journal entry is that GP advanced $90,444.33 to the Braves for a 2% note. The remaining $9,555.67 is GP's tax basis in the tickets, which are recorded as prepaid expenses.

3. What tax consequences are there when Georgia Products uses the tickets?

The tax consequences to GP differ depending upon how GP uses the tickets. We analyzed three possibilities: (1) GP gives the tickets to employees for their personal use; (2) GP offers the tickets to the general public as part of a promotional campaign; and (3) GP uses the tickets to entertain customers

(1) The tickets are entertainment-related expenses. Unless entertainment expenses are either directly related to or associated with the active conduct of the taxpayer's trade or business, section 274 disallows any deduction for entertainment expenses. However, if GP treats the tickets as employee compensation and as wages subject to withholding, they can deduct the cost of the tickets [[section]274(e)(2)]. Otherwise, GP's deduction would be limited to 50% of its cost under the entertainment expense limitations of section 274(n).

(2) Entertainment expenses are directly related to trade or business if during the entertainment, the taxpayer engaged in a bona fide business activity with a reasonable expectation of deriving income or some other specific business benefit [[section]1.274-2(c)(3)(i)-(iv)]. An entertainment expense is associated with a taxpayer's trade or business if it immediately precedes or follows a bona fide business discussion and was incurred for a clear business purpose. Section 274(m) limits the amount of the deduction to 50% of its cost. Accordingly, GP could deduct $4,7777.84 if the customer entertainment was either directly related to or associated with their business.

(3) GP would be allowed to deduct the entire $9,555.67 as promotional expenses [[section]274(e)(7)].

KEY ISSUES--RECONCILIATION OF ACCOUNTING AND TAX DIFFERENCES

1. How should Georgia Products handle the differences between financial statement and tax return revenues and expenses?

The following table summarized these differences assuming GP deducted the entire cost of the tickets:

Since taxable income temporarily exceeds financial statement income in 2003, Georgia Products has a deductible temporary amount that causes financial statement tax expense to exceed taxes payable in 2003. Georgia Products should create a deferred tax asset in 2003 and decrease financial statement tax expense in 2004 and 2005 as the temporary difference reverses.

David Coffee, Western Carolina University

Roger Lirely, Western Carolina University

 Cash Interest Interest Discount Carrying
Period Received Income Amortized Amount

1-1-2003 $80,105
12-31-03 $2,000 8,010 $6,010 $86,115
12-31-04 $2,000 $8,611 $6,611 $92,726
12-31-05 $2,000 $9,274 $7,274 $100,000

1-1-03 Notes Receivable 100,000
 Season Tickets (Asset) 19,895
 Discount Notes Rec 19,895
 Cash 100,000
12-31-03 Cash 2,000
 Discount on Notes Rec 6,010
 Interest Income 8,010
12-31-03 Promotion Expense 19,895
 Season Tickets 19,895
12-31-04 Cash 2,000
 Discount on Notes Rec 6,611
 Interest Income 8,611
12-31-04 Cash 102,000
 Discount on Notes Rec 7,274
 Interest Income 9,274
 Notes Receivable 100,000

Expense fully tax deductible

Pretax financial income 2003 2004

Interest revenue $8,010.00 $8,611.00
Expense (19,895.00) $0.00
Income before taxes ($11,885.00) $8,611.00
Taxable revenue $5,014.96 $5,182.13
Expense (9,555.67) $0.00
Taxable income ($4,540.71) $5,182.13

Pretax financial income 2004 2003-2005 Total

Interest revenue $9,274.00 $25,895.00
Expense $0.00 ($19,895.00)
Income before taxes $9,274.00 $6,000.00
Taxable revenue $5,358.58 $15,555.67
Expense $0.00 ($9,555.67)
Taxable income $5,358.58 $6,000.00