Jeffrey Boyd, the president of Eagle Furniture Company (average annual gross rec

Question

Jeffrey Boyd, the president of Eagle Furniture Company (average annual gross receipts of $4 million), has prepared the company’s financial statements and income tax returns for the past 15 years. In July 2016, however, he hires you to prepare the 2015 corporate income tax return because he has not studied taxes for over 20 years and suspects that the rules may have changed. Eagle uses the accrual method of accounting. Based on an initial examination of Eagle’s trail balance and some account analyses, you have determined that the following items may require adjustments.

• The company uses the FIFO inventory method, as valued at cost. However, all freight expenses on incoming merchandise have been expenses for the 15 years the company has been in business.

• The company experiences inventory shrinkage (due to breakage and theft) of about 1% of sales each year. The shrinkage is not taken into account until the company takes a physical inventory each October, but the corporation’s fiscal year ends January 31.

• The company has used an allowance for uncollectable accounts, which has a balance of $60,000. In the past, the company has been able to accurately predict it actual bad debt expense.

• The company sells a three-year service contract on its appliances. The company treats 1/36 of the contract price as earned each month. At the beginning of the year, the company had $120,000 in its account for unearned revenues from the service contracts.

• The company deducts its state income tax in the year paid. Thus, the 2015 state income tax expense includes the estimated taxes paid in 2015 and the additional amount paid in 2015 on 2014 taxes.

Write a letter to Mr. Boyd, explaining what adjustments will be required and how they will be implemented. The address of Eagle Furniture Company is 1000 East Maryland Street, Evansville, IL 47722.

Explanation / Answer

Dated : 10-12-2015

Mr. Boyd

Eagle Furniture Company

1000 East Maryland Street,

Evansville, IL. 47722

Dear Sir,

Thanks for giving us the opportunity to serve as the consultant in the Income Tax preparation for 2013. We have gone through the Trial Balance and Account entries and in our opinion you need to make the adjustments in to arrive at Taxable Income for the year.

Inventory valuation: Incoming Freight expenses are expensed out instead of inventorizing. This may cause inflated COGS reporting if the ending inventory is higher as the inventory does not contain the freight component. This needs to be corrected and as per the correct accounting principle , freight inwards needs to be inventorized.

Inventory shrinkage: The shrinkage happens at the rate of 1% of sales . The physical inventory verification happens and stock adjusted in October. However, the Financial year closes on Jan 31. So, an adjustment entry for recognizing inventory shrinkage for three months for the inventory value corresponding to 1% sales qty has to be taken by crediting inventory and debiting allowance for inventory shrinkage account. This amount is allowable deduction for Income Tax purpose.

Business bad debt needs to be recognized in the year it becomes worthless. As the company could accurately predict bad debts, there should not be additional bad debts allowance of previous year carried forward this year unless there is business justification for it. The bad debt to be predicted correctly , calculated accurately and the write off to be made for this year’s bad debt only.

The revenue from service can be recognized in the period when the deliverables are complete. The unearned revenue in a year can be recognized in a year if the service deliverables can be completed next year. If the service deliverables are expected to be complete in later part of next year , then the unearned revenue can be considered for tax purpose in the next year. If the unearned revenue $120,000 has not been accounted for Tax purpose in the previous year , it can be recognized this year if the deliverables are completed this year.

State Income Tax can be deducted in the year it is paid irrespective of the year to which the Tax pertains. So the state Income Tax for 2013 & 2012 will be deductible for Federal Income Tax calculation.

You are requested to get these entries adjusted for Federal Tax calculation purpose. We may further discuss for any clarification required in any aspect.

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