New accounting rules for advertising conflict with tax treatment.

The AICPA's Accounting Standards Executive Committee has issued Statement of Position (SOP) 93-7, Reporting on Advertising Costs, which will be a change in accounting method for many companies. Tax practitioners need to understand these new rules and how they differ from the tax law governing the time for deducting advertising costs. This article summarizes financial and tax accounting for advertising costs and highlights how to avoid potential pitfalls in obtaining Federal income tax deductions.

The SOP is effective for years beginning on or after June 15, 1994. Therefore, these rules will first apply for calendar-year 1995, but could apply to calendar-year 1994 if adopted early. The statement provides that the costs of all advertising should be expensed either as incurred, or the first time the advertising takes place, with two exceptions.

The first exception is direct response advertising. If the primary purpose of the direct response advertising is to elicit sales from customers who could be shown to have responded to such advertising, and it results in probable future economic benefits (i.e., future sales), direct response advertising should be capitalized. If direct response advertising is capitalized, it will be amortized over the estimated period of the benefits, based on the proportion of current period revenue from the advertisement to probable future revenue, and the asset will be reported at its net realizable value.

The second exception relates to advertising costs paid in a period later than the one in which the revenues are recognized from those costs. These expenditures should be accrued and the advertising costs expensed when the related revenues are recognized. For example, in a cooperative advertising agreement, entities assume an obligation to reimburse their customers for some or all of the customer's advertising costs.

Prior to adopting these rules, companies had used diverse methods of expensing and capitalizing advertising expenses. The objective of SOP 93-7 is to standardize the practices of recognizing advertising expenses by various reporting entities, and to reduce the amount of "soft" assets reported by these entities. The new accounting rules have accomplished this by accelerating the expensing of these costs in most cases.

Although companies will be required to change their method of accounting for advertising costs for financial reporting and disclosure purposes, SOP 93-7 will not require companies to apply to the IRS for change in their tax accounting methods.

Costs incurred to enhance overall goodwill or elicit immediate sales are included in the ordinary and necessary business expenses allowed as deductions under Sec. 162. These costs are deductible in the year incurred, depending on the taxpayer's method of accounting. The IRS confirmed this position in Rev. Rul. 92-80: "Only in the unusual circumstance where advertising is directed toward obtaining future benefits significantly beyond those traditionally associated with ordinary product advertising or with institutional or goodwill advertising, must the costs of that advertising be capitalized." Advertising costs are required to be capitalized if they relate to fixed assets or identifiable intangible assets with determinable lives in excess of one year, such as trade catalogs or bill-boards. (See Rev. Rul. 68-360; Cleveland Electric Illuminating Co., 7 Cl. Ct. 220 (1975); Alabama Coca-Cola Bottling Co., TC Memo 1969-123.)

For accrual-basis taxpayers, determining when an advertising expense is treated as incurred can be a complex question. Regs. Sec. 1.461-1(a)(2) applies the "all events" and "economic performance" tests in determining when an expense should be accrued. This "all events" test provides that a liability is incurred, and generally is taken into account for Federal income tax purposes, in the tax year in which all the events have occurred that establish the fact of the liability, and the amount of the liability can be determined with reasonable accuracy. In addition to the "all events" test, economic performance must have occurred with respect to the liability. Sec. 461(h) provides that, with respect to services and property provided to the taxpayer, economic performance occurs as the services and property are provided. Regs. Sec. 1.461-4(d)(6)(ii) expands the economic performance rule, and permits taxpayers to treat services (or property) as provided when the taxpayer makes payment to the person providing the services if the taxpayer can reasonably expect the person to provide the services within 3 1/2 months after the date of the payments.

There is an important exception to the economic performance rule. Under the recurring item exception of Sec. 461(h)(3), an item will be treated as incurred before economic performance takes place if the "all events" test is otherwise met, and economic performance occurs within the earlier of the date the taxpayer files a timely return (including extensions) or the fifteenth day of the ninth calendar month after the close of the tax year (Regs. Sec. 1.461-5(b)(1)). The item must be recurring, and the taxpayer must treat such items consistently. In addition, the item must be either not material in amount or the timing of inclusion of the item must result in a better matching of income and expense than if the economic performance rule were applied.

Although the emphasis often falls on the economic performance rule when considering if an accrued liability is deductible, the "all events" test has been the stumbling block in certain situations. Letter Ruling (TAM) 9416004 addressed this question with respect to cooperative advertising; Letter Ruling (TAM) 9343006 discussed promotional allowances. These advertising programs were very similar, and the IRS rulings were virtually identical.

The Service ruled that a manufacturer may not accrue a deduction for cooperative advertising expense or promotional allowances prior to the year in which claims (i.e., the proof of performance of the advertising services) were submitted. For purposes of the "all events" test, the manufacturer's liability to the retailer for the advertising services was fixed when the retailer submitted its claim for payment, not when the advertising service was performed. The IRS reached this conclusion because the contract between the manufacturer and the retailer provided that payment would not be made until the claim was properly filed. This position is consistent with the decision in General Dynamics Corp., 481 US 239 (1987), in which the Supreme Court held that medical insurance claims were required to be filed before the "all events" test would be met with respect to the insurance liabilities. The fact that medical services were provided was insufficient to prove that proper claims would be filed and insurance liabilities would be created.

Both the letter rulings and Supreme Court case clearly indicate that if an advertising agreement provides that a manufacturer must receive a proper claim before payment will be made to the retailer, the "all events" test will not be met until that claim is made. However, the Service requires only that proof of performance be submitted before the accrued liability could be deducted (if that was a requirement of the advertising agreement). Alternatively, the agreement could provide that the retailer is entitled to payment on performing the service, and would be required to refund any payments made that were later found to be unsubstantiated. Therefore, manufacturers and wholesalers may wish to reconsider making proof of performance a prerequisite to making payments in their advertising agreements.

The new financial accounting rules may create new reconciling items (Schedule M-1 items) between book and tax accounting for advertising costs. These costs may be deducted for tax purposes in a period earlier than they are expensed for books if the advertising is capitalized direct response advertising, which is not required to be capitalized for tax purposes. Conversely, advertising costs may be expensed for book purposes in a period earlier than they are deducted for tax purposes if they are recorded prior to performance of the advertising services, and the "all events" and "economic performance" tests have not been satisfied. Advertising costs may also be expensed for book purposes in a period earlier than they are deducted for tax purposes if the advertising costs are required to be capitalized for tax purposes, but not for books.

In the case of advertising costs (as is the case with many Federal income tax rules), planning and documentation of customer agreements is very important. With respect to year-end accruals, the contract provisions and timing of payments can be critical as to when an item is deductible for income tax purposes. To secure the earliest deduction of these expenses, taxpayers should review the agreements with their customers and see if changes can be made that would cause the "all events" test to be satisfied by year-end. The agreement should establish the fact of the liability on the execution of the agreement, and provide that the right to receive payments will be at the time the service is rendered, not when claim for payment is submitted. Once the "all events" test is satisfied before year-end, additional planning can be implemented to secure the deduction. The recurring item exception may be available to accrue the deduction, or the 3 1/2-month rule may be invoked by prepaying the liability.

From Daniel J. Moore, CPA, Parsippany, N.J.