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Tax implications on the financial accounting treatment of cooperative advertising reimbursements.

The Financial Accounting Standards Board's (FASB's) Emerging Issues Task Force (EITF) recently released Issue No. 0216, Accounting by a Customer (Including a Reseller) for Certain Cash Consideration Received from a Vendor. Although this consensus provides guidance, in part, on the financial statement treatment of amounts received by a customer, including a reseller (collectively, reseller) for cooperative advertising arrangements, it introduces a potential conflict between the EITF's and the IRS'S treatments of cooperative advertising allowances.


The EITF assists the FASB in identifying emerging issues affecting financial reporting. It consists mainly of CPAs from public accounting firms, but also includes the SEC's chief accountant. EITF decisions, which are labeled a consensus, are considered Generally Accepted Accounting Principles (GAAP).

What Is Cooperative Advertising?

Vendors often agree to compensate resellers if the reseller advertises the vendors' products. The program for encouraging this advertising is referred to as cooperative advertising.

The specifics of such programs vary. In some cases, the allowance may depend on the actual cost of the promotional activities conducted by the reseller. In others, the reseller might not have to provide any specific advertising. Typically, the allowance depends on the volume of purchases, although sometimes it is a fixed amount for the year.

The promotional agreement typically describes the arrangement's terms. If the reseller performs any required advertising under the promotional agreement, it might have to submit documentation to prove adherence to the agreement, including actual copies of advertisements, invoices, dates the advertisements were run, etc. In other cases, it may not need documentation. If the advertising allowance is based on a percentage of purchases or is volume-based, generally the vendor will reduce the reseller's outstanding receivable or issue a credit for future purchases.

The Problem

Most manufacturers or other vendors offer a variety of rebates or trade discounts, including an "allowance" for advertising. Usually, these inducements depend on the volume or quantity of purchases or other factors negotiated by the vendor and the reseller. While "trade discounts" are not defined in the regulations, Rev. Rul. 84-41 defines them as a vendor's reduction to the purchase price, which varies depending on volume or quantity purchased. If a discount is always allowed regardless of time of payment, it is deemed to be a trade discount. Regs. Sec. 1.471-3(b) requires trade or other discounts to be treated as reductions in the purchase price of the inventory to which they relate, rather than as gross income. The result is generally a deferral of taxable income to the extent discounted goods remain in inventory at the end of the tax year. This deferral occurs because the discount is not an item of income when the merchandise is purchased, but rather, an adjustment to inventory (and, thus, taken into income when the merchandise is sold). For a LIFO taxpayer, the deferrals may be extended over a longer period.

Because most vendors offer cooperative advertising allowances through their trade discount programs and taxpayers view this allowance as a rebate or discount, the treatment of these amounts has raised issues. In Field Service Advice (FSA) 199915011, the IRS viewed such allowances as a reimbursement for a reseller's services, not as a reduction in merchandise cost. The Service further stated that the allowance was outside the scope of a trade-discount program, was an accession to wealth and, thus, includible in income. The issuance of FSA 199915011 has resulted in the IRS taking a very narrow approach toward treating cooperative advertising allowances as part of a wade-discount program.

While an FSA is dearly not precedential and merely represents the Office of Chief Counsel's response to an inquiry from an IRS agent or Chief Counsel litigator, it nevertheless sets forth the IRS's technical (and presumably litigation views) on the issue. The FSA makes some very strong statements. For example, it states that cooperative advertising is the performance of services by a reseller for a manufacturer (or other vendor), with income and expenses accrued in the year the advertising is placed. Further, according to the FSA, an advertising allowance is a reimbursement for a reseller's cost that benefits both the vendor and the retailer. The vendor is receiving a service--advertising--for which it is willing to pay; the reseller is performing a service for which it is compensated.

Following the FSA, the IRS National Office has taken a very strict approach in processing accounting-method changes when any form of advertising is involved. For the most part, the Service is disregarding the fact that the "discounts" are conditioned on the reseller's purchases of merchandise and, thus, do not rise to the level of gross income. The IRS's determination is based solely on a review of the vendor and reseller's agreement (i.e., form of the transaction), while disregarding the economic realities. The reseller does not view itself as being in the advertising business or even performing a service on the vendor's behalf, it advertises as part of normal business strategies regardless of whose merchandise is being advertised.

Financial Accounting Treatment of Cooperative Advertising

In Issue No. 02-16, the EITF reached a consensus that cash consideration received by a reseller from a vendor for cooperative advertising is presumed to be a reduction of the prices of the vendor's products or services and, thus, should be classified as a reduction of cost of sales when recognized in the reseller's income statement. However, that presumption is overcome if the consideration is either (1) a payment for assets or services delivered to the vendor (in which case, the cash consideration should be classified as revenue (or other income, as appropriate) when recognized in the reseller's income statement; or (2) a reimbursement of costs the reseller incurred to sell the vendor's products, in which case, the cash consideration should be classified as a reduction of that cost when recognized in the seller's income statement.

The result of applying this consensus may change the period in which amounts normally referred to as reimbursements for cooperative advertising are recognized. That is, if an amount of reimbursement previously classified as an advertising expense reduction does not overcome the presumption described above, the allowance should be classified as a reduction of inventory costs or costs of goods sold. This may result in income being recognized in a different period than that in which the reimbursement would have been recognized before the consensus.

The Conflict

Clearly, a conflict exists between Issue No. 02-16 and the IRS's treatment of cooperative advertising allowances. As a result of the EITF consensus, amounts that an entity has historically classified as a reduction of advertising expense for financial accounting purposes will have to be reclassified as a reduction of inventory costs or cost of goods sold. In those situations, income-statement recognition generally will occur in the period the inventory is sold, rather than in the period in which the advertising expenditure is incurred. A change in treatment for cooperative advertising reimbursements due to the EITF consensus would, most likely, constitute an accounting-method change for tax purposes.

In general, an accounting method that consistently applies GAAP will be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year; see Regs. Sec. 1.446-1(a) (2) and -1(c)(2)(ii). However, adherence to GAAP does not necessarily mean that the method clearly reflects income when the Code or regulations specifically provide for the use of an alternative accounting method; see Thor Power Tool Co., 439 US 522 (1979). Note: the regulations do not specifically address the treatment of cooperative advertising allowances, so the reference to clear reflection of income in Thor Power should not apply.

Taxpayers will be faced with the dilemma of following the EITF for financial statement purposes and a different set of rules for Federal income tax purposes, creating book-tax differences, which most taxpayers want to avoid. More importantly, however, taxpayers will be faced with an administrative nightmare of having to separate vendor allowances for cooperative advertising from other allowances or rebates that they must treat under the regulations as part of the cost of inventory. LIFO taxpayers will now be faced with an additional burden of complexity, because of the computational differences between their LIFO Lax-basis inventory and the valuation used for GAAP purposes.

Is There a Compromise?

The IRS's view that resellers are performing an advertising service for vendors is somewhat questionable, particularly when the allowance is based on volume or as a percentage of purchases. The trade discount that might be attributable to cooperative advertising has no connection to the actual advertising the reseller may incur. Put simply, an increase in the discount from the vendor does not necessarily mean that the reseller will increase its advertising budget. Conversely, a reseller may decide to increase advertising expenditures for a certain product, even if little or no advertising allowance is available. Resellers advertise products to increase sales whether or not an allowance is available from the vendor.

Section 9.05 of the Appendix to Rev. Proc. 2002-9 (the automatic procedure for accounting-method changes) permits taxpayers to automatically change their method for reporting volume-related trade discounts, providing "... the taxpayer is neither obligated nor expected to perform or provide any services in exchange for the discount." While most resellers are not required to perform any service to earn a trade discount, most vendors "expect" them to advertise their products. This is not an unrealistic expectation; based on Appendix Section 9.05 language, resellers may be hesitant to file for an automatic change.

Unofficially, IRS representatives have stated that the EITF is a GAAP pronouncement and at this time the IRS does not plan to alter its views on reporting advertising allowances.

Caveat emptor.



David Madden, J.D., LL.M.


Washington National Tax Service


Washington, DC
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Author:Madden, David
Publication:The Tax Adviser
Date:Jun 1, 2003
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