Number 73 - Accounting Theory and Illustrations Related to Unusual Reporting Areas
Department of Transportation, Research and Special Programs Administration, Office of Aviation Information Management
Issue Date: June 14, 1985
Section2, 8, 15, 16, 17
Subsection 2-6, 2-7, 2-16, 15-91, 16-95, 17-96, 17-97
Paragraph 2-6(a) through (e), 2-7(a) through (e)
Recent Form 41 reports have included a number of apparent reporting errors in the following data items:
|Description||Functional Account||Detail Classification Function and Objective Account|
|Income Taxes Applicable to Extraordinary Items||9700||9797|
|Income Tax Effect of NOL||9700 and 9100||9797 and 9100|
There are no discrepancies between generally accepted accounting principles (GAAP) and our regulatory accounting principles and requirements for these items. However, the Uniform System of Accounts and Reports for Large Certificated Air Carriers (14 CFR 241 or USAR) does require specific disclosures and tests of materiality that air carriers should take into consideration when evaluating the accounting classification of such items.
Generally, items included in the above special classifications should be explained in the footnotes to the Form 41 financial statements (Schedule P-2) in the period the data are reported in the Statement of Operations. Such a brief footnote would define the nature of the item that distinguishes it from ordinary transactions.
Among the most frequent problems encountered are those dealing with accounting and reporting for income taxes.
For instance, although the definitions of the income tax objective accounts (9191, 9192 and 9193) in section 14 CFR 241 may appear to be overly complex and detailed--reflecting the turbulent history of income tax accounting and reporting--the accounting theory In section 2-6 of 14 CFR 241 is fully consistent with GAAP. However, it appears some carriers have problems in determining or reporting the income tax data, due to the complexities of accounting for investment tax credits and other tax elements to arrive at the current and deferred portions of Federal, state, foreign or other income taxes.
A rather controversial issue is the application of Net Operating Losses (or NOL's) to reduce current and noncurrent income tax provisions. Under generally accepted accounting principles, as we interpret them, NOL's affect both Account 9100 and Account 9797.
The reduction in Income taxes from carryforward of prior year's operating losses (the tax effect of NOL's), that is shown in Account 9797, is also a component in the Account 9100 tax provision. Chapter 13 of the Accountants' Handbook, Sixth Edition, Siedler and Carmichael, Editors, Wiley/Ronald, New York 1981, offers an illustration of a new company with an operating loss of $400,000 its first year and $1,000,000 income before taxes its second year, with no permanent or timing differences and a tax rate of 40%. In its second year, the company owes only $240,000 in income taxes, because the $400,000 NOL carryforward reduces its taxable income to $600,000. For both GAAP and Form 41 Schedule P-1.2 reporting, the financial statement presentation is:
|Income before income taxes and extraordinary items||$1,000,000||8999||Provisions for income taxes: Currently payable||$240,000||Tax effect of NOL carrryforward||160,000||Total provisions||400,000||9100||Income before extraordinary items||600,000||9199||Extraordinary item taxes:Tax effect of NOL's||160,000||9797||Net income||760,000||9899||Total income taxes, net of tax effect of NOL's||240,000||N/A|
This presentation on the financial statements is consistent with the requirements of Accounting Principles Board Opinions No. 9 and 11. The components of income taxes (taxes payable, deferred taxes, and the tax effects of operating losses) must be disclosed In the income statement, according to APB 11. This Opinion also requires an extraordinary item presentation of the tax effect of NOL's--when such tax benefits are realized in a later period. In summary, in order to fully disclose the tax effect of NOL carrryforwards in Account 9797, the offsetting or tax avoided amount is shown as a component of Account 9100.
DISCONTINUED OPERATIONS AND EXTRAORDINARY ITEMS
These areas are explained in Attachments I and II.
If you have any questions, please contact Mr. Donald Bright on (202) 426-7372.
Robin A. Caldwell
1. Discontinued Operations
Example A - This is a discontinued operation:
A large air carrier has a maintenance base generating very large annual maintenance revenues that exceed the air carrier's annual transport revenues. Even though the maintenance base is not a corporate entity that is a legal subsidiary of the air carrier, it Is of such material size (as defined in section 1-6 of 14 CFR 241) that the air carrier accounts for it as a nontransport entity, with its own separate management, books and records. The financial and operating results of the maintenance base primarily impact the air carrier in its investment accounts (A/C 1510) and its nonoperating income and loss accounts (Function 8100). Otherwise, the nontransport entity is totally isolated from the air carrier's transport and transport-related financial position and operating results data.
A new low-cost carrier offers to buy the maintenance base, which has been operating at a loss for years. After evaluation, the air carrier decides to discontinue the maintenance base rather than sell. The carrier closes out its $90 million of accumulated losses in Account 1510 (including employee severance pay, losses on sale of maintenance base assets, tax adjustments, and other closing costs) against its $100 million investment in the maintenance base. The remaining $10 million of investment Is written off by a charge to Account 9695 and a credit to Account 1510.
These discontinued operation entries are summarized:
Entry to establish $100 million investment in Nontransport Entity
Dr. A/C 1510.21 Advances to Associated Companies-Investment in Nontransport Division - $100,000,000
Cr. A/C 1010 Cash - $100,000,000
Entry to record nontransport entity's last acounting period operating loss of $20 million, bringing total accumulated losses to $90 million
Dr. A/C 8189.86.0 Income from Nontransport Divisions - $20,000,000
Cr. A/C 1510.22 Advances to Associated Companies-Accumulated Losses - $20,000,000
Entry to write off investment and discontinue operations
Dr. A/C 9695.2 Loss on Disposal of Discontinued Ops. - $10,000,000
Dr. A/C 1510.22 Advances to Associated Companies-Accumulated Losses - $90,000,000
Cr. A/C 1510.21 Advances to Associated Companies-Investment in Nontransport Division - $100,000,000
Example B - This is not a discontinued operation:
A small air carrier (which does not own any subsidiary companies and does not have any non-transport operations as described in section 1-6(b) of 14 CFR 241) conducts only air transport operations, and its only source of other income Is the incidental and minor (immaterial) transport-related revenues from liquor sales on passenger flights. It performs air transport operations as (1) nonscheduled passenger and cargo charters with two narrow bodied aircraft and (2) nonscheduled all-cargo operations with ten wide-bodied aircraft. The passenger aircraft are not a significant portion of the carrier's fleet in terms of capacity or dollar value.
The carrier decides to sell the mixed configuration (passenger/cargo) aircraft and to concentrate on all-cargo charters. It realizes a gain of $200,000 on the sale. This is not an item reportable in Account 9695, even though it may be a material item under the criteria in section 2-7 of 14 CFR 241. Instead, it is by definition a gain on equipment disposition that should be reported in Account 8188.5 (included in control account 8189) in accordance with section 5-3(e)(5) of 14 CFR 241. The only impact from its materiality would be an explanatory footnote on Form 41, Schedule P-2.
Accounting Theory - Discontinued Operations:
The distinguishing feature of the classification decision, as to whether an item is accounted for as a discontinued operation, is whether the transaction involves a separate major segment of business of an enterprise. For air carriers, this may be a nonairtransport entity with its own separate books, records and management, such as a major nontransport division, or an owned subsidiary in a separate major line or business other than air transport operations. An example is a hotel operation that is incorporated as a separate and distinct entity from the carrier's air transport operations.
On the other hand, the phasing out of a class of service, or discontinuance of part of a line of business, or a shift in marketing emphasis, or product mix, are all decisions that are central to the air transport operations of the air carrier that (under APO No. 30) do not qualify as discontinued operations.
II. Extraordinary Items
Example A - This is an extraordinary Item:
An air carrier established a route to a developing nation. The new entrant-had total annual operating revenues of $15 million. Based on the materiality test in section 2-7 of 14 CFR 241, the following loss transactions are material.
The new entrant incurred building leasehold improvement costs of $2 million in establishing a station for its route, deferred $500,000 of developmental and preoperating costs and purchased a $4.5 million maintenance building solely for its own operations--with no services provided to other air carriers.
A new government came into power and passed a law prohibiting the carrier from serving the developing nation (thus making worthless the $500,000 of deferred costs recorded in Account 1830). The new government also expropriated its $2 million leasehold on the passenger terminal. The maintenance facility building was destroyed, producing an extraordinary casualty loss of $1,000,000--the air carrier's "deductible" under its insurance coverage.
These highly unusual and nonrecurring/infrequent events--the prohibition of service under a newly enacted law (a $500,000 write-off), the expropriation of passenger station assets (of $2 million) and the casualty loss from the destroyed maintenance facility (of $1 million) should be accounted for as follows:
Entry to record extraordinary losses,
Dr. A/C 9796 Extraordinary Loss-Developing Nation - $3,500,000
Cr. A/C 1830 Unamortized Developmental and Preoperating Costs - $500,000
Cr. A/C 1890 Other Assets-Work Order on Property Losses - $3,000,000
It is clear that property and equipment capital gains and losses should normally be recorded in Account 8188.5 "Capital Gains and Losses-Operating Property" in accordance with section 6-1890(c) of 14 CFR 241. However, the extraordinarily unusual and nonrecurring events related to the developing nation items caused them to be classified, by definition, as transactions which should be recorded in Account 9796 under the accounting regulations in section 2-7 of 14 CFR 241.
Example B - This is not an extraordinary item:
A small air carrier does not maintain perpetual inventories of spare parts for aircraft (small value expendable items in Account 1300 "Spare Parts and Supplies" and large dollar, nonrecurrent items in Account 1608 "Flight Equipment Rotable Parts and Assemblies"), since it does not realize that this procedure is necessary (section 5-1(b) of 14 CFR 241). The spares are for the carrier's fleet, not for resale.
At yearend, the auditors from the carrier's CPA firm discover that the inventory, with a net book value of $2 million,-has disappeared. Since the company only had an unaudited net profit of $500,000 on revenue of $4 million for the year before the CPA firm discovered the loss, management considers this an extraordinary item to be recorded in Account 9796.
This is not an extraordinary item although it is a capital loss (to be reported in Account 8188.5) that is significant or material enough to be reported on Form 41, Schedule P-2 in accordance with the criteria in section 2-7 of 14 CFR 241.
Accounting Theory - Extraordinary Item:
Under GAAP and the regulatory accounting principles in 14 CFR 241, the extraordinary items are those material events or transactions which are both unusual and infrequent/nonrecurring. In summary, an extraordinary event is a transaction that is not common to the principal revenue generating activities that constitute an air transport entity's primary function. As an aside, GAAP does not encompass a materiality test such as that prescribed in section 2-7 of 14 CFR 241. Under GAAP, materiality is determined by informed judgement based upon the material circumstances affecting such transactions. For accounting and reporting consistency, and practical application, a more concrete rule was included in the Uniform System of Accounts and Reports.
If an event is a transaction common to the ordinary and typical activities involved in the airline's central operations (including such decisions as the write-down of receivables or inventories or the disposition of equipment), it is not extraordinary.