Question

Q3. Barrel Bottom Brewing Corp. manufactures and sells beer. A substantial amount of its sales volume is draft beer. Draft beer is sold to distributors in fifteen-gallon aluminum barrels. Barrel Bottom Brewing pays $4 per barrel to purchase them and charges customers a $5 deposit for the barrel, in addition to the $120 charge for the beer. The deposit is refunded to any distributor who returns a barrel in good condition, without regard to whether the barrel was attributable to beer sold to the distributor. Experience indicates that 90 percent of the barrels are returned undamaged. How should Barrel Bottom Brewing treat the deposits and refunds on the barrels for tax purposes?

Answer 1

Generally if a deposit is refundable it is treated as a deposit for both accounting and tax purposes and it is excluded from income for federal income tax calculations. The deposits received for the barrels should be treated as liability which is repayable on return of the barrel in good condition. However this liability should be partially released to income to account for the barrels that are going to be damaged in which case the deposit need not be returned. This amount that has to be released to income should be estimated based on past history and experience of the company. In the given case, since the past experience shows that 90% of the barrels will be returned in good conditions and hence the deposits have to be returned. This implies that 10% of the refundable deposits or the liability should be recognized as income by the company. Let us say 1000 barrels of draft beer was sold by the company. This means the company would have collected $ 5000 as deposit which will be shown as a liability. As per history 10% of the barrels will be damaged on which refund of deposit is not payable. Hence $ 500 should be considered as an income and the liability reduced by $ 500.

We can also argue that since the deposit is refundable to any distributor who returns a barrel in good condition irrespective of the fact that the company had sold beer to that distributor or not. This may give rise to a situation where the company receives more barrels in excess of the barrels originally supplied to the distributors and thus in excess of balance lying in the refundable deposit account. Thus where a situation arises when excess amount has to be refunded such excess amounts should be treated as prepaid expense because the company has the right to use the barrel and recirculate them.