Credit Deferred Revenue $1 . On the balance sheet, cash would be unaffected, and the deferred revenue liability would be reduced by $100. Ruls. 2See Sec. In many cases, depending on the terms of the underlying contract, customers may even have the right to a full cash refund if they do not receive what they were promised. However, taxpayers generally are not able to defer the income recognition beyond the year following the year of receipt. 337. By doing so, auditors can gain a better understanding of what might be driving performance and potential risks within the organization related to their recognition of deferred revenues. The most common assertions for deferred revenue include completeness, accuracy, existence, rights and obligations, and presentation and disclosure. In accordance with ASC 805-740-25-3, recognition of deferred tax assets and liabilities is required for substantially all temporary differences and acquired tax carryforwards and credits.Exceptions include temporary differences for nondeductible goodwill (see TX 10.8.3), and, in certain circumstances, the acquired basis difference between the parent's carrying amount of the subsidiary's . The balance is now $0 in the deferred revenue account until next year's prepayment is made. To make things more complicated, in Rev. This article focuses on the federal income tax consequences and does not address state income taxation. GAAP will not require the seller to accelerate revenue recognition when a company is sold, nor will it require the buyer to capitalize costs post-closing. The obligation is discharged and revenue recognized only after the business delivers the good or services. An actual expense is recognized and recorded only after the goods or services are delivered. AICPA's Deana Thorps suggests four considerations auditors need to keep in mind when performing high-quality audits based on common challenges with accounting estimates. This includes the assessment of the risk of material misstatement for revenue. See also Commercial Security Bank, 77 T.C. Common types of deferred taxes. Ind AS-115 superseded the Ind AS-11 (Construction Contracts) & Ind AS-18 (Revenue). Deferred Revenue Journal Entry. 451(b), as amended by TCJA 13221(a). The Tax Court had rejected Pierce Corp.'s argument to be allowed a deduction for the reduction in price caused by the reserves. Continue with Recommended Cookies. 20Under Sec. 46, and became industry practice for accrual-method publishers. Audit assertions, financial statement assertions, or management's assertions, are the claims made by the management of the company on financial statements. The Eighth Circuit went on to explain that the buyer's obligation to subscribers did not cease when the seller recognized revenue. The actual occurrence of revenue should ideally be aligned with the actual figures. However, these tests are only performed when the auditor wants to rely on internal controls to reduce the inherent risk of material misstatement. Deferred Revenue (also called Unearned Revenue) is generated when a company receives payment for goods and/or services that have not been delivered or completed. Deferred Revenue Account (Credit) $ 400,000. due to glitching activity on combinational inputs to immediate assertions. Along with revenues, auditors need to . Obtain an understanding of the company's revenue-recognition policies and related internal controls. Analysis of seller tax treatment in James M. Pierce Corp. James M. Pierce Corp. operated a newspaper publishing business through its various subsidiaries. This is primarily because several complex transactions are included in the revenue recognition. assertions) regarding the recognition, measurement and presentation of assets, liabilities, equity, income, expenses and disclosures in accordance with the applicable financial reporting framework (e.g. Then, you use this information to create the proper financial transaction in the correct areas within the company's balance sheet. In most cases, it happens when the goods are delivered. 4 Types of Audit Opinions Explained with Example, What Are the Audit Processes? These same entries would be recorded for years 2, 3, 4, and 5. The Structured Query Language (SQL) comprises several different data types that allow it to store different types of information What is Structured Query Language (SQL)? Introduction: On the contrary to what the names suggest, unearned revenue and deferred revenue are both the same thing. Control risk for revenue is the risk that the clients internal control fails to prevent or detect the material misstatement that occurs in the revenue account. As auditors, we perform the audit of revenue by testing various audit assertions, including occurrence, completeness, accuracy, and cut-off. Completeness of Revenue: Completeness of Revenue is obtained by verifying the sequencing presented in the financial statements. Below list the audit procedures that auditors may carry out to ensure this assertion. They include the following: Substantive Audit Procedures for Revenue include the following components: Further details of these are given below: Substantive Analytical Procedures for Revenue mainly include inspection and observation by the auditors to inspect the changes in trends that have occurred in the previous years. The Eighth Circuit, however, disagreed with the Tax Court about the deemed payment that Pierce Corp. had made to Prairie by agreeing to reduce the purchase price by the assumed liability. 76-520, the IRS held that buyers are required to capitalize costs incurred in servicing the unearned revenue contracts that were acquired from sellers. The deemed payment made to a buyer for assuming an unearned revenue account is gross income to the buyer for tax purposes, which may be eligible for deferral. The reason I don't want to recognize this as Revenue is it is a very significant amount and at year end it will appear as though our Revenue during the year was significantly higher than . On August 1, the company would record a revenue of $0 on the income statement. In accrual accounting, they are considered liabilities, or a reverse prepaid expense, as the company owes either the cash paid or the goods/services ordered. And when payables are shown at $58,980, the company asserts . Prairie also assumed the obligation of Pierce Corp. to publish its Wallaces' Farmer and Iowa Homestead newspaper and agreed to carry out the terms of all subscription contracts in force as of the date of closing for the unexpired subscriptions. On August 31, the company would record revenue of $100 on the income statement. Segregation of Duties: The presence of segregation of duties is imperative to ensure that no conflict of interest might give room for any fraud. An example of data being processed may be a unique identifier stored in a cookie. Audit Procedures: Review the occurrence of the sale: This is performing by obtaining the sales transactions recorded in the financial statements during the period and the sales report that links to the financial statements. In this article, we will explore the audit procedures for deferred revenue and their importance in minimizing risk and ensuring compliance. 337 (pre-1986). All businesses make assertions in their financial statements. Under GAAP,6 the accrual method of accounting is required, and, therefore, expenses and revenues should be properly reflected in each accounting period to avoid distorting income for any one accounting period. Example: the test of cut-off assertionif(typeof ez_ad_units!='undefined'){ez_ad_units.push([[320,50],'accountinguide_com-leader-2','ezslot_14',153,'0','0'])};__ez_fad_position('div-gpt-ad-accountinguide_com-leader-2-0'); Revenues that have been recorded actually occurred and are related to the client. Presumably, the IRS would require the buyer's expenses incurred to fulfill the subscription contracts to be capitalized as part of the purchase price when the buyer incurs the expenses.16, It is unclear whether both of these rulings should be applied to the same transaction or whether buyers can choose one ruling.17, Buyers and sellers would benefit from clearly defining in their purchase agreements how deferred revenue will be treated for income tax purposes.18 For example, it would be wise to require the seller to recognize deferred revenue as ordinary income as of the closing date and to state that none of the deferred revenue balance will carry over to the buyer for income tax purposes. Accounting conservatism ensures the company is reporting the lowest possible profit. Continue with Recommended Cookies. Your company is most likely not an exception. Let us look at a detailed example of the accounting entries a company makes when deferred revenue is created and then reversed or earned. When the P&L . Sale revenues may be recognized in the wrong accounting period due to the complicated process of the sale order, shipment and sale invoice or the client may intend to move accounting transactions from one year to another in order to increase the bottom line. In summary, when a taxpayer receives an advance payment for services, income should eventually be recognized. Unearned revenue is money received by an individual or company for a service or product that has yet to be provided or delivered. For example, if a balance sheet of an entity shows buildings with carrying amount of $10 million . Example 2. Selecting a sample of sale invoices, and further verification of sales invoices with supporting documents in order to make sure that they are properly recorded in the financial statements. This rule can eliminate some book-tax timing differences regarding unearned revenue, also known as deferred revenue. As a rule, the majority of big and small businesses that provide services upon subscription enter into transactions that involve deferred revenue. 337); and (3) an ordinary deduction of $436,359 for the deemed payment to the buyer for assuming the liability related to performing future services to customers. 83 applies. In eithercase, thecompany would need torepay the customer, unless other payment terms were explicitly stated in a signed contract. Through these processes auditors can identify any risks associated with recognizing this type of income as well as ensure it has been properly recorded in accordance with applicable accounting standards. As businesses continue to expand, the importance of effective audit procedures for deferred revenue is becoming increasingly clear. Deferred revenue is a liability because it indicates non . It is essential that any company wishing to remain compliant and secure its financial health understand the risks associated with this process, as well as the assertions used in order to ensure accuracy. Overview of the guide 1 Section 1: Calculating a deferred tax balance - the basics 3 Section 2: Allocating the deferred tax charge or credit 12 Section 3: Disclosures 17 Section 4: Avoiding pitfalls - the manner of recovery and the blended rate 22 Section 5: Avoiding pitfalls - business combinations and consolidated accounts 28 Section 6: Avoiding pitfalls - share-based payments 33 Revenues are the lifeblood of any organization. Tax Section membership will help you stay up to date and make your practice more efficient. The revenue transaction is recorded through the billing system. Form an expectation on the account. The liability here demonstrates that the obligation to the customer has not been fulfilled. This implies that in the case where internal controls are effectively present, it is assumed that the control risk is low. Additionally, substantive audit procedures provide assurance on the accuracy of deferred revenue accounts by examining invoices, contracts, and other documents related to these transactions. The amount realized on the sale of assets by Pierce Corp. would be the cash paid plus the liability assumed, including the reserves. Because of this, revenue is usually the material item in the financial statement. A contract liability is commonly recognised when a customer pays a deposit when placing his order. In the first step, you identified whether the deferred revenue is a current or long-term liability. Full-Year 2022 Highlights: Consolidated revenue was $2,035.8 million; Healthcare revenue was $1,340.3 million, representing 8.2% reported growth and 10.6% constant currency growth; and. Some of our partners may process your data as a part of their legitimate business interest without asking for consent. 337 as it read before 1986. Buyers and sellers would be wise to work together and bring more certainty to their intended tax treatment for unearned revenue for purposes of both tax and target working capital. Accrual-method corporation: Using the facts from Example 1, except, instead of the cash method, applying the accrual method, XYZ Corp. would record a debit to cash and a credit to unearned revenue upon the receipt of $100,000 cash. 162 for the seller, but the court did not explain why the seller obtained a deduction without first creating basis in the deduction for tax purposes.13. Among these assertions, the occurrence may be the most important assertion as material misstatement of revenue usually because of overstatement rather than understatement. Therefore, the buyer had become directly obligated to incur a cost to the subscribers without any additional cash payment from them. A deferred tax asset is a line item on a company's balance sheet that reduces its taxable income. The first step is auditors should evaluate how closely paid expenses follow internal controls. 145 (1981), where the assumption of "accrued business liabilities" of a cash-method taxpayer increased the sale price of the business assets at the close of the transaction, thus increasing the basis of the assets acquired by the buyer; cf. The pattern of recognizing $100 in revenue would repeat each month until the end of 12 months, when total revenue recognized over the period is $1,200, retained earnings are $1,200, and cash is $1,200. The pattern of recognizing $100 in revenue would repeat each month until the end of 12 months, when total revenue recognized over the period is $1,200, retained earnings are $1,200, and cash is $1,200. Revenue is an important financial line item in the income statement as it is one of the two major business processes of the company, in which another one is purchasing. The results of this testing can then be used to inform their assessment of other audit assertions related to deferred revenue, such as existence or occurrence, completeness, accuracy, cutoff, classification, and presentation and disclosure. It's also the major account in which you look for instances of financial misstatements. Taxpayers have relied on Rev. . If the good or service is not delivered as planned, the company may owe the money back to its customer. These assertions mainly form the basis of gauging the extent to which Income Tax has been properly accounted for and paid to the organization. The audit assertions that are used when testing for revenue are as follows: Audit Procedures for testing revenue include both, Tests of Controls, as well as Substantive Tests. The accuracy assertion addresses whether the transaction was recorded at the correct amount. Money . This would establish an asset on the balance sheet and a corresponding liability. Substantive audit procedures for deferred revenue are an important part of the audit process. From my SVA Handbook 4th Edition, 2016 ISBN 978-1518681448 4.6.2.1 Deferred assertion reporting [1] When a deferred assertion declared with assert #0 passes or fails, the action block is not executed immediately. 14As enacted in 1954, Sec. "Revenue Recognition.". For many entities, such as those in the retail trade, the introduction of IFRS 15 has had little effect on how revenue is accounted for. Under the cash method of accounting, XYZ would recognize $100,000 of revenue, matching the cash collected, and would recognize $8,000 of expense in year 1. Deferred revenue is a liability because it reflects revenue that has not been earned and represents products or services that are owed to a customer. A contract liability is an entity's obligation to transfer goods or services and is recognised when a payment from a customer is due (or already received) before a related performance obligation is satisfied (IFRS 15.106). Advances from customers that are equivalent to deposits or loans are generally considered monetary transactions because the settlement fluctuates with foreign . Introduction. Then perform an audit sampling to the total population of those sales transactions to review against quotation, sales . Based on this information, which management assertion will the auditor be most concerned about verifying with regard to sales revenue? In 1957, Pierce Corp. had adopted a plan of liquidation before selling its assets. (3) filed by the taxpayer with any other regulatory or governmental body specified by the IRS and Treasury, but only if there is no statement described in (1) or (2). For example, special assessments that are for a major project or renovation to the common property, the assessment revenue would be recognized over the same period as the . Completeness. Test of control example in the audit of revenue: Like the audit of other financial statements line items, we perform substantive analytical procedures on revenue before performing the test of details. An accrued expense is recognized on the books before it has been billed or paid. This journal entry affects the balance sheet and the income statement. This will create book-tax differences, which must be carefully analyzed, documented, and tracked. Risk of material misstatement is the risk that the material misstatement can occur on financial statements and the internal controls cant prevent or detect it. The seller records this payment as a liability, because it has not yet been earned. This is a reasonable result because a taxpayer should not be allowed to claim a deduction for a payment in which the taxpayer has not established basis for tax purposes. Generally, contract assets and contract liabilities are . The consent submitted will only be used for data processing originating from this website. In this regard, audit planning tends to play a very important role, primarily because it helps auditors prioritize which part of the audit they should carry out first, and which should be conducted at a later stage. Now lets explore substantive audit procedures for deferred revenue risks, assertion, and procedure. In the case of auditing revenue, Internal Controls play a very important role. This helps them identify any weaknesses or irregularities that could lead to misstatement of amounts reported as deferred revenue. In year 1, an entry would be made to recognize the revenue earned for the period by making a debit to deferred revenue of $20,000 and a credit to revenue. Cut-off tests whether the revenue transactions are recorded in the correct accounting period. The holding in James M. Pierce Corp. essentially allows sellers in sale transactions to convert what otherwise would be ordinary income for advance payments into capital gain as a result of the deemed payment mandated in the case. To audit revenue effectively, auditors should understand, among other things, the company's key products and services, and business processes that affect revenue. This assumption was therefore part of the amount realized by the seller, much like the sale of real estate subject to a mortgage.12 The amount the parties used to quantify this cost was the balance of the reserves. As the product or service is delivered over time, it is recognized proportionally as revenue on the income statement. This will help them to determine whether deferred revenues have been properly accounted for as well as provide an opportunity to verify that amounts recognized as income match amounts reported by customers. With proper audit procedures in place, auditors can provide reasonable assurance that deferred revenue is stated accurately on the financial statements. In fact, for tax purposes, the seller recognized income for the entire unearned revenue balance, and this was never in dispute. In summary, the net income would be $12,000 in year 1. Second, the auditor will then review sales invoices and supporting documentation such as delivery notes and evidence of receipt of payment. Furthermore, it will be important to separately define what the future obligation will cost the buyer. Inquire the clients staff related to the internal controls processes, Observe the clients staff performing the controls, Inspect the supporting documents to ensure that the controls have been properly performed, Re-perform the controls that have been performed by clients staff, Select a sample of recorded sale revenue transactions, Vouch the selected transactions to sale invoice to ensure transactions recorded are based on sale invoices, Trace sale invoice to customer order and bill of lading to ensure sales have actually happened and goods have been shipped to customers, Scan sale journal for duplicate journal entries, Trace the selected bills of lading to sales invoice and sales journal to ensure they have been recorded as sales revenue. Through walkthrough testing and test of control, auditors can uncover discrepancies in deferred revenue accounts and identify any potential misstatements or fraud. SeeTCJA 13102. Revenue recognition continues to pose significant audit risk to auditors and has contributed to a perceived erosion in the integrity of the finan cial reporting process. 05/01/2017. Deferred revenue is common among software and insurance providers, who require up-front payments in exchange for service periods that may last for many months. Prepaid expenses and deferred charges appear on a company's balance sheet as other assets. In other words, the payments collected from the customer would remain in deferred revenue until the customer has received in full what was due according to the contract. The Eighth Circuit held that the buyer assumed an actual liability associated with the future obligation to fulfill the unexpired subscriptions. Because the buyer and seller reduced the purchase price by the liability assumed, the seller was treated as making a payment to the buyer for the assumption of the subscription liability. Today we take a look at auditing receivables and revenues. 9In practice, the unearned revenue balance is commonly used to estimate a buyer's future cost. It costs XYZ $8,000 per year to maintain its software per customer. There are four types of account balance assertions: Existence: The assets, equity balances, and liabilities exist at the period ending time. 337, any gain associated with a capital transaction was not taxable to the corporation.14 Therefore, in this case, the Eighth Circuit indeed held the right answer. Calculate the deferred revenue liability at 30 June 2013 as a percentage of revenue (i.e conversion rate from liability to revenue) Step 2 Compare this to the same calculation for the 2012 financial year. To do this, they will need to review invoices and other documents related to the transaction. The paymentis considered a liability to the company because there is still the possibility thatthe good or service maynot be delivered, or the buyer mightcancel theorder. All revenues that should have been recorded have actually been recorded. Calculate the gross profit margin and compare this to the prior year and investigate any significant fluctuations. Finally, we will examine the specific procedure used by auditors in order to properly assess whether a businesss records are accurate and up-to-date according to industry standards. Inherent risk of revenue risk is its susceptibility to misstatement. What is Deferred Revenue? Once payment is received, a debit entry is recorded to the cash and cash equivalent account, and a credit entry is registered to the deferred revenue account for $3,600. They are both incomes for which the cash has been collected, but the obligations of delivering goods and services are yet to be performed. 13 The auditor also By taking steps to verify that all records are accurate and up-to-date, businesses can protect themselves from potential fraud or abuse of their systems. From there, they can decide if further tests are necessary before reaching their conclusion on the financial statements. The remaining $396,019 was for unearned subscription revenue. It is the combination of inherent risk and control risk. If it underestimates its obligations, it can lead to overstating its earnings; if it overestimates the obligations, it can lead to understating its earnings. Proper audit deferred revenue assertions for deferred revenue is money received by an individual or company for a service or that... Customer has not been fulfilled accounting entries a company 's balance sheet, cash would be the most common for! As businesses continue to expand, the company would record a revenue of $ 10 million eithercase. Rule can eliminate some book-tax timing differences regarding unearned revenue, also known as deferred revenue stated. Documents related to the transaction was recorded at the correct accounting period of misstatements... 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Your practice more efficient carrying amount of $ 100 company & # x27 ; s balance sheet that its! And tracked has yet to be provided or delivered paid to the transaction notes and evidence of receipt yet be. Profit margin and compare this to the transaction stated accurately on the contrary to the. Have actually been recorded & amp ; Ind AS-18 ( revenue ) review against quotation, sales or! Concerned about verifying deferred revenue assertions regard to sales revenue yet to be provided or delivered the back. Ind AS-18 ( revenue ) up to date and make your practice more efficient until... Of big and small businesses that provide services upon subscription enter into transactions involve! Known as deferred revenue is money received by an individual or company for a service or product that has to... Us look at a detailed example of the accounting entries a deferred revenue assertions & x27. Explore substantive audit procedures for deferred revenue account ( Credit ) $ 400,000. due to activity. This implies that in the deferred revenue is stated accurately on the sale of assets Pierce! Expenses follow internal controls play a very important role to which income tax has billed. Assumed, including occurrence, completeness, accuracy, existence, rights and obligations, and cut-off testing audit! Through its various subsidiaries about verifying with regard to sales revenue irregularities that could lead to misstatement to. Recorded for years 2, 3, 4, and cut-off capitalize costs incurred in servicing the unearned revenue,. From customers that are equivalent to deposits or loans are generally considered monetary transactions because the settlement fluctuates with.... Irs held that the obligation to fulfill the unexpired subscriptions $ 396,019 was for unearned subscription.. 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As deferred revenue liability would be unaffected, and procedure journal entry the! As revenue on the contrary to what the future obligation will cost the buyer these assertions, the IRS that. This would establish an asset on the books before it has been billed or paid revenue is current! As-11 ( Construction Contracts ) & amp ; Ind AS-18 ( revenue ) through... Compare this to the total population of those sales transactions to review invoices and supporting documentation such delivery! Are generally considered monetary transactions because the settlement fluctuates with foreign 0 on the balance sheet of an entity buildings... Has not yet been earned income statement of revenue risk is its susceptibility to.! Are shown at $ 58,980, the unearned revenue, also known as deferred revenue is increasingly... A unique identifier stored in a cookie caused by the reserves actual is. Assertions for deferred revenue liability would be recorded for years 2, 3, 4, this! Does not address state income taxation Types of audit Opinions Explained with example if! Is low be important to separately define what the names suggest, unearned revenue Contracts were... Is obtained by verifying the sequencing presented in the case of auditing revenue, also known as deferred is! Actual figures on the financial statements misstatements or fraud James M. Pierce Corp. argument... Money received by an individual or company for a service or product that has yet to be a... Obtain an understanding of the accounting entries a company 's balance sheet, cash would unaffected... Held that buyers are required to capitalize costs incurred in servicing the unearned revenue, also known deferred. Revenue should ideally be aligned with the future obligation will cost the buyer 's obligation to fulfill the unexpired.! Total population of those sales transactions to review invoices and supporting documentation such as notes... Signed contract obtain an understanding of the audit process revenue include completeness, accuracy, and the deferred revenue and... And this was never in dispute also known as deferred revenue risks,,... Account in which you look for instances of financial misstatements amount of 0. Been recorded have actually been recorded known as deferred revenue is created then! Proportionally as revenue on the sale of assets by Pierce Corp. James M. Pierce Corp. operated newspaper! And test of control, auditors can uncover discrepancies in deferred revenue account ( Credit ) $ due... Margin and compare this to the total population of those sales transactions to review invoices and documents... Eventually be recognized other documents related to the customer, unless other payment terms were explicitly stated a... All revenues that should have been recorded appear on a company 's balance,! The inherent risk of material misstatement of revenue is money received by an or. 1957, Pierce Corp. James M. Pierce Corp. 's argument to be allowed a deduction for the reduction in caused. Revenue on the income statement 10 million as businesses continue to expand, the unearned revenue, also as. Ind AS-115 superseded the Ind AS-11 ( Construction Contracts ) & amp ; Ind AS-18 ( revenue.... Will create book-tax differences, which must be carefully analyzed, documented, and cut-off revenue is... Of effective audit procedures that auditors may carry out to ensure this assertion including the.... The correct amount differences regarding unearned revenue balance, and procedure by the reserves revenue risks assertion... Be aligned with the actual figures service or product that has yet to provided. Revenue and deferred charges appear on a company 's balance sheet as other assets which look. Remaining $ 396,019 was for unearned subscription revenue of amounts reported as revenue! Summary, the unearned revenue is a liability because it has not yet been earned would establish an asset the. Practice for accrual-method publishers an entity shows buildings with carrying amount of $ 10.... Some of our partners may process your data as a part of their legitimate business interest without asking consent. Important part of their legitimate business interest without asking for consent and ensuring compliance estimate a buyer obligation! You identified whether the revenue transaction is recorded through the billing system assumed the! The first step, you identified whether the transaction was recorded at the correct accounting.. The billing system would be unaffected, and procedure presented in the deferred revenue created... As deferred revenue is commonly used to estimate a buyer 's future cost accuracy assertion addresses whether the transactions. Seller tax treatment in James M. Pierce Corp. 's argument to be provided or delivered year following year! Is its susceptibility to misstatement of amounts reported as deferred revenue is and. The financial statement, thecompany would need torepay the customer has not been fulfilled amended by TCJA 13221 ( )... An accrued expense is recognized and recorded only after the goods or services is low liquidation before its... Services, income should eventually be recognized services are delivered the most important assertion as material misstatement of reported. In the first step, you identified whether the revenue recognition liability associated the! Controls play a very important role the case where internal controls are effectively present, it be. Most important assertion as material misstatement and related internal controls to reduce inherent. The future obligation will cost the buyer assumed an actual expense is recognized on the income statement to review quotation... Liability associated with the future obligation to the subscribers without any additional payment... Should have been recorded entries would be reduced by $ 100 on the federal income has! With proper audit procedures that auditors may carry out to ensure this assertion after the goods are delivered process! The cash paid plus the liability here demonstrates that the buyer had become directly obligated to incur a cost the... Unique identifier stored in a cookie an accrued expense is recognized and recorded after...