Accounting Methods — General Principles, written by George L. White, Esq., (of an earlier version by Louis H. Diamond, Esq. and James E. Salles, Esq.), discusses the tax effects of selecting an accounting method.  

In general, any consistent and predictable treatment of a material item of income or expense constitutes an accounting method. The two most commonly used methods of accounting are the cash method and the accrual method, but any method of accounting that clearly reflects income generally will be permitted. The determination as to what clearly reflects income, however, depends on tax accounting principles, which frequently deviate from generally accepted accounting principles. If the two conflict, tax accounting principles control for tax purposes. 

This Portfolio analyzes “accounting methods,” i.e., those procedures, processes, or practices regularly followed in determining taxable income, and the rules governing the timing of items of income, deduction, or credit that depend on the taxpayer's method of accounting.   The Portfolio provides an overview of the permissible methods of accounting and the factors that bear on the taxpayer's choice of methods, including statutory restrictions, the “conformity requirement,” and the elusive concept of “clear reflection of income.”  

In addition, this Portfolio summarizes the rules governing a taxpayer's choice between cash and accrual as the taxpayer's “overall method” of accounting or as a method applicable to particular items of income and deduction.  It provides an overview of the treatment of income and deduction items under each method, and it discusses timing issues relating to items of income and deduction, respectively, under the cash and accrual methods of accounting. 

Rules applicable only to taxpayers engaged in farming businesses are the subject of a separate Portfolio. The special accounting issues surrounding the tax treatment of inventories and the determination of cost of goods sold, the recognition of income on long-term contracts for the manufacture, installation, or construction of property, and the capitalization rules applicable in these situations are also the subjects of other Portfolios. 

This Portfolio outlines the consequences of using an accounting method that does not clearly reflect income and discusses such issues as 

• the significance of differentiating between a “permissible” and an “erroneous” accounting method
• the problems of conforming tax accounting with accounting for financial statements and other reports
• the “all events” test used to determine when an item of income or expense is taken into consideration under the accrual method of accounting
• limitations on the use of the cash method of accounting
• the economic performance requirement under the accrual method of accounting 

Accounting Methods — General Principles allows you to benefit from:

• Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area.
• Invaluable practice documents including tables, charts and lists.
• Plain-English guidance from world-class experts.
• Real-world and in-depth analysis that lets you explore various options.
• Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more.
• Alternative approaches to both common and unique tax scenarios.

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which cover every federal tax topic with expert, in-depth analysis, and offer commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

Detailed Analysis

I. Introduction and Statutory Outline

A. Scope of Portfolio

B. Statutory Framework

1. General Rule - Section 446

2. Restrictions on the Cash Method - Section 448

3. Inclusions in Income - Sections 451, 454, 455, 456, and 458

4. Deductions and Credits - Sections 461, 468, 468A, and 468B

II. What Is a Method of Accounting?

Introductory Material

A. Material Items

1. The “Item”

2. Materiality

B. Consistency

C. Method of Accounting vs. Error

1. The Stakes

a. Consequences of a Change in Method

b. Consequences of Correcting an Error

2. “Deviations” from “Overall Methods of Accounting”

3. Unintentional Misapplications of Methods

4. Capitalization and Amortization Errors

5. Inventory Costing and “Valuation” Errors

6. Omissions from Inventory

D. “Change in Method” vs. Difference in Underlying Facts

1. Introduction

2. Rights Under Contracts

3. Valuations

III. Permissible Methods of Accounting

Introductory Material

A. Overview of Permissible Methods

1. Cash Method

2. Accrual Method

3. Other Permissible Methods

a. In General

b. Hedging Transactions

c. Dealers in Securities and Notional Principal Contracts

(1) Dealers in Securities

(2) Notional Principal Contracts

d. Mutual Fund Distributor Commissions

(1) Distribution Fee Period Method

(2) Five-Year Method

(3) Useful Life Method

4. “Hybrid” Methods

B. Multiple Trades or Businesses

C. The Conformity Requirement

1. Generally

2. What Comprises a Taxpayer's “Books”?

3. Change in Practices

D. Statutory Restrictions on the Use of the Cash Method

1. Section 448

a. Affected Taxpayers

(1) C Corporations

(2) Partnerships Including C Corporations

(3) Tax Shelters

b. Exceptions

(1) Farming Businesses

(2) Qualified Personal Service Corporations

(3) Small Business Exception

(4) Taxpayer with Gross Receipts of $1 Million or Less

2. Other Statutory Provisions

E. Clear Reflection of Income

1. Introduction

2. Taxpayers’ Use of Methods Contrary to the Regulations - The “Substantial Identity of Results” Test

3. The “Clear Reflection” Standard as Applied to Otherwise Permissible Methods

4. Regulatory Restrictions and Administrative Relief on the Choice of Method

a. Certain Combinations of Cash and Accrual Methods Prohibited

b. Taxpayers Selling “Merchandise” Must Keep Inventories

c. Taxpayers Using Inventories Must Accrue Purchases and Sales

d. Fees Paid to Holders of Residual Interests in REMICs

e. Administrative Relief for Certain Taxpayers with Gross Receipts of $10 Million or Less

f. Other Administrative Relief Measures

5. Application of the “Clear Reflection” Standard to Taxpayers’ Choice of the Cash Method

6. Clear Reflection and the Terminating Taxpayer: Use of the Cash Method in the Taxpayer's Final Year

F. Implementation of the “Abuse of Discretion” Standard in Clear Reflection Cases

1. Changes Initiated by the IRS

2. Changes Initiated by the Taxpayer with Consent

3. Changes Initiated by the Taxpayer Without Consent

4. Who Initiates a Change?

IV. Inclusions in Income

A. Overview

1. Topics Covered Elsewhere

a. Claim of Right

b. Disposition of “Property”

c. Property Received for Services

2. Differences Between Cash and Accrual Methods

B. Cash Method Taxpayers

1. The Boundaries of “Property”

a. Cash Equivalence

(1) Transferability

(2) Form of Obligation

(3) Discounted Obligations

b. Economic Benefit

(1) “Transfers” of “Property”

(2) The Requirement of Vested Rights

(3) Rights Need Not Be Transferable

(4) Amount Includible

c. “Mere Promises to Pay”

(1) Unsecured Obligations Are Not “Property”

(2) Obligations of “Third Parties” to the Transaction

(3) Third Party Guarantors

(4) The Issue of “Cash Equivalence”

2. “Receipt”: Actual and Constructive

a. Receipt

b. Constructive Receipt

(1) The Right to Receive

(2) Deferrals of Income

(3) The Power to Collect

(4) Substantial Limitations

(5) Payments by Mail

3. The Receipt of Checks

4. Special Statutory Rules

a. Employee Tips

b. Crop Insurance Proceeds and Disaster Payments

c. Sales of Livestock

d. “Frozen Deposits” in Financial Institutions

e. Obligations Issued at a Discount

f. Prizes and Awards

C. Accrual Method Taxpayers

1. The “All Events” Test

a. Fixed Rights

(1) Inclusion of Amounts Due

(2) Inclusion of Amounts “Earned”

(3) Contingencies

(4) Uncertainty of Payment

b. Reasonable Accuracy

c. Special Rules

(1) Amounts Accruing Because of the Taxpayer's Death

(2) Income Earned from Provision of Utility Services

(3) Service Receivables

(4) Short-Term Government Obligations

(5) Returns of Magazines, Paperbacks, and Records

2. The Receipt of Prepayments

a. General Principles

(1) Prepayments for Goods and Services

(2) Prepayments for Interest and Rent

b. Special Rules

(1) Advance Payments for Goods

(2) Advance Payments Under Rev. Proc. 2004-34

(3) Credit Card Annual Fees

(4) Trading Stamps and Premium Coupons

(5) Prepaid Subscription Income

(6) Prepaid Dues Income

(7) Deposits to Secure Performance

(8) Service Warranty Contracts

V. Deductions and Credits

A. Overview

1. Threshold Consideration

2. Differences Between Cash and Accrual Methods

B. Cash Method Taxpayers

1. “Payment”

a. Payments by Note and Check

b. Payments with Borrowed Funds

2. Prepayments

a. The Three-Prong Test

b. The One-Year Rule for Period Costs

c. Prepaid Interest

C. Accrual Method Taxpayers

1. The “All Events” Test

a. Fixed Liability

(1) Contingencies

(2) Liabilities Based on Measurement Periods

(3) Contested Liabilities

(4) Obligations Conditioned on Ability to Pay

(5) Deferred Obligations

(6) Continuing Liabilities

(7) Liabilities to Unknown Payees

(8) Liabilities Directly Associated with Income Items

(9) Liabilities to Provide Goods or Perform Services

(10) Employment Taxes on Year-End Wages

b. Reasonable Accuracy

c. Special Rules

(1) Death

(2) Ratable Accrual of Real Property Taxes

(3) Taxes Accelerated After 1960

(4) Dividends and Interest Credited by Certain Financial Institutions

(5) Payments Against Contested Liabilities

2. Economic Performance

a. General Rule

b. Liabilities Attributable to Property or Services Provided to the Taxpayer

c. Property and Services Provided by the Taxpayer

d. Liabilities Assumed in Connection with Sale of Trade or Business

e. Payment as Economic Performance

f. Interest

g. Deferred Compensation

h. Exceptions to Economic Performance Rule

(1) “Recurring Items”

(2) Mining and Solid Waste Reclamation Costs

(3) Nuclear Decommissioning Costs

(4) Transfers to “Designated Settlement Funds” and “Qualified Settlement Funds”

(a) Designated Settlement Funds - 468B

(b) Qualified Settlement Funds

(c) Taxation of Designated and Qualified Settlement Funds

(d) Transferors and Claimants of Designated and Qualified Settlement Funds

(e) Effective Dates and Transition Rules

(5) Estimated Costs of Improvements to Real Property

D. Transactions Between Related Parties - The Matching Rules of 267(a)(2) and (3)

1. Background and Purpose

2. Section 267(a)(2) Deferral

a. In General

b. Related Persons

c. Deductions To Which 267(a)(2) Applies

d. Exception to Matching Rule for Employee Plans

3. Section 267(a)(3): Deferral of Deductions as to Payments to Related Foreign Persons

Working Papers

TABLE OF WORKSHEETS

Worksheet 1 Excerpts from IRM 4.10.3, Examination Techniques - Taxpayer's Books and Records (Accounting Records, Systems and Methods)

Worksheet 2 Excerpt from IRS Publication 334, Tax Guide for Small Business, Ch. 2 (Accounting Periods and Methods)

Worksheet 3 Rev. Proc. 2001-10, 2001-02 I.R.B. 272

Worksheet 4 Rev. Proc. 2002-28, 2002-18 I.R.B. 815

Worksheet 5 Announcement 2002-45, 2002-18 I.R.B. 833

Worksheet 6 Service Warranty Income Method Election Statement Under Rev. Proc. 97-38, 1997-2 C.B. 479

Worksheet 7 Election Statement to Defer Prepaid Dues Income Under 456

Worksheet 8 Election Statement to Defer Prepaid Subscription Income Under 455

Worksheet 9 Merchandise Return Election Statements for Magazines, Paperbacks and Records Under 458

Worksheet 10 Election Statement By Common Parent of Affiliated Personal Service Corporations Relating to the Cash Method Under 448(d)(4)(C)

Worksheet 11 Election Statement to Treat Qualified Payment Made to Court Ordered Fund As Payment Made to Designated Settlement Fund Under 468B(d)(2)(F)

Worksheet 12 Securities & Financial Service Firms Coordinated Issue - Taxable Year of Inclusion of Stock Broker's Commission Income

Worksheet 13 Construction Industry Coordinated Issue - Advance Payments from Construction Service Contracts [Decoordinated]

Worksheet 14 Pharmaceutical Industry Coordinated Issue

Worksheet 15 Joint Committee on Taxation Description of Revenue Offsets for Medicare Home Health Provisions of Omnibus Consolidated and Emergency Supplemental Appropriations Act (H.R. 4328) (10/20/98)

Worksheet 16 Advance Notice of Proposed Rulemaking (ANPRM), REG-125638-01, 67 Fed. Reg. 3461 (1/24/02) (Regarding Deduction and Capitalization of Expenditures)

Worksheet 17 Chief Counsel Notice CC-2002-021 (3/15/02) (Change in Litigating Position Regarding Capitalization of Transaction Costs)

Worksheet 18 Preamble to REG-125638-01, 67 Fed. Reg. 77701 (12/19/02) (Prop. Regs., Guidance Regarding Deduction and Capitalization of Expenditures)

Worksheet 19 T.D. 9107, 69 Fed. Reg. 435 (1/5/04)

Bibliography

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