Chapter I:11 Accounting Periods and Methods Learning Objectives After studying this chapter, the student should be able to 1. 2. 3. 4. 5. 6. 7. Explain the rules for adopting and changing an accounting period. Explain the differences among the cash, accrual, and hybrid accounting. Determine whether specific costs must be included in inventory. Determine the amount of income to be reported from a long-term contract. Compute the gain to be reported from an installment sale. Compute the amount of imputed interest in a transaction. Determine the tax treatment of duplications and omissions that result from changes of accounting methods. Areas of Greater Significance The areas of inventory costing and installment sales may have the most widespread usage for the student. Many manufacturing and sales organizations need expertise in the area of inventory costing. Installment sales rules are especially important in real estate transactions. Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and procedural considerations. I:IO11-1 Problem Areas for Students The following areas may prove especially difficult for students: 1. 2. 3. Determination of inventory cost. Installment sales method calculation. Imputed interest computation. Highlights of Recent Tax Law Changes No items of tax law have changed from the 2006 edition of this chapter. Teaching Tips 1. The students are already familiar with inventory costing from financial accounting courses. Concentrate on the tax differences in inventory costing (i.e., uniform capitalization rules). 2. Spend some time on the installment sales method and imputed interest as this is an important tax planning tool. Lecture Outline I. Accounting Periods (Examples I:11-2, I:11-3) Annual accounting periods are used to measure taxable income. The taxable year may be a calendar year or a fiscal year under certain restrictions. Partnerships, S corporations, and personal service corporations have special restrictions on utilization of a fiscal year. Utilization of a 52-53 week year (i.e. tax year ending on the last Friday of December) is also allowed. A. Required Payments and Fiscal Years (Examples I:11-4, I:11-6) 1. As calendar-year tax years are required for more entities, the year-end reporting crunch for tax professionals increases. 2. Under certain conditions, partnerships, S corporations, and personal service corporations may elect a taxable year that results in a deferral of three months or less. 3. All trusts (except tax-exempt) are required to report on the calendar year. I:IO11-2 B. Changes in the Accounting Period (Example I:11-7; Questions I:11-4, I:11-8) 1. In some instances the taxpayer can change accounting periods without IRS approval, but generally IRS approval is required. 2. In cases where IRS approval must be obtained, the taxpayer must establish a substantial business purpose (non-tax) for the proposed accounting period change. 3. Situations where IRS approval is not necessary include: a. Conformity between newly married spouses b. Change to a 52/53 week year ending in the same calendar month as the prior tax year c. Conformity between financial reporting year and tax year d. Certain corporations which have not changed accounting periods within 10 years. C. Returns for Periods of Less than 12 Months (Examples I:11-8, I:11-9, I:11-10; Topic Review I:11-1; Problem I:11-39) 1. A taxpayer may be required to file a short period return for the first or final tax year, or when an accounting method changes. 2. Taxpayers changing from one accounting period to another must annualize their taxable income. The resulting tax calculation will eliminate any potential bracket benefit for including less than a full year of income. 3. Annualization starts with modified taxable income (taxable income for the short period utilizing itemized deductions only and prorated exemptions). Modified taxable income is grossed-up by multiplying it by 12 divided by months in short period. The tax is then calculated on this grossed-up number. The resulting tax is reduced by multiplying it by months in short period divided by 12. II. Overall Accounting Methods (Example I:11-11) Accounting methods are used to determine the tax year in which income and expenses are reported. A. Cash Receipts and Disbursements Method (Examples I:11-12, I:11-13) 1. Cash basis taxpayers report income for the tax year in which payments are actually or constructively received. Expenses are generally deducted in the year paid. Prepaid expenses which have a life that extends substantially beyond the end of the tax year are required to be capitalized and amortized. 2. Most individuals and many service businesses utilize the cash receipts and disbursements method. I:IO11-3 B. Accrual Method (Question I:11-20) 1. Accrual basis taxpayers report income and deduct expenses under the allevents and economic performance tests. 2. The all-events test is met when all events have occurred to fix the taxpayer's right to receive the income and the amount of income can be determined with reasonable accuracy. The all-events test for deductions is met when the liability is established and the amount of expense can be determined with reasonable accuracy. 3. Economic performance occurs when the property or services are actually rendered by the other party. EXAMPLE: A cash method taxpayer would deduct state income tax when paid, regardless of the tax year involved. An accrual method taxpayer would deduct state income tax expense for the tax year involved whether paid or not. C. Hybrid Method (Topic Review I:11-2) 1. Taxpayers with inventories are required to use the accrual method for sales and purchases (exception for businesses with average annual <a href="/keyword/gross-receipts/" >gross receipts</a> &lt; $1 million; or &lt; $10 million if the taxpayer s principal business is not the sale of inventory), but may use cash method for other income and expenses. 2. The hybrid method is the least used method by taxpayers of the three major overall accounting methods. III. Inventories (Problem I:11-43; Instructor Aid I:11-1) A. Determination of Inventory Cost (Example I:11-19) 1. Generally, taxpayers value inventory at the lower of cost or market (replacement cost). EXAMPLE: If a taxpayer's cost in an item is $50/unit and replacement cost is $45/unit, the tax valuation of these inventory items would be $45/unit. This test would normally be applied to each item of inventory. 2. 3. Taxpayers who have elected LIFO must value inventory at cost. Uniform Capitalization Rules The regulations require inventory costing determined under the Uniform Capitalization rules and specifically delineate the expenses that must be included: I:IO11-4 a. b. Direct labor and materials Manufacturing overhead including factory repairs and maintenance, utilities, rent, insurance, small tools, tax depreciation, factory administration and officers' salaries related to production, taxes (other than income), quality control and inspection, rework, scrap, spoilage, current and past service costs of pension and profitsharing plans, and service support (i.e. purchasing, payroll, and warehousing costs). B. LIFO Method 1. LIFO is preferable for tax purposes in inflationary periods as it matches the highest costs against revenues. 2. Record-keeping for LIFO is difficult, but simplified methods are available including &quot;dollar-value&quot; pools and governmental price indexes. IV. Special Accounting Methods There are special accounting methods applicable to transactions that cover multiple tax years. A. Long-Term Contracts (Examples I:11-21, I:11-22; Instructor Aid I:11-2) 1. Under complex rules, long-term contracts may be accounted for under the percentage-of-completion method, completed contract method, or modified percentage-of-completion method. Any contact accounted for using the percentage-of-completion method or a combination method is subject to a lookback interest adjustment calculated on any excess of the tax that would have been paid if actual costs would have been known over the tax that was paid utilizing estimated costs. 2. The restrictions on the completed contract method are increasing over time (i.e. it is increasingly more difficult to qualify to use the completed contract method). This method is currently available only to companies whose average <a href="/keyword/gross-receipts/" >gross receipts</a> for the three preceding tax years are $10 million or less, for construction contracts that are expected to take 2 years or less to complete, and for certain other taxpayers for home construction contracts. I:IO11-5 B. Installment Sales Method (Example I:11-23; Question I:11-24; Topic Review I:113; Instructor Aid I:11-3; Problem I:11-47) When any disposition of property for a gain occurs where at least one payment is received after the taxable year of disposition, the installment sale rules apply. The income is reported over the period payments are received, unless the taxpayer elects out of the installment method. 1. The gross profit percentage (Gross Profit/Contract Price) is multiplied by the collections of principal in any tax year to determine recognized income. All depreciation recapture must be recognized in year of disposition. 2. The gain to be recognized on the disposition of installment obligations is the excess of the amount realized over the adjusted basis of the obligations. The adjusted basis of the installment obligations can be calculated as follows: Face Amount X (100% - Gross Profit Percentage) 3. Generally dealers in personal property may not use the installment method for installment sales. 4. Special rules apply to installment sales for more than $150,000 and installment sales between related parties. C. Deferred Payment Sales (Example I:11-28) 1. If a taxpayer elects out of the installment method or a loss is involved, the deferred payment sales rules are applicable to determine the amount and timing of recognized gain or loss. Generally, the entire gain or loss is recognized in the year of sale. 2. Indeterminate market value of the installment obligations (an unlikely event) can result in basis recovery before any income recognition. V. Imputed Interest (Example I:11-30; Topic Review I:11-4; Problem I:11-51) The tax law imputes interest in a deferred payment contract where no interest or a low rate of interest is provided. The effect of interest imputation is to reallocate characterization of payments from principal to interest. A. Imputed Interest Computation (Example I:11-31) If imputed interest is required, the applicable federal rate may be substituted by the IRS for the contractual rate. Accrual of Interest (Example I:11-32) In most situations, imputed interest is reported as it accrues. I:IO11-6 B. EXAMPLE: Imputed interest can be reported on the cash method in the following situations: 1. 2. 3. 4. 5. C. Sales of personal residences Certain farm sales for &lt; $1,000,000 Transactions with total payments &lt; $250,000 Related party land sales for &lt; $500,000 Certain sales with principal &lt; $2,000,000 if borrower and lender jointly elect Gift, Shareholder, and Other Loans (Example I:11-33) 1. Imputed interest may also be applicable to gift loans, corporationshareholder loans, compensation related loans, and other tax avoidance loans. 2. In these types of loan situations, the lender is treated as returning the imputed interest to the borrower, resulting in possible gift tax consequences, dividend treatment, or compensation. 3. Special rules exist for gift loans totaling $100,000 or less, and certain other below-market loans totaling less than $10,000. VI. Changes in Accounting Methods (Example I:11-34) A. Generally, an accounting period is chosen by using it on the tax return for the first year in which the method is applicable. 1. IRS approval is generally required to change accounting methods. 2. However, taxpayers may change to LIFO inventory without prior IRS consent. B. Amount of change (Example I:11-35) Generally, a change in accounting methods results in duplications or omissions of income or expense items. I:IO11-7 C. Reporting the Amount of the Change (Example I:11-36) The period over which the accounting method change is reported depends on: 1. The amount EXAMPLE: Involuntary changes involving a positive adjustment &lt; $3,000 are reported in the year of change. 2. Whether the change was voluntary or involuntary EXAMPLE: Involuntary changes (&gt; $3,000 positive adjustment) are reported over a 3-year period. Voluntary changes (&gt; $3,000 positive adjustment) may be reported under the reconstruction of income method or over a 6-year period. 3. Any specific statutory mandates EXAMPLE: When the Tax Reform Act of 1986 disallowed reserves for bad debts, the income from the reversal of the reserves was mandated to be taken into income over four years. D. Obtaining IRS Consent The necessity of obtaining IRS approval is not always clear. EXAMPLE: It is unclear whether a taxpayer must obtain prior IRS approval to change only financial reporting (in light of book and tax conformity requirements) and to change from an incorrect accounting method (i.e. cash method for purchases and sales of inventory) to a correct method (i.e. hybrid or accrual). VII. Tax Planning Considerations A. Accounting Periods 1. Remaining opportunities to control tax years should be investigated carefully. 2. Short initial and termination years may result in tax benefit due to the utilization of lower tax brackets. I:IO11-8 B. Accounting Methods Accounting methods should be selected carefully to avoid unfavorable tax consequences on an accounting change. EXAMPLE: LIFO for inventory in inflationary times and cash method for service businesses may reduce tax. Such elections should be made on the initial return. C. Installment Sales Installment sales treatment will normally be selected for qualifying sales, but low income or loss tax years may suggest current recognition. EXAMPLE: If a taxpayer expects a net operating loss in the current year, he may want to elect out of the installment method to offset the entire gain in the current year. VIII. Compliance and Procedural Considerations Procedures for Changing to LIFO (Example I:11-37) 1. 2. Form 970 should be filed notifying the IRS of a change to the LIFO method. Advance IRS approval is not necessary to change to LIFO. Court Case Briefs Howard F. Brunton v. CIR, 1982 PH T.C. Memo &amp; 82,166, 43 TCM 956. The taxpayers, who owned rental property, used a cash basis method of accounting for all receipts and some expenses, but used an accrual method basis of accounting for all real estate tax expenses. On their federal income tax return, the Bruntons claimed expense deductions for unpaid real estate taxes for which they were liable. The IRS disallowed the use of the accrual method for the real estate taxes and claimed that Mr. Brunton was a cash basis taxpayer. Sec. 466(a) states that taxable income is to be computed using the method of accounting that the taxpayer regularly uses to compute his income in keeping his books unless the taxpayer's method does not clearly reflect income. The regulations in Sec. 1.446-1(c)(1)(iv)(a) further provide that a taxpayer &quot;who uses the cash method of accounting in computing gross income ... shall use the cash method in computing expenses ....&quot; Consequently, the Tax Court disallowed the expenses of the real estate taxes that had not actually been paid. I:IO11-9 James E. Mahon v. CIR, 1987 PH T.C. Memo &amp; 87,449, 54 TCM 439. Mr. Mahon, a retired colonel of the United States Air Force, filed a return electing &quot;married filing separate return&quot; status. His wife also filed a return electing &quot;married filing separate return&quot; status. They each included in their separate returns one-half of his wages and retirement income and one-half of her retirement income. Each attached to their returns a &quot;Declaration of Policy for Income Tax Payment,&quot; which stated their perception that all their income was &quot;joint income, equally shared, and the withheld taxes are jointly and equally paid, although the W-2s were issued in only one of our names ...&quot; The IRS issued a notice of deficiency, claiming that Mr. Mahon failed to report one-half of his income. The Mahons claimed that they had always thought of themselves as a team and that she had &quot;earned&quot; one-half of his income as a member of that team. The court, however, argued that &quot;one of the primary principles of our income tax system is that income should be taxed to the one who earns it.&quot; Regardless of the taxpayer's belief that the income was attributable to both himself and his wife, the entire amount of his wages and his retirement income was paid to Mr. Mahon for services performed by Mr. Mahon. I:IO11-10 Instructor Aid I:11-1 Inventory Costs Inventory Valuation Methods (1) (2) Cost (Must be used with LIFO cost-flow method) Lower of cost or market (each item valued separately) Cost Flow Assumptions (1) (2) (3) Average cost FIFO (first-in, first-out) LIFO (last-in, first-out) includes specific goods method, dollar-value method, and simplified method. I:IO11-11 Instructor Aid I:11-2 Long-Term Contract Accounting Methods Completed Contract Method Net income from contract reported in year of completion. Only available for (1) Contracts expected to take two years or less to complete, AND where taxpayer's average <a href="/keyword/gross-receipts/" >gross receipts</a> for the three preceding tax years is $10 million or less, and (2) Certain home construction contracts. Percentage of Completion Method Percentage of expected net income reported in each year of contract based on estimated percentage of completed work. Any taxpayer may use. Percentage of Completion Capitalized Cost Method - 90% of a contract's net income accounted for under percentage of completion method and 10% accounted for under taxpayer's regular method of accounting (i.e., completed contract method). Only available for (1) Contracts entered into before July 11, 1989, and (2) Certain residential construction contracts. Modified Percentage-of-Completion Method Percentage-of-completion method is utilized only after a minimum cumulative estimated total cost of 10% has been incurred. Any taxpayer may use. I:IO11-12 Instructor Aid I:11-3 Installment Method If a transaction qualifies for the installment method, the appropriate gross profit percentage is multiplied by the receipts under the contract during the year to determine the gross income from the contract for the year. Realized Gain not otherwise required to GROSS PROFIT PERCENTAGE = recognized in the year of sale* Contract Price CONTRACT PRICE = Gross sales price - liabilities assumed by buyer + any excess of liabilities assumed over the adjusted basis of the subject property.** *Secs. 1245 and 1250 recapture are required to be recognized in the year of sale. ** Any excess of liabilities assumed over the adjusted basis is treated as a receipt in the year of sale. IIO11-13