comprehensive volume c16-1 chapter 16 accounting periods and methods copyright ©2010 cengage...

C16-C16-11Comprehensive VolumeComprehensive Volume

Chapter 16Chapter 16

Accounting Periods and MethodsAccounting Periods and Methods

Copyright ©2010 Cengage Learning

Comprehensive Volume


Accounting Periods(slide 1 of 3)


• Taxable year– The tax year may be shorter but is usually not

longer than 12 months– Taxpayer elects a tax year by the timely filing

of the initial return– Permission to change taxable years must be

obtained from the IRS

• Taxable year– The tax year may be shorter but is usually not

longer than 12 months– Taxpayer elects a tax year by the timely filing

of the initial return– Permission to change taxable years must be

obtained from the IRS




• Types of taxable years– Calendar year: January 1 – December 31– Fiscal year: must start on the first day of a

month and end the last day of a month, other than December, 12 months later

• Example: July 1 – June 30

• Types of taxable years– Calendar year: January 1 – December 31– Fiscal year: must start on the first day of a

month and end the last day of a month, other than December, 12 months later

• Example: July 1 – June 30




• Types of taxable years– 52/53 week year: ends on same day of week

that is either closest to its normal monthly year-end or occurs last in its year

• Example: year-end is always the last Saturday in April

• Types of taxable years– 52/53 week year: ends on same day of week

that is either closest to its normal monthly year-end or occurs last in its year

• Example: year-end is always the last Saturday in April


Accounting Periods— Partnerships

Accounting Periods— Partnerships

• Tax year-end must be that of (in descending order)– Majority interest partners

• Own a > 50% interest in partnership capital & profits

– Principal partners• Partner with a 5% or more interest in partnership

capital or profits

– Least aggregate deferral of income

• Tax year-end must be that of (in descending order)– Majority interest partners

• Own a > 50% interest in partnership capital & profits

– Principal partners• Partner with a 5% or more interest in partnership

capital or profits

– Least aggregate deferral of income


Accounting Periods—S Corps and PSCs

Accounting Periods—S Corps and PSCs

• Generally, these entities must have a calendar year– Other tax years may be available if certain

requirements can be met

• Generally, these entities must have a calendar year– Other tax years may be available if certain

requirements can be met


Accounting Periods—Other Allowable Year-Ends

Accounting Periods—Other Allowable Year-Ends

• Partnerships, S corps, and PSCs can elect to have other fiscal year-ends if any of the following are met:– A valid business purpose can be shown– §444 election is made and year-end results in no more

than a 3-month deferral• Requires certain payments

– §444 election was made to retain the same year as was used for the fiscal year ending in 1987

• Requires certain payments

• Partnerships, S corps, and PSCs can elect to have other fiscal year-ends if any of the following are met:– A valid business purpose can be shown– §444 election is made and year-end results in no more

than a 3-month deferral• Requires certain payments

– §444 election was made to retain the same year as was used for the fiscal year ending in 1987

• Requires certain payments


Accounting Periods—Valid Business Purpose

Accounting Periods—Valid Business Purpose

• IRS acknowledges only one valid business purpose for using a fiscal year-end– Conforming the tax year to the entity’s natural

business year (seasonal businesses)• Example: a September 30 year-end may be a natural

business year-end for a swim suit manufacturer

• IRS acknowledges only one valid business purpose for using a fiscal year-end– Conforming the tax year to the entity’s natural

business year (seasonal businesses)• Example: a September 30 year-end may be a natural

business year-end for a swim suit manufacturer


Accounting Periods—§444 Deferral and Required Tax Payments

Accounting Periods—§444 Deferral and Required Tax Payments

• Partnerships and S corporations (not their owners) must make tax payments at the highest individual rate plus 1% (e.g., 36%) on estimated deferral period income– The amount due is reduced by the amount of

required tax payments for the previous year

• Partnerships and S corporations (not their owners) must make tax payments at the highest individual rate plus 1% (e.g., 36%) on estimated deferral period income– The amount due is reduced by the amount of

required tax payments for the previous year


Accounting Periods—§444 Deferral and Required Salary Payments

Accounting Periods—§444 Deferral and Required Salary Payments

• PSCs must pay shareholder-employees salaries during the deferral period that are at least proportionate to their salaries for the preceding fiscal year– Failure to make required salary payments

reduces PSCs deduction for salaries paid to shareholder-employees

• PSCs must pay shareholder-employees salaries during the deferral period that are at least proportionate to their salaries for the preceding fiscal year– Failure to make required salary payments

reduces PSCs deduction for salaries paid to shareholder-employees


Example of §444 Deferral and Required Salary Payments

Example of §444 Deferral and Required Salary Payments

• PSC has October 31 year-end and cannot satisfy the business purpose test for a fiscal year– Provides 2 month deferral

– Has one shareholder-employee with $60,000 in salary for prior fiscal year

– PSC should pay shareholder-employee at least $10,000 in salary during the deferral period

• $60,000 × 2/12 = $10,000

• PSC has October 31 year-end and cannot satisfy the business purpose test for a fiscal year– Provides 2 month deferral

– Has one shareholder-employee with $60,000 in salary for prior fiscal year

– PSC should pay shareholder-employee at least $10,000 in salary during the deferral period

• $60,000 × 2/12 = $10,000


Change in Accounting PeriodChange in Accounting Period

• Must obtain IRS consent before changing tax year

• IRS will not consent to a change unless taxpayer demonstrates a substantial business purpose for change, such as changing to natural business year

• Must obtain IRS consent before changing tax year

• IRS will not consent to a change unless taxpayer demonstrates a substantial business purpose for change, such as changing to natural business year


Change in Accounting Period—Natural Business Year

Change in Accounting Period—Natural Business Year

• Objective test: At least 25% of entity’s gross receipts are realized in the final 2 months of the desired tax year for 3 consecutive years

• IRS usually establishes certain conditions that the taxpayer must accept if approval for change is to be granted– In particular, if the taxpayer has a net operating loss

(NOL) for the short period, the IRS requires that the loss be carried forward

• The loss cannot be carried back to prior years

• Objective test: At least 25% of entity’s gross receipts are realized in the final 2 months of the desired tax year for 3 consecutive years

• IRS usually establishes certain conditions that the taxpayer must accept if approval for change is to be granted– In particular, if the taxpayer has a net operating loss

(NOL) for the short period, the IRS requires that the loss be carried forward

• The loss cannot be carried back to prior years


Accounting Periods—Short Taxable Year

Accounting Periods—Short Taxable Year

• A short taxable year is a period of less than 12 calendar months– Can occur in the first taxable year, the last taxable year,

or when there is a change in the taxable year

• If the short-period year is caused by a change in taxable year, the short-year income must be annualized– Necessary due to the progressive tax rate structure

• A short taxable year is a period of less than 12 calendar months– Can occur in the first taxable year, the last taxable year,

or when there is a change in the taxable year

• If the short-period year is caused by a change in taxable year, the short-year income must be annualized– Necessary due to the progressive tax rate structure


Mitigation of the Annual Accounting Period Concept

(slide 1 of 2)


(slide 1 of 2)

• Several Code provisions provide relief from harsh results produced by the combined effects of an arbitrary accounting period & a progressive rate structure, for example– NOL carryover rules

• A loss in one year can be carried back 2 years & carried forward for 20 years

– Special relief is provided for casualty losses pursuant to a disaster and for reporting insurance proceeds from destruction of crops

• Several Code provisions provide relief from harsh results produced by the combined effects of an arbitrary accounting period & a progressive rate structure, for example– NOL carryover rules

• A loss in one year can be carried back 2 years & carried forward for 20 years

– Special relief is provided for casualty losses pursuant to a disaster and for reporting insurance proceeds from destruction of crops



(slide 2 of 2)


(slide 2 of 2)

• Farmers and fishermen – Often subject to wide fluctuations in income

• Allowed to use an averaging system that helps avoid higher marginal tax rates associated with a large amount of income received in one year

• Crop insurance proceeds may be received in a year before the income from the crop would have been realized

– Allowed to defer reporting the income until the year following the disaster

• Section 451(e) provides similar relief when livestock must be sold on account of drought or other weather-related conditions

• Farmers and fishermen – Often subject to wide fluctuations in income

• Allowed to use an averaging system that helps avoid higher marginal tax rates associated with a large amount of income received in one year

• Crop insurance proceeds may be received in a year before the income from the crop would have been realized

– Allowed to defer reporting the income until the year following the disaster

• Section 451(e) provides similar relief when livestock must be sold on account of drought or other weather-related conditions


Accounting Methods(slide 1 of 10)


• There are 3 generally permissible overall methods of accounting – Cash receipts and disbursements method– Accrual method– Hybrid method

• Generally, any of the three methods of accounting may be used – Must be consistently employed and clearly reflect

income• In most cases the taxpayer is required to use the

accrual method for sales and costs of goods sold if inventories are an income-producing factor

• There are 3 generally permissible overall methods of accounting – Cash receipts and disbursements method– Accrual method– Hybrid method

• Generally, any of the three methods of accounting may be used – Must be consistently employed and clearly reflect

income• In most cases the taxpayer is required to use the

accrual method for sales and costs of goods sold if inventories are an income-producing factor




• Cash receipts and disbursements method– Income is recognized when it is actually or

constructively received– Expenses are deductible when they are paid

• Most courts have applied the “one year rule” for prepaid expenses

– Requires that prepaid expenses whose benefits extend beyond the end of the following tax year must be capitalized

• Cash receipts and disbursements method– Income is recognized when it is actually or

constructively received– Expenses are deductible when they are paid

• Most courts have applied the “one year rule” for prepaid expenses

– Requires that prepaid expenses whose benefits extend beyond the end of the following tax year must be capitalized




• Cash receipts and disbursements method - Restrictions on use

– Cash method cannot be used by corporations, partnerships with a corporate partner, and tax shelters

• Exceptions: – Farming business– Qualified PSC– An entity that is not a tax shelter whose average annual

gross receipts for most recent three-year period are $5 million or less

• Cash receipts and disbursements method - Restrictions on use

– Cash method cannot be used by corporations, partnerships with a corporate partner, and tax shelters

• Exceptions: – Farming business– Qualified PSC– An entity that is not a tax shelter whose average annual

gross receipts for most recent three-year period are $5 million or less




• Restrictions on use of cash method (cont’d)– As an administrative convenience, the IRS permits the

following entities to use the cash method• Entities with $1 million or less average annual gross receipts

during last three-year period (even if buying and selling inventory) , and

• Certain entities with average annual gross receipts of greater than $1 million but not more than $10 million during last three-year period with the following restrictions

– Inventory on hand at the end of the tax year cannot be deducted until the inventory is sold (i.e., must be capitalized)

– Not eligible are entities whose principal business activity is selling goods, manufacturing, mining, and certain publishing activities

• Restrictions on use of cash method (cont’d)– As an administrative convenience, the IRS permits the

following entities to use the cash method• Entities with $1 million or less average annual gross receipts

during last three-year period (even if buying and selling inventory) , and

• Certain entities with average annual gross receipts of greater than $1 million but not more than $10 million during last three-year period with the following restrictions

– Inventory on hand at the end of the tax year cannot be deducted until the inventory is sold (i.e., must be capitalized)

– Not eligible are entities whose principal business activity is selling goods, manufacturing, mining, and certain publishing activities




• Special Rules for Small Farmers– Although inventories are material to farming

operations, the IRS allows small farmers to use the cash method of accounting

• Applies to unincorporated farms and closely held farming corps with gross receipts < $25 million

– Must still capitalize costs of raising trees with preproduction period > two years

• Special Rules for Small Farmers– Although inventories are material to farming

operations, the IRS allows small farmers to use the cash method of accounting

• Applies to unincorporated farms and closely held farming corps with gross receipts < $25 million

– Must still capitalize costs of raising trees with preproduction period > two years




• Special Rules for Small Farmers (cont’d)– Farmers producing crops that take > 1 year

from planting to harvesting can elect to use the crop method to report income

• Under the crop method, costs of raising crops are capitalized and then deducted in year income from crop is realized

– Cash basis farmers must capitalize the purchase price of animals, whether acquired for sale or breeding

• The costs of raising the animal can be expensed

• Special Rules for Small Farmers (cont’d)– Farmers producing crops that take > 1 year

from planting to harvesting can elect to use the crop method to report income

• Under the crop method, costs of raising crops are capitalized and then deducted in year income from crop is realized

– Cash basis farmers must capitalize the purchase price of animals, whether acquired for sale or breeding

• The costs of raising the animal can be expensed




• Accrual method: Income– Income is recognized when it is earned

• Income is earned when all events have occurred to fix the taxpayer’s rights to the income, and

• The amount can be determined with reasonable accuracy

• Accrual method: Income– Income is recognized when it is earned

• Income is earned when all events have occurred to fix the taxpayer’s rights to the income, and

• The amount can be determined with reasonable accuracy




• Accrual method: Deductions– Expenses are deductible when they meet the all

events test and the economic performance test– Economic performance test is waived for

certain recurring items

• Accrual method: Deductions– Expenses are deductible when they meet the all

events test and the economic performance test– Economic performance test is waived for

certain recurring items




• Hybrid method involves the use of more than one method– e.g., A combination of cash and accrual

methods– Generally used when inventory is a material

factor• e.g., Accrual accounting used for determining gross

profit from inventory & cash accounting used to report other income & expenses

• Hybrid method involves the use of more than one method– e.g., A combination of cash and accrual

methods– Generally used when inventory is a material

factor• e.g., Accrual accounting used for determining gross

profit from inventory & cash accounting used to report other income & expenses




• Change in accounting method– Taxpayer elects accounting method for

subsequent years by filing the initial return– Must obtain permission from IRS to change

accounting methods • Adjustments may be required to prevent distortion

of taxable income

– Correction of error is not a change in accounting method

• Change in accounting method– Taxpayer elects accounting method for

subsequent years by filing the initial return– Must obtain permission from IRS to change

accounting methods • Adjustments may be required to prevent distortion

of taxable income

– Correction of error is not a change in accounting method


Disposition Of Net Adjustment From Change in Accounting Method

(slide 1 of 2)


(slide 1 of 2)

• Required changes in accounting methods are the result of an IRS examination– IRS will not require a change unless the net adjustment

is positive• Adjustment generally must be included in gross income for the

year of the change• Additional tax and interest on the tax will be due

– If adjustment is greater than $3,000, the taxpayer can elect to calculate the tax by spreading the adjustment over one or more previous years

• Required changes in accounting methods are the result of an IRS examination– IRS will not require a change unless the net adjustment

is positive• Adjustment generally must be included in gross income for the

year of the change• Additional tax and interest on the tax will be due

– If adjustment is greater than $3,000, the taxpayer can elect to calculate the tax by spreading the adjustment over one or more previous years



(slide 2 of 2)


(slide 2 of 2)

• For voluntarily changes from incorrect methods and to facilitate changes from one correct method to another– IRS generally allows the taxpayer to spread a positive

adjustment into future years• 1/4th of the adjustment is applied to the year of change, and

1/4th of the adjustment is applied to each of the next 3 taxable years

• A negative adjustment can be deducted in the year of the change

• For voluntarily changes from incorrect methods and to facilitate changes from one correct method to another– IRS generally allows the taxpayer to spread a positive

adjustment into future years• 1/4th of the adjustment is applied to the year of change, and

1/4th of the adjustment is applied to each of the next 3 taxable years

• A negative adjustment can be deducted in the year of the change


Installment Method(slide 1 of 11)


• Installment method of reporting gain allows the taxpayer to recognize gain as payments on the sale are received

• Installment method of reporting gain allows the taxpayer to recognize gain as payments on the sale are received




• To qualify for installment treatment, the taxpayer must receive at least one payment after the year of sale

• May elect out of installment treatment

• To qualify for installment treatment, the taxpayer must receive at least one payment after the year of sale

• May elect out of installment treatment




• Installment treatment is not allowed for the following:– Gains on property held for sale in the ordinary course of business– Depreciation recapture under §1245 and §1250– Sale of securities traded on established markets

• As an exception to the first item (above), the installment method may be used to report gains from sales of the following– Time-share units (e.g., the right to use real property for two weeks

each year)– Residential lots (if the seller is not to make any improvements)– Any property used or produced in the trade or business of farming

• Installment treatment is not allowed for the following:– Gains on property held for sale in the ordinary course of business– Depreciation recapture under §1245 and §1250– Sale of securities traded on established markets

• As an exception to the first item (above), the installment method may be used to report gains from sales of the following– Time-share units (e.g., the right to use real property for two weeks

each year)– Residential lots (if the seller is not to make any improvements)– Any property used or produced in the trade or business of farming




• Computing the gain recognized:– Gain recognized each year is dependent on the

payments received during the year – Recognized Gain =

Total gain × Payments ReceivedContract Price

• Computing the gain recognized:– Gain recognized each year is dependent on the

payments received during the year – Recognized Gain =

Total gain × Payments ReceivedContract Price




• Definitions– Total gain = selling price less selling expenses

less adjusted basis of property– Contract price = Sales price less liabilities

assumed by buyer • Generally is equal to amount (other than interest)

seller will receive from purchaser

• Definitions– Total gain = selling price less selling expenses

less adjusted basis of property– Contract price = Sales price less liabilities

assumed by buyer • Generally is equal to amount (other than interest)

seller will receive from purchaser




• If liabilities assumed by buyer exceed the seller’s basis and selling expenses– The difference must be added to the contract

price and to payments received in year of sale

• If liabilities assumed by buyer exceed the seller’s basis and selling expenses– The difference must be added to the contract

price and to payments received in year of sale




• Depreciation recapture under §1245 & §1250– Depreciation recapture is ineligible for

installment treatment• All recapture must be recognized in year of sale

– Because most, if not all, of the gain on the sale of tangible property is §1245 recapture, benefit of installment treatment is generally limited to sales of real property

• Depreciation recapture under §1245 & §1250– Depreciation recapture is ineligible for

installment treatment• All recapture must be recognized in year of sale

– Because most, if not all, of the gain on the sale of tangible property is §1245 recapture, benefit of installment treatment is generally limited to sales of real property




• Imputed interest– Deferred payment contracts where the sales

price exceeds $3,000• Reasonable rate of interest (at least the applicable

Federal rate) must be charged by taxpayer on the outstanding balance

• Failure to charge adequate interest will result in imputed interest at Federal rate

• Imputed interest– Deferred payment contracts where the sales

price exceeds $3,000• Reasonable rate of interest (at least the applicable

Federal rate) must be charged by taxpayer on the outstanding balance

• Failure to charge adequate interest will result in imputed interest at Federal rate




• Related party installment sales– Limitations on the use of the installment

method• Nondepreciable property: disposition of property by

related purchaser generally accelerates recognition of gain on installment obligation for related seller

• Depreciable property: installment method is not available on sale to controlled entity (i.e., more than 50% interest) unless it can be demonstrated that tax avoidance was not a principal purpose

• Related party installment sales– Limitations on the use of the installment

method• Nondepreciable property: disposition of property by

related purchaser generally accelerates recognition of gain on installment obligation for related seller

• Depreciable property: installment method is not available on sale to controlled entity (i.e., more than 50% interest) unless it can be demonstrated that tax avoidance was not a principal purpose




• Disposition of obligation– Generally, disposition of an installment obligation triggers

recognition of remaining deferred gain• The gift or cancellation of an installment note is treated as a taxable

disposition by the donor– The amount realized from the cancellation is the face amount of the note

if the parties (obligor and obligee) are related to each other• Exceptions are provided for the following transfers

– Tax-free incorporations under § 351– Contributions of capital to a partnership– Certain corporate liquidations– Transfers due to the taxpayer’s death, and – Transfers between spouses or incident to divorce

• In such situations, the deferred profit is shifted to the transferee– Transferee is responsible for payment of tax on subsequent collections

• Disposition of obligation– Generally, disposition of an installment obligation triggers

recognition of remaining deferred gain• The gift or cancellation of an installment note is treated as a taxable

disposition by the donor– The amount realized from the cancellation is the face amount of the note

if the parties (obligor and obligee) are related to each other• Exceptions are provided for the following transfers

– Tax-free incorporations under § 351– Contributions of capital to a partnership– Certain corporate liquidations– Transfers due to the taxpayer’s death, and – Transfers between spouses or incident to divorce

• In such situations, the deferred profit is shifted to the transferee– Transferee is responsible for payment of tax on subsequent collections




• Interest on deferred taxes– Required to pay interest on the deferred taxes

related to the excess obligation amount (excess of $5 million) when

• Installment obligation is from sale of property for more than $150,000, and

• Sum of such obligations outstanding at year-end exceeds $5 million

• Interest on deferred taxes– Required to pay interest on the deferred taxes

related to the excess obligation amount (excess of $5 million) when

• Installment obligation is from sale of property for more than $150,000, and

• Sum of such obligations outstanding at year-end exceeds $5 million


Long-Term Contracts(slide 1 of 5)


• Long-term contract defined– A building, installation, construction, or

manufacturing contract that is not completed within the same taxable year in which it began

• A manufacturing contract is long-term only if a contract to manufacture:

– A unique item not normally carried in finished goods inventory, or

– Items that normally require more than 12 months to complete

• Long-term contract defined– A building, installation, construction, or

manufacturing contract that is not completed within the same taxable year in which it began

• A manufacturing contract is long-term only if a contract to manufacture:

– A unique item not normally carried in finished goods inventory, or

– Items that normally require more than 12 months to complete




• Methods of accounting for long-term contracts– Completed contract: Home construction and

certain other real estate construction contracts if• The contract is expected to be completed within the

two-year period beginning on the commencement date of the contract

• The contract is performed by a taxpayer whose average annual gross receipts for the 3 preceding taxable years do not exceed $10 million

– Percentage of completion: All other contracts

• Methods of accounting for long-term contracts– Completed contract: Home construction and

certain other real estate construction contracts if• The contract is expected to be completed within the

two-year period beginning on the commencement date of the contract

• The contract is performed by a taxpayer whose average annual gross receipts for the 3 preceding taxable years do not exceed $10 million

– Percentage of completion: All other contracts




• Completed contract method– Income recognition occurs when the contract is

completed and accepted

• Completed contract method– Income recognition occurs when the contract is

completed and accepted




• Percentage of completion– A portion of the gross contract price is included

in income each year as the work progresses– Amount of revenue accrued:

• (Costs incurred in tax year/total estimated costs) × contract price = revenue accrued in tax year

– Current year costs are deductible

• Percentage of completion– A portion of the gross contract price is included

in income each year as the work progresses– Amount of revenue accrued:

• (Costs incurred in tax year/total estimated costs) × contract price = revenue accrued in tax year

– Current year costs are deductible




• Percentage of completion lookback provisions– In the year that the contract is completed, the

profit and related taxes must be recalculated• If taxpayer overpaid taxes, interest on the

overpayment is paid to taxpayer

• If taxpayer underpaid taxes, interest on the underpayment is due from taxpayer

• Percentage of completion lookback provisions– In the year that the contract is completed, the

profit and related taxes must be recalculated• If taxpayer overpaid taxes, interest on the

overpayment is paid to taxpayer

• If taxpayer underpaid taxes, interest on the underpayment is due from taxpayer


If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

comprehensive volume c16-1 chapter 16 accounting periods and methods copyright ©2010 cengage...

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