ACCOUNTING PERIODS AND METHODS LEARNING OBJECTIVES After studying this chapter, you should be able to > Explain the rules for adopting and changing an accounting period > Explain the differences among cash, accrual, and hybrid accounting P> Determine whether specific costs must be included in inventory Determine the amount of income to be reported from a long-term contract B> Compute the gain to be reported from an installment sale D> Compute the amount of imputed interest in a transaction D> Determine the tax treatment of duplications and omissions that result from changes of accounting methods11-2 Individuals ¥ Chapter 11 CHAPTER OUTLINE —_ An accounting method is a system of rules and procedures used to determine the year in ‘Accounting Perods.11-2 which income and expenses are reported for tax purposes. The accounting methods used ‘Overall Accounting Methods..1.7 in computing income for tax purposes generally must be the same as those used in keep- inventories.1-11 ing the taxpayer's books and records and determine when income and expenses are Special Accounting Methods.11-15 reported, not whether they are reported. Although the accounting methods used by a tax- Imputed Interest..11-22 rer do not necessarily af 1e amount of income reported over the life of a business, Change in Accounting payer do not ly affect th tof ported over the life of a business, Gepealnioes they do affect the tax burden in two ways. First, selecting the appropriate accounting TaxPlanning Considerations.1128 method can accelerate deductions or defer income recognition in order to postpone tax Compliance and Procedural payments, and second, because of the progressive tax rate structure, taxpayers can save Consderatons..1128 taxes by spreading income over several accounting periods rather than having income bunched into one period. EXAMPLE [:11-1 D> Jane, a taxpayer using the cash method of accounting, has a 28% marginal tax rate for 2008 ‘and expects to have a 15% marginal tax rate in 2009. Jane plans to make a charitable contribu- tion of $1,000 in January 2009. A contribution in 2009 will reduce Jane's tax by $150 (0.15 x $1,000), whereas a contribution in 2008 will reduce Jane's tax by $280 (0.28 x $1,000). ‘Obviously Jane may wish to accelerate the contribution in order to reduce her tax liability. << rails vusiset PERIODS Taxable income is computed on the basis of the taxpayer's annual accounting period, which is ordinarily 12 months (either a calendar year or a fiscal year). A fiscal year is a 12- Span nerus re ‘month period that ends on the last day of any month other than December. The tax year Song dd Gece must coincide with the year used to keep the taxpayer's books and records. Taxpayers accounting period who do not have books (e., an individual with wage income) must use the calendar year.! A taxpayer with a seasonal business may find a fiscal year to be advantageous. During the slow season, inventories may be lower and employees are available to take inventory and perform other accounting duties associated with the year-end. The tax year is elected on the first tax return that is fled by a taxpayer and cannot be changed without ‘consent from the IRS. A partnership generally must use the same tax year as the partners who own the majority (greater than 50%) of partnership income and capital. If a majority of partners do not have the same year, the partnership must use the tax year of its principal partners (chose with more than a 5% interest in the partnership). Ifthe principal partners do not hhave the same tax year, the partnership must use the taxable year that results in the least aggregate deferral of income to the partners.¥ An exception is made for partnerships that ‘can establish to the satisfaction of the IRS a business purpose for having a different year. ‘The purpose of the strict rules for selecting accounting periods is to prevent partners from deferring partnership income by choosing a different tax year for the partnership. For example, calendar-year partners might select a partnership year that ends on January 31. Because partnership income is considered to be earned by the partners on the last day of the partnership's tax year, reporting the profits would thus be deferred 11 months because the partnership year ends after the partner's year. (See the section entitled Required Payments and Fiscal Years in this chapter for further discussion of the calendar- year requirement.) A similar rule generally requires S corporations and personal service corporations to adopt a calendar year unless the corporation has a business purpose for electing a fiscal year.’ Taxpayers willing to make required payments or distributions may choose a fiscal year. (See the Required Payments and Fiscal Years section in this chapter) Q STOP & THINK Question: The tax rules related to accounting periods essentially require most partnerships, S corporations, and personal service corporations to report on the calendar ¥ See. a4) 5 Reg. Sc. 1.706-1(aK3) See 1441-10), 4 See 1378EXAMPLE E:11-2 ADDITIONAL ‘COMMENT ‘The use ofa 52-53-week year aids in budgetary matters and satis ‘al comparisons because a four ‘week period, unl a calendar ‘months @ uniform, fixed period. REAL-WORLD EXAMPLE Meri inch & Company uses a 52-53.week year ending on the last Friday in December: TYPICAL MISCONCEPTION itis sometimes mistakenly believed that a tax year can end ‘on a day inthe middle ofthe month EXAMPLE 11-3 > Accounting Periods and Methods W In duals 11-3 year basis. Of course, almost all individual taxpayers also report on the calendar year basis. What impact does this have on accountants? Solution: The principal impact is a compression of tax compliance work into the “accounting busy season.” A substantial portion of auditing and other accounting work also takes place at year-end. As a result, these services are also compressed into the accounting busy season. The accounting profession has sought to have these rules changed, but has, at least so far, been unsuccessful An improper election to use a fiscal year automatically places the taxpayer on the cal- cendar year.5 Thus, if the first return is filed late because of oversight, the option to choose a fiscal year is lost. ity Corporation receives its charter in 2006 but does not begin operations until 2008. Tax returns are required for 2006 and 2007 as well as for 2008. Timely returns are not filed because the City's officers are unaware that returns must be filed for inactive corporations. Thus, City Corporation must use the calendar year. City Corporation may petition the IRS for approval to use a fiscal year. < ‘While most tax years end on the last day of a month, the tax law allows taxpayers to use a tax year that always ends on the same day of the week, such as the last Friday in October. This means that the tax years will vary in length between 52 and $3 weeks. ‘Taxpayers who regularly keep theit books over a period that varies from 52 to 53 weeks ‘may elect the same period for tax purposes. A $2-53-week taxable year must end either the last time a particular day occurs during a calendar month (e.g., the last Friday in October) oF the occurrence of the particular day that is closest to the end of a calendar month (e.g., the Saturday closest to the end of November). Under the first alternative, the year may end as many as six days before the end of the month, but must end within the month. Under the second alternative, the year may end as many as three days before oF after the end of the month. ‘The 52-53-week year is especially useful to businesses with inventories. For example, ‘a manufacturer might choose a $2-53-week year that ends on the last Friday in December to permit inventory to be taken over the weekend without interfering with the company’s manufacturing activity. Similarly, wage accruals would be eliminated for a company with a weekly payroll if the payroll period always ends on Friday. Although the 52~53-week year may actually end on a day other than the last day of the month, it is treated as ending on the last day of the calendar month for “effective date” changes in the tax law that would otherwise coincide with the yearend, Eagle Corporation has adopted a 52-53-week year. Eagle's tax year begins on December 29, 2008. Assume that a new tax rate schedule applies to tax years beginning after December 31, 2008. The new tax rate schedule is applicable to Eagle because, in the absence of the 52-53- ‘week year, its tax period would have started on January 1, 2009. < REQUIRED PAYMENTS AND FISCAL YEARS Virtually all C corporations (other than personal service corporations) have flexibility in choosing an accounting period. Other taxpayers, such as partnerships and S corporations, ‘may use a fiscal year if they have an acceptable business purpose. However, most of these businesses are unable to meet the rather rigid business purpose requirements outlined by the IRS. As a result, these businesses report using the calendar year concentrating most tax work during the early months of the year. Concer over this problem led Congress to ‘enact Sec. 444 which allows partnerships, S corporations, and personal service corpora- tions (such as incorporated medical practices) to elect a taxable year that results in a tax: deferral of three months or less (e.g.,a partnership with calendar-year partners may elect ‘a September 30 year-end). This is called the Sec. 444 election. Furthermore, partnerships, 50.4. Calhoun 1 US, 33 AFTR 24 74-308, 74-1 USTC 49104 (D.C. Va Se. 441 973),