Revised Procedures for Changing Accounting Methods

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What is a change in accounting method? What approvals are necessary? How are the adjustments resulting from the charge treated? When should a taxpayer change a method of accounting? These and other questions are discussed as a result of new IRS rules.

The IRS, in Rev. Proc. 92-20, issued a new set of rules for changing accounting methods, replacing previous guidelines in Rev. Proc. 84-74. The purpose of the new rules is to encourage changes from impermissible accounting methods to those allowed by the IRC, regulations, and Supreme Court decisions. In reporting taxable income, no single method of accounting is required of all taxpayers. IRC Sec. 446 requires accounting methods to clearly reflect income and be used consistently. The principle of clearly reflecting income is an issue often decided upon examination of the tax return. Consistent application of a specified set of accounting principles, however, is more objectively determined. Any deviation from the method of accounting regularly used to compute taxable income may require the consent of the IRS Commissioner.

While the IRC does not offer a specific definition of a change in accounting method, the regulations note it "includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan." Treasury Reg. 1.446-1 includes the following as changes in accounting methods: a switch from cash receipts and disbursements method to an accrual method, or vice versa, a change in the method or basis used in valuing inventories, a switch from cash or accrual method to a long-term contract method, or vice versa, adoption, use or discontinuance of any specified method of computing taxable income, such as the crop method, and changes for which the IRC and regulations require the consent of the commissioner before the adoption of such change. Changes in accounting methods do not include corrections for mathematical or posting errors, computational mistakes, and non-timing adjustments, such as the correction of items deducted as business expenses that are really dividends and personal expenses. In addition, a change in the method of accounting does not include adjustments to an addition to a reserve for bad debts or to the useful life or basis of an asset. Once an item has been reported under a specific accounting method, a pattern is established. Any change in treatment of such an item requires notification and permission from the IRS. A taxpayer wishing to request consent for a change in method must file a Form 3115 within 180 days of the beginning of the tax year in which the change will first apply. The form requires complete information regarding the old and new method as well as the adjustment to taxable income that results from the change. The request for consent must be filed regardless of whether the change is made from a prohibited method or a permissible method. A user fee is required with the submission of the request. For most taxpayers (other than employee plans and exempt organizations) the current fee is $500.

Sec. 481(a) requires adjustments necessary to prevent duplications or omissions of income or deductions when a new accounting method is applied. The adjustment may be positive (increase in taxable income) or negative (decrease in taxable income). For example, a calendar-year taxpayer currently using lower of cost or market to value inventories wishes to change to cost for the year 1993. If inventory is valued at $365,000 under lower of cost or market on December 31, 1992, and $410,000 at cost on January 1, 1993, the Sec. 481(a) adjustment is a positive $45,000. This means the taxpayer must include $45,000 in taxable income in 1993 or over a specified adjustment period.

CATEGORIES OF METHODS

There are four classifications (two categories and two designations) of accounting methods and specific guidelines are provided regarding the appropriate time period for spreading the Sec. …