Accounting Method Changes
Grimes, Scott E., Sanchez, Victor, Wiggam, Marilyn K., Journal of Accountancy
To the relief of many businesses, new rules now make it easier than ever before for an entity to obtain IRS consent to change its method of accounting for its operations. Revenue procedure 97-27, 1997-21 IRB, contains the procedures, terms and conditions that apply when taxpayers request permission to make such changes under IRC section 446. It modifies and supersedes revenue procedure 92-20, 1992-1 CB 685, eliminating many of the complex rules found there. This review of revenue procedure 97-27 discusses some of the planning opportunities available to entities considering a change in accounting method.
CHANGE RULES CHANGE
An accounting method change may involve switching from one permissible method to another or from an impermissible method to a permissible one. The use of impermissible methods is relatively common and will be addressed in greater detail later in this article.
The new revenue procedure provides eligible entities with incentives to encourage voluntary compliance with proper tax accounting principles. A taxpayer generally receives more favorable terms and conditions if it files the request before the IRS contacts it for an examination of its current method. In addition, revenue procedure 97-27 says the taxpayer as well as the return preparer may be subject to penalties if the IRS finds the entity is using an impermissible method.
Change in accounting method. A change in an entity's accounting method is a change in its overall plan of accounting for gross income or deductions (cash or accrual methods), or a change in the treatment of a material item. A material item involves the proper timing of when to include that item in income or if the item can be taken as a deduction. If a practice does not permanently affect a taxpayer's lifetime income but does affect the taxable year in which income is reported or a deduction taken, the practice involves timing and is considered a method of accounting.
An entity generally does not adopt an accounting method without consistent treatment--the treatment of a material item in the same way for purposes of determining gross income or deductions in two or more consecutively filed tax returns. If a taxpayer treats an item properly in the first return that reflects the item, however, it is considered to have adopted a method of accounting. Corrections of mathematical or posting errors or errors in the computation of tax liability are not considered changes in accounting method.
Terms and conditions for a change. Usually, a taxpayer files Form 3115, Application for Change in Accounting Method, during the taxable year in which it wants to make a change; retroactive method changes are not permitted. Certain changes (such as changes in the last-in, first-out [Lifo] inventory method) must be made using a cut-off method. That means only items originating on or after the beginning of the year of change are accounted for under the new method and items preceding the year of change continue to be accounted for under the old method.
Most accounting method changes, however, involve an IRC section 481 (a) adjustment. When section 481 (a) is applied, an entity must determine income for the taxable year preceding the year of change under the old method and income for the year of change and subsequent years under the new method--as if the new method had always been used. When the new method is adopted, section 481 (a) requires an entity to take into account those adjustments necessary to prevent amounts from being duplicated or omitted.
Ordinarily, an entity must make a change initiated by the IRS as part of an examination that results in a positive (increase to taxable income) section 481 (a) adjustment in the earliest taxable year under examination. The section 481 (a) adjustment period for taxpayer-initiated changes, however, generally is four tax years, beginning with the year of change, for both positive and negative adjustments. …