Chapter I11
Accounting Periods and Methods
Discussion Questions
I11-1 In the long run, the amount of income reported by a taxpayer will generally be the same
regardless of the accounting methods used by the taxpayer. In a given year the amount of income
reported by a taxpayer can vary significantly depending on the accounting method used by the
taxpayer. p. I11-2.
I11-2 The accounting methods used by a taxpayer can accelerate or defer the recognition of income,
and, thereby, change when the tax must be paid. Also, because of the progressive tax rate structure,
taxes can be saved by spreading income over several years, rather than having income bunched into
one year. p. I11-2.
I11-3 The tax year must coincide with the year used to keep books and records. Taxpayers who do
not have books must use the calendar year. Most individuals who are wage earners do not keep
books and, therefore, must file using a calendar year. p. I11-2.
I11-4 Once a tax year is elected, it cannot be changed without IRS approval. The appropriate tax
year can make record keeping easier. If the year ends 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. pp. I11-2 and I11-3.
I11-5 A partnership must use the same tax year of the partners who own the majority of the
partnership income and capital. If the majority does not have the same tax year the partnership must
use a taxable year which is the same as the taxable year of all its principal partners (or the same
taxable year of all its principal partners who do not have such taxable year concurrently change). If
the principal partners do not have the same tax year, a taxable year that results in the least aggregate
deferral of income to the partners must be used. Partnerships may also elect a natural business year
even if it differs from the tax year of its partners. Also, a partnership may elect a fiscal year
involving a deferral period of three months or less if the partnership makes a required tax payment.
pp. I11-3 and I11-32.
I11-6 Yes. S corporations are generally required to adopt a calendar year unless either the
corporation has a natural business year or elects to make required tax payments. Rules similar to
those imposed upon partnerships (see Question I11-5) are applied to S corporations. pp. I11-2 and
I11-3.
I11-1
I11-7 The 52- to 53- week year is especially useful to businesses with inventories. For example, a
manufacturer might choose a 52- to 53- week year that ends on the last Friday in December so as to
permit the inventory to be taken over the weekend without interfering with the company's
manufacturing process. p. I11-3.
I11-8 A newly married person may change his or her tax year to conform to that of the other spouse
so that a joint return may be filed. Also, a 52- to 53- week year can be adopted if the year ends on a
day that refers to the same month in which the taxpayer's prior year ended. p. I11-4.
I11-9 A subsidiary corporation filing a consolidated return with its parent is required to change its
accounting period to conform with its parent. p. I11-4.
I11-10 a.
When a taxpayer files his or her first or final return or when the taxpayer changes
accounting periods.
b.
Annualization is required when a change in the accounting period occurs.
c.
Due to our progressive tax rates, annualization generally increases the taxpayer's tax
liability. pp. I11-4 and I11-5.
I11-11 The final return of a decedent is filed as though the decedent had lived throughout the entire
taxable year. In the case of other taxpayers, final returns are filed, and taxes are paid, as if they were
returns for a 12 month period ending on the last day of the short period. p. I11-5.
I11-12 a.
New taxpayers may generally choose any overall accounting method except that the
accrual method must be used for sales and cost of goods sold if inventories are an income producing
factor to the business. This is not a requirement that taxpayers with inventories use the accrual
method for other items on their returns.
b.
In general, other taxpayers may choose any accounting method they want. This, of
course, assumes that the method chosen clearly reflects income. Also, C corporations and
partnerships with a corporate partner may use the cash method only if the average annual gross
receipts for the three preceding taxable years do not exceed $5,000,000 or the business meets the
professional services requirements (owned by professionals who are using the business to provide
professional services).
c.
The cash method is preferred to the accrual method because it is simpler to use. It
frees the taxpayer from having to make the year end accruals associated with the accrual method.
Also, it enables taxpayers to accelerate deductions by prepaying expenses. Similarly, earned income
is not taxable until it is collected. Thus, the cash-method taxpayer does not have to report
uncollected receivables. pp. I11-7 through I11-11.
I11-13 a.
The term method of accounting is used to refer not only to overall methods of
accounting but also the accounting treatment of any item. Examples of accounting methods for
specific items include Sec. 174 relating to research and experimentation, Sec. 451 relating to
long-term contracts, and Sec. 453 relating to installment sales.
I11-2
b.
Accounting methods generally affect when income is reported not whether it is
reported. Thus, the total amount of income reported over time is not affected by a taxpayer's
accounting method.
c.
Because an accounting method determines when income is reported, it can change the
total amount of tax paid because tax brackets differ over time. p. I11-8.
I11-14 a.
A cash-method taxpayer deducts expenses when they are paid. A cash-method
taxpayer is, however, required to capitalize fixed assets and recover the cost through depreciation or
amortization. Prepaid expenses must also be capitalized and deducted over the term of the
prepayment if that term extends substantially beyond the end of the tax year. Typically,
capitalization is required only if the term of the prepayment extends beyond the close of the tax year
following the year of payment.
b.
No. Prepaid interest is not deductible. An exception permits a cash-method taxpayer
to deduct points paid on a home mortgage if the property is the taxpayer's principal residence and the
mortgage was for the purchase or improvement of the residence.
c.
Yes. Cash-method taxpayers are subject to the same rules as other taxpayers. pp.
I11-8 and I11-9.
I11-15 Smaller companies (those whose average gross receipts for the three preceding years were
$10 million or less) may use the completed contract method for construction contracts that are
expected to take two years or less to complete. In addition, the completed contract method may be
used for home construction contracts. pp. I11-15 and I11-16.
I11-16 A taxpayer cannot deduct a deposit as long as he has a right to receive a refund. p. I11-9.
I11-17 Payment can be either by check that is honored in due course or by use of a credit card.
Payment by credit card is considered to be the equivalent of borrowing funds and using the borrowed
funds to pay the expense. A taxpayer's note is not considered to be the equivalent of cash. p. I11-9.
I11-18 Economic performance of services or property to be provided to a taxpayer occurs when the
property or the services is actually provided by the other party. If a taxpayer is obligated to provide
property or services, economic performance occurs in the year the taxpayer provides the property or
service. pp. I11-9 and I11-10.
I11-19 Five conditions must be met. They are:
1. The all events test, without regard to economic performance, must be satisfied.
2. Economic performance must occur within a reasonable period (but in no event more than 8
1/2 months) after the close of the taxable year.
3. The item is recurring and is treated consistently by the taxpayer.
I11-3
4. Either the amount is not material or the earlier accrual of the item results in a better matching
of income and expense.
5. The taxpayer is not a tax shelter. p. I11-10.
I11-20 No. The all events and economic performance tests prevent the deduction of estimated
expenses. The expense becomes deductible once the actual cost is known. pp. I11-10 and I10-11.
I11-21 The Regulations state that inventory methods used by a taxpayer must conform to the best
accounting practice in the trade or business and it must clearly reflect income. In Thor Power Tool
Co., the Supreme Court held that the clear reflection of income standard shall prevail in cases where
the two standards conflict. Regulation Sec. 1.471- 4(b) states that obsolete and other slow moving
inventory cannot be written down unless the selling price is also reduced. Thor Power Tool Co.
wrote-off the cost of obsolete inventory. The Supreme Court held this practice was not acceptable as
it conflicted with the clear reflection of income requirement. pp. I11-11 and I11-12.
I11-22 a.
Manufacturing overhead (such as factory repairs and maintenance, utilities, rent and
other costs relating to the manufacturing process) must be included in inventory. Nonmanufacturing
costs (such as advertising, interest, and selling expenses) are not required to be included in inventory.
Other overhead costs (such as employee benefits, and factory administration) must also be included
in inventory unless they relate to the nonmanufacturing areas such as selling or advertising.
b.
Retailers whose average gross receipts for the three preceding years exceeds $10
million must include in inventory a portion of purchasing, warehousing, packaging, and related
administrative costs.
c.
No. Financial accounting does not require retailers to include purchasing,
warehousing, packaging, and related administrative costs in inventory. Financial accounting rules
have not required manufacturers to inventory employee benefits and certain administration costs that
must now be included in inventory for tax purposes. Similarly, financial accounting rules do not
require that interest be added to the cost of inventory with long-term production periods. For
example, financial accounting does not require that interest be added to the cost of whiskey that is
being aged while such interest must be included in inventory cost for tax purposes. pp. I11-12 and
I11-13.
I11-23 Long-term contracts include building, installation, construction, or manufacturing contracts
that are not completed in the same taxable year in which they are entered into. A long-term
manufacturing contract involves the manufacture of either a unique item not normally carried in
finished inventory or items that normally require more than 12 calendar months to complete.
Contracts for services do not qualify for long-term contract treatment. p. I11-15.
I11-4
I11-24 a.
The installment sales method is applicable only to transactions involving gains where
at least one payment is to be received after the close of the taxable year in which the disposition
occurs. It may not be used in connection with the sale of publicly traded property or inventory.
b.
One reason to elect out of the installment method could relate to the application of
lower tax rates in the current year where higher tax rates are anticipated during the installment
period. Also, a taxpayer with current operating and/or capital losses or expiring loss carryovers may
prefer to offset a gain against the losses in the current year. p. I11-18.
I11-25 In effect, the installment sale method is not available because the entire amount of ordinary
income must be reported in the year of the sale. p. I11-19.
I11-26 The gifting of an installment obligation is a taxable event. The donor must recognize gain
equal to the difference between the face of the obligation and its adjusted basis.
p. I11-21.
I11-27 Installment sales to related persons are subject to the same rules as other installment sales
except when the property is resold by the related purchaser. In the case of a resale, the first seller is
required to treat amounts received by the related person as having been received personally. The
acceleration provision is applicable only if the resale takes place within two years after the initial sale
to the related party. p. I11-22.
I11-28 The imputed interest rules may reallocate the amount received from an installment sale
between selling price and interest if the stated interest rate is below the applicable federal rate. The
result is to increase the amount of interest (versus principal reported) in early years under an
installment sale. All of the interest is taxable versus only a portion of the principal. As a result the
amount of income reported in the early years is greater. Less income is reported in later years. Also,
the imputed interest rules may convert a favorably taxed capital gain into interest which is taxed at
ordinary rates. pp. I11-23 through I11-25.
I11-29 Taxpayers may elect to change to the LIFO inventory method without IRS approval. p.
I11-27.
I11-30 a.
The IRS can require a taxpayer to change accounting methods if the method that has
been used does not clearly reflect income. If the accounting method used by a taxpayer clearly
reflects income, the IRS cannot require a change to another method that would also clearly reflect
income.
b.
In the case of involuntary changes, there are three alternative methods of reporting the
amount of the change. If the change is one that results in a reduction in reported taxable income or
an increase in taxable income of $3,000 or less, the entire amount is reported in the year of the
change. Larger increases in income can be reported under the three year method under which the
amount is divided by three and the result is added to the taxable income of three years that include
the year of the change and the two previous years. Alternatively, such changes can be made by
reconstructing income for all years using the newly adopted accounting method. p. I11-28.
I11-5
I11-31 The purpose of both is to spread the amount of the change of several years in order to reduce
the tax rates that might apply. The three year rule is generally simpler. p. I11-29.
I11-32 Although the answer is not clear, it would seem to be no. Book and tax accounting methods
must be the same, but the term "books" seems to include a supplemental reconciliation of income.
Hence, if the two methods are reconciled, a taxpayer is presumably complying with the requirement.
p. I11-32.
Issue Identification Questions
I11-33 There are two obvious questions. One question is how she should value the automobiles she
receives as trades. The second question is how Judy should value the automobiles that she has had
on hand for two years or longer. Reg. Sec. 1.471-2(c) states that second-hand goods taken in
exchange, should be valued at bona fide selling pricing less direct cost of disposition. This suggests
that Judy should estimate how much she expects to receive when she sells a trade, and subtract from
that amount the estimated costs of disposition (e.g., commissions to salesperson).
Reg. Sec. 1.471-2(c) also applies to the vehicles that have been on hand for two years or
longer. That is, they may not be valued at less than a bona fide selling price less the direct cost of
disposition. The regulation further specifies that a bona fide selling price means an actual offering of
goods during a period ending not later than 30 days after the inventory date. As selling prices are
negotiated by Judy and individual customers, she must somehow demonstrate that she has reduced
the price of individual vehicles. The regulation states that she should maintain records of
dispositions of goods so as to enable verification of the inventory valuation. pp. I11-12 and I11-13.
I11-34 The principal issue is whether surveying constitutes a new and separate trade or business, or
alternatively, is an extension of the existing trade or business. If it is judged to be a new trade or
business, Lana has the opportunity to elect different accounting methods than she currently uses for
the appraisal activity.
Other issues discussed elsewhere in the text may center on whether the passive activity loss
rules apply. If there are two activities, she must materially participate in both in order to be able to
deduct a loss from a passive activity against the active income of the other. She will need to obtain
another employer identification number if the two activities are judged to be separate businesses.
Also, her coverage by a retirement plan might be affected as such participation is centered on lines of
business. p. I11-8.
I11-35 Accepting the second offer will result in an transaction where the installment sales rules
apply. Thus, an obvious question is how do they apply when the amount John will receive is
unknown? It is necessary to decide how to value the future payments. Also, as no interest is stated,
the imputed interest rules must be considered. p. I11-18.
I11-36 Because winter is the slow season, it is unlikely that Lee will be able to meet the 25% test
normally used by the IRS in deciding whether the business is sufficiently seasonal to warrant a fiscal
year. That is, it is unlikely that 25% of Lee's income is generated in January and February. Lee
I11-6
could request a fiscal year ending on September 20, October 31, or November 30. Such a year-end
would result in required payments equal to 40.6% of the deferred income.
As Lee is likely to be in a lower tax bracket, such payments will probably be viewed as too
burdensome. Even if the corporation obtains a fiscal year Lee's personal taxable period will still be
the calendar year. Therefore, Lee's individual return will still be due April 15. pp. I11-3 and I11-4.
Problems
I11-37 a.
Not acceptable. Year would have to end on the last day of the month (January 31 or
December 31).
b.
Acceptable.
c.
Acceptable.
d.
Not acceptable, based on the least aggregate deferral of income to the partners, a
March 31 year-end would be required. Note to Instructor: The calculation is as follows:
Year-End
A (3/31)
3/31
4/30
6/30
-03.67
3.00
B (4/30)
.33
-03.33
C (6/30)
1.00
.67
-0-
Least Aggregate
Deferral
1.33
4.34
6.33
Since the March 31 year-end results in the least aggregate deferral, that year-end must be
used.
e.
Acceptable. pp. I11-2 through I11-4.
I11-38 Approval is not required in any of the situations. Iowa Corporation is required to change its
accounting period to conform with its parent if a consolidated return is filed. pp. I11-3 and I11-4.
I11-39 Only situation (c) involves a change in accounting year. Hence, annualization is required
only for situation (c). Annualization is required even though the change itself does not require IRS
approval. p. I11-5.
I11-40 1.
Modified taxable income
Practice income
Interest
Itemized deductions
Exemptions (7/12 x $2,700)
Modified taxable income
$40,000
3,000
( 6,435)
( 1,575)
$35,000
2.
Annualized taxable income 12/7 x $35,000
$60,000
3.
Tax on annualized income
$13,504
I11-7
4.
Current tax (7/12 x $13,504)
$ 7,877
pp. I11-4 and I11-5.
I11-41 Items (b) and (d) are not deductible. Prepaid interest is not deductible. A note does not
constitute payment. Payment by credit card and payment with borrowed funds constitute cash
payment. Further, a check mailed (and postmarked) before year end constitutes payment. pp. I11-8
and I11-9.
I11-42 a.
Only warranty work actually performed in 1998 is deductible. Hence, Camp can
deduct $74,000.
b.
As all work has been completed, $20,000 is deductible.
c.
As the $5,000 is refundable, no amount is deductible.
d.
The $18,000 of rent is deductible. The security deposit of $1,000 is not deductible.
pp. I11-9 and I11-10.
I11-43 a, c, e, f, g, and h must be included. p. I11-12.
I11-44 1999 inventory:
1999 inventory at 1998 prices:
130% x $134,000 = $130,000
134%
Base inventory (1998)
Plus: 1999 layer
134% x ($130,000 - $110,000)
130%
1999 ending inventory
$110,000
20,615
$130,615
2000 inventory:
2000 inventory at 1998 price:
130% x $125,000 = $116,071
140%
Base inventory (1998)
Plus: 1999 layer
134% x ($116,071 - $110,000)
130%
2000 ending inventory
$110,000
6,258
$116,258
As there was a reduction in inventory from 1999 to 2000, there is no 2000 layer. Further, the 1998
layer has been reduced. pp. I11-13 and I11-14.
I11-8
I11-45 The entire amount of $80,000 is taxable in 1998 as the amount is all ordinary income. Only
the interest is taxable in subsequent years. pp. I11-18 and I11-19.
I11-46 Gross profit:
Selling price
Minus: Adjusted basis
Selling expenses
Gross profit
$180,000
( 87,000)
( 12,000)
$ 81,000
Contract price:
Greater of the gross profit of $81,000 or the selling price ($180,000) reduced by the
mortgage ($100,000). Since $81,000 is greater, that amount is used.
Gross profit percentage:
$81,000 = 100%
$81,000
Gain reported in 1998:
Amount received
Mortgage in excess of basis and
selling expenses ($100,000 [$87,000 + $12,000])
Total
Times: Gross profit percent
Gain in year of sale
Gain reported in 1999
$ 20,000
( 1,000)
$ 21,000
x 100%
$ 21,000
$ 20,000
pp. I11-18 through I11-20.
I11-47 Since the installment sales method is not available to dealers, Bear must report all of the 1998
gross profit of $144,000 (0.32 x $450,000). The profit on 1996 and 1997 sales was previously
reported. p. I11-18.
I11-48 a.
b.
Gross profit
($20,000 - $14,000)
Gross profit percentage
($6,000/ $20,000)
Gain recognized in 1998
(0.30 x $5,000)
Selling price
Basis [$15,000 - (0.30 x $15,000)]
Gain
I11-9
$ 6,000
30%
$ 1,500
$13,800
(10,500)
$ 3,300
pp. I11-20 and I11-21.
I11-49 a.
$10,000
$50,000
x ($50,000 - $36,000) = $2,800
b.
$49,000 - $1,000 - [$40,000 - ($40,000 x 0.28)] = $19,200
c.
$49,000
d.
The gain is the lesser of: (0.28 x $40,000) - $1,000 = $10,200 or $10,000 - $2,800 =
e.
$40,000 - (0.28 x $40,000) + $7,200 + $1,000 = $37,000
$7,200
pp. I11-21 and I11-22.
I11-50 a.
Joe reports a loss of $11,000 ($32,000 - $3,000 - $40,000).
b.
The same as in part (a), a loss of $11,000.
c.
Joe reports a loss of $15,000 ($28,000 - $3,000 - $40,000).
d.
In parts (a) and (b) there would be no impact as Joe has deducted a loss of $11,000 at
the time of the sale. In part (c), Joe would report an ordinary gain of $4,000. pp. I11-22 and I11-23.
I11-51 a.
$32,288 [$200,000 - ($200,000 x 0.83856)].
b.
2000. As the stated sales price is less than $250,000, no accrual of interest is
required.
c.
$37,712 ($200,000 - $32,288 - $130,000).
d.
2000. Assuming Amy does not elect out of the installment sales method, the gain is
reported in the year the sales price is collected.
e.
$167,712 ($200,000 - $32,288). pp. I11-23 through I11-25.
I11-52 a.
The amount of the adjustment is $2,800 ($6,000 + $12,000 - $15,200). The 1998
receivables had not been included in income in prior years, so this must be added to income. The
cost of the 1998 inventory had been ignored in 1998 which means the cost was deducted when it
should not have been. The 1998 payables had not been deducted in 1998 although they would have
been deductible under accrual accounting.
b.
As the amount of this adjustment is less than $3,000, the amount must be added to
1999 income. pp. I11-28 and I11-29.
I11-53 a.
b.
The addition to the deposit is $21,800 ($400,000 x 40.6% x 9/12 - $100,000).
The payment must be made by April 15, 2000.
I11-10
c.
No. The amount cannot be subtracted from the partner's personal tax liability. The
amount of the deposit is adjusted up or down each year to reflect changes in the partnership's income.
In the event of a decline in the partnership's income a portion of the deposit will be refunded to the
partnership. pp. I11-6 and I11-7.
I11-54 a.
Because there is no stated interest, interest must be imputed into the installment due
one year after the sale.
Down payment
Installment
(.92456 x $300,000)
Total
$200,000
277,368
$477,368
b.
Lorenzo must report interest of $22,632 ($300,000 - $277,368) when the $300,000
payment is received.
c.
Selling price
Minus: Adjusted basis
Gain on sale
$477,368
(400,000)
$ 77,368
d.
Yes. However, a gross profit of $77,368 is reported. pp. I11-23 through I11-27.
I11-55 a.
For income tax purposes, it is not necessary to impute interest on this gift loan
because the amount of the loan is under the $100,000 threshold and John's net investment interest
income is under $1,000.
b.
Assuming an applicable federal rate of 8%, imputed interest equals $10,000 (.08 x
$125,000) per year.
c.
The interest appears to be qualified residential interest and as such is deductible.
d.
Jane is treated as having received the $10,000 as interest income for the year. Further,
she is treated as having made a gift to John of an equal amount. Unless there are other gifts,
however, the annual gift tax exclusion means there is no requirement that Jane file a gift tax return.
pp. I11-25 and I11-26.
I11-56 a.
King reports $360,000 of income during year one computed as follows:
Expected profit ($11,200,000 - $10,000,000)
Percentage complete ($3,000,000 / $10,000,000)
Income--year one
b.
$1,200,000
x
0.30
$ 360,000
The reported income for the second year is $480,000 computed as follows:
I11-11
Expected profit
Percentage complete ($8,000,000 / 10,000,000)
Income--year one and two
Minus: Previously reported income
Income--year two
c.
$1,200,000
x
0.80
$ 960,000
( 360,000)
$ 600,000
The reported loss for year three is $260,000 computed as follows:
Contract amount
Minus: Actual costs
Income from contract
Minus: Previously reported income
Current loss
$11,200,000
(10,500,000)
$ 700,000
( 960,000)
($ 260,000)
d.
King overestimated its income from the contract, and as a result, overpaid its tax.
Under the look-back interest rule, King is entitled to receive interest on the additional tax it paid
because it overreported income in years one and two. pp. I11-15 through I11-17.
Tax Form/Return Preparation Problem
I11-57 (See Instructor’s Guide)
Case Study Problems
I11-58 (See Instructor’s Guide)
I11-59 (See Instructor’s Guide)
I11-60 (See Instructor’s Guide)
Tax Research Problems
I11-61 (See Instructor’s Guide)
I11-62 (See Instructor’s Guide)
I11-63 (See Instructor’s Guide)
I11-12