Defining a method of accounting.

• Author: Gibbs, Paul K.

A taxpayer's accounting methods determine the time for reporting income and expenses. Classifying the treatment of an item of income or expense as a method of accounting can provide a taxpayer with certain benefits when changing the method. Sec. 446(e) generally requires a taxpayer to obtain the IRS's consent before changing a method of accounting. This consent requirement applies to (1) a change from one proper method of accounting to another, (2) a change from an improper method to a proper method, and (3) most changes from one elective status to another. Classification of the treatment as a method of accounting may:

* Allow a taxpayer changing to a more favorable method to reach back into closed tax years (i.e., years in which the deduction would otherwise be lost).

* Allow a taxpayer changing to a less favorable method to spread the increase in taxable income generally over four tax years. (Rev. Procs. 9727 and 2002-9 require some taxpayers to accelerate the recognition of a positive Sec. 481(a) adjustment.)

* Generally prevent the IRS from proposing an audit adjustment in an earlier tax year for the particular item of income or expense when the taxpayer has received permission to change such method of accounting (i.e., audit protection).There are, however, limited exceptions when a taxpayer does not receive audit protection (e.g., changes in the treatment of sale or lease transactions, changes in the method or amortization period for research and experimentation expenditures, and changes in the treatment of de minimis original issue discount).

Method of Accounting

The term "method of accounting" is not specifically defined in the Code or regulations. Regs. Sec. 1.446-1 (e)(2)(ii) (a) generally defines a method of accounting as any practice involving the treatment of the overall plan of accounting for items--such as the cash or accrual method--or the treatment of any specific material item of income or expense within such an overall plan. Thus, the term applies to a taxpayer's overall accounting method and accounting for specific items. Examples of overall methods of accounting are cash receipts and disbursements, accrual, hybrid, and combinations of overall methods with a method prescribed for an individual item. Examples of methods for individual items of income or expense include the accounting treatment for research and experimentation expenditures, depreciation, and installment sales (Regs. Sec. 1.446-1 (a)(1)). Special methods of accounting, or limitations on particular methods, are required in certain situations. Taxpayers that sell merchandise, for example, must use the accrual method for purchases and sales but may use the cash method for all other items of income and expense, provided income is otherwise clearly reflected.

An accounting method can be described as a regular practice for determining when to recognize items of income or expense in taxable income. The regulations, IRS rulings, and court...