Rule of 78's no longer acceptable.

• Author: LaBelle, Brett E.
• Position: Interest computation method

Lenders have historically used the rule of 78's method of computing interest income on certain loans. This method calculates interest income by multiplying the total interest payable over the life of the debt by a fraction, the numerator of which is the number of periods remaining on such debt at the time the calculation is made and the denominator of which is the sum of the periods' digits for the term of the debt. The rule of 78's method generally front loads interest, in comparison to the constant-yield method provided for m Regs. Sec. 1.1272-1(c). Under the constant-yield method, interest is accrued by applying an effective rate of interest to the unpaid balance of a loan for a given period. No matter which method is employed, however, the total interest payments over the term of the loan are identical, assuming the loan is not prepaid before the scheduled maturity date.

Rev. Proc. 84-27 provided that the rule of 78's method for computing interest income was generally prohibited from being considered an acceptable accounting method; however, it also provided an exception for certain consumer loam. The IRS indicated that, as a matter of "administrative convenience" it would allow the rule of 78's for certain short-term consumer loans only when there was a self-amortizing loan that required level payments (at regular intervals at least annually) over a period not in excess of five years (with no balloon payment at the end of the loan term) and when the loan agreement between the borrower and the lender provided that interest was earned (or when the prepayment of the loan interest was treated as earned) in accordance with the rule of 78's method.

Recently, the Service issued Rev. Proc. 98-60, which provides automatic consent procedures available to taxpayers to change their methods of accounting for specific items. Rev. Proc. 98-60 prohibits use of the rule of 78's as an acceptable method of accounting for loans issued on or after the first day of the first tax year beginning after 1998. This procedure applies to taxpayers that will change their method for the first or second tax year beginning after 1997.

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