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6.2 Changes in US tax return methods of accounting
Publication date: 31 Dec 2022
us Income taxes guide
The two most important characteristics of a tax method of accounting (hereinafter "accounting method") are (1) timing and (2) consistency. In order to affect timing, the treatment must impact the year in which an income or expense item is to be reported. If the treatment of the item affects the total amount of income or expense recognized by the taxpayer over the item’s life, then an accounting method is not involved and generally IRS approval is not needed to change it.
In general, to establish an accounting method, the method must be consistently applied. This consistency requirement varies depending upon whether an accounting method is proper or improper (i.e., impermissible):
- The use of a proper accounting method in a single US federal income tax return constitutes consistency and, therefore, results in the adoption of an accounting method.
- An improper accounting method is adopted after it has been used consistently in two or more consecutive returns.
Once an accounting method has been adopted for tax purposes, any change must be requested by the taxpayer and approved by the IRS. Changes in accounting methods generally cannot be made by amending returns. Rather, there are two procedures for requesting a voluntary change from the IRS: (1) automatic and (2) non-automatic. In the case of an automatic change, IRS consent is deemed to have been received once all the requirements of the IRS guidance are met. With a non-automatic change, IRS consent is received only upon written consent from the IRS. In either case, the request for change is generally filed on federal Form 3115.
6.2.1 Transition to new tax return accounting method
In general, the tax law provides two approaches for a transition from an old accounting method to a new accounting method: the cut-off approach and the cumulative catch-up approach.
The "cut-off" approach results in a prospective change beginning with the year of change. Transactions arising during or subsequent to the year of change are reported utilizing the new accounting method. Transactions arising prior to the year of change continue to be accounted for using the old accounting method.
The "cumulative catch-up" approach, as the name implies, results in a catch-up adjustment, referred to as an Internal Revenue Code §481(a) adjustment. Under this approach, a taxpayer must compute a §481(a) adjustment as of the first day of the year of change as if the new method of accounting had been used previously. In general, a negative §481(a) adjustment (i.e., reduction of taxable income) is taken into income entirely in the year of change while the tax law permits a positive adjustment (i.e., increase to taxable income) to be spread over four years, beginning with the year of change. In certain circumstances, the four-year period may be shortened, and therefore, the applicable procedures governing tax accounting method changes should be carefully considered in relation to the taxpayer’s specific facts and circumstances.
ASC 740-10-55-59 through ASC 740-10-55-61 address the temporary differences created when a taxpayer changes its accounting method. Accounting method changes that result in a positive adjustment (i.e., an increase in taxable income) and do not conform to the book treatment for the related item initially will result in two temporary differences. The first temporary difference is the basis difference between book and tax basis of the asset or liability, like any other temporary difference. The second temporary difference relates to the deferred income, for tax purposes, from the §481(a) adjustment.
Accounting method changes that result in a negative adjustment (i.e., a reduction of taxable income) and do not conform to the book treatment for the related item will generally result in only one temporary difference: the basis difference between book and tax, like any other temporary difference.
6.2.2 Timing of recognizing changes in tax return accounting methods
When the effects of a change in accounting method are reflected in a reporting entity's financial statements depends on whether or not a company is changing from a proper or improper accounting method and whether or not the change qualifies as an automatic or non-automatic change.
6.2.2.1 Voluntary change from one proper accounting method to another
Changes from one proper accounting method to another can be either automatic or non-automatic.
IRS guidance specifies the accounting changes that qualify for automatic approval, assuming the taxpayer complies with all of the provisions of the automatic change request procedure. We believe that automatic changes should be reflected in the financial statements when management has concluded that the entity qualifies, and management has the intent and ability to request the change. An automatic change in accounting method is similar to other annual elections that are made by the taxpayer upon filing the tax return. Management should make its best estimate as to how it will treat such items when filing its tax return and account for the items in a consistent manner when preparing the financial statements.
Non-automatic changes require the affirmative consent of the IRS. The effects of a non-automatic change from one proper method to another should not be reflected in the financial statements until approval is granted because there is discretion on the part of the IRS to deny the application or alter its terms. Appropriate financial statement disclosure of anticipated or pending requests for method changes should be considered. Example TX 6-1 illustrates the accounting for a non-automatic proper to proper accounting method change.
EXAMPLE TX 6-1
Non-automatic proper to proper accounting method change that results in a positive §481(a) adjustment
Non-automatic proper to proper accounting method change that results in a positive §481(a) adjustment
Company XYZ, a calendar year taxpayer, has elected to change its accounting method of depreciating fixed assets for tax year 20X1. The change is from one proper accounting method to another and is a non-automatic method change as prescribed by the IRS. In the second quarter of 20X2, Company XYZ received approval of the method change from the IRS. A positive §481(a) adjustment of $2 million (increase to taxable income) is calculated as of 1/1/20X1. The applicable statutory tax rate is 25%. The following book and tax bases in the fixed assets exist as of 1/1/20X1:
Existing Method |
New Method |
|
Book basis of fixed assets
|
$9,000,000
|
$9,000,000
|
Tax basis of fixed assets
|
4,000,000
|
6,000,000
|
Taxable temporary difference
|
$5,000,000
|
$3,000,000
|
What is the accounting treatment?
Analysis
In its 20X1 financial statements, Company XYZ would not reflect the impact of the accounting method change, as approval has not been received from the taxing authority. To the extent the potential impact of the method change is significant to the financial statements, disclosure may be warranted.
When IRS approval is received in the second quarter of 20X2, Company XYZ would reflect the impact of the accounting method change in its financial statements. The Company would record the deferred tax liability for the positive §481(a) adjustment as a result of the increased tax basis of fixed assets. Additionally, the Company would record the impact of adjusting the taxable temporary differences as of 1/1/20X1. In this case, the positive §481(a) adjustment will be recognized in taxable income over the customary four-year period.
Company XYZ will also need to consider the impact of the 20X1 current and deferred activity discretely in its 20X2 interim tax provision calculation. Company XYZ would unwind the remaining deferred tax liability related to the §481(a) adjustment over the remainder of 20X2, and the following two years.
6.2.2.2 Voluntary change from an improper accounting method
A taxpayer may determine that it is using an improper accounting method for tax return purposes. As a result, it will need to consider whether the historical financial statements included an error and the effects of an uncertain tax position, including potential interest and penalties. Refer to TX 6.3 for a more detailed discussion on discerning a financial statement error from a change in estimate.
A company may look to change voluntarily to a proper accounting method by filing a Form 3115 with the IRS. When a taxpayer files for a change from an improper to a proper accounting method, the taxpayer generally receives “audit protection” for prior years, which means that the IRS cannot require the taxpayer to change its method of accounting for the same item for a taxable year prior to the year of change and therefore the taxpayer will generally not be subject to interest and penalties. We believe that the tax effects of making a voluntary change from an improper method to a proper method (e.g., release of uncertain tax position, interest etc.) should generally be recorded in the financial statements when the Form 3115 has been filed with the IRS to the extent that an analysis of the law confirms that the company has audit protection.
Upon changing to a proper accounting method with a positive §481(a) adjustment, any liability for unrecognized tax benefits previously recorded should be reclassified to a deferred tax liability, which now represents the deferred tax consequences of the §481(a) adjustment.
6.2.3 Changes in accounting methods as a result of tax law change
In the event that a change in accounting method is tied to a change in tax law, the tax effects of the change would be reported as a change in tax law in continuing operations in the period in which the change in tax law is enacted (pursuant to ASC 740-10-45-15) unless IRS permission is required to change the accounting method. If IRS permission is required, the tax effects of the change would be reported in the period in which IRS permission is granted.
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