6

The Accrual Method

§6.01 GENERALLY The accrual method is authorized as a permissible method of accounting in Section 446(c) of the Code. It was authorized by Congress “to enable taxpayers to keep their books and make their returns according to scientific accounting principles by charging against income earned during the taxable period, the expenses incurred in and properly attributable to the process of earning income during the period.”1 The IRS views the accrual method as the most accurate method of tax accounting. It is often used by the IRS to challenge a taxpayer's use of the cash method. The accrual method usually requires more record keeping than the cash method and is more complex than the cash method. Under the accrual method, income is recognized generally in the year in which

• All the events have occurred that fix the taxpayer's right to receive income;2 and • The amount of income can be determined with reasonable accuracy. This is sometimes referred to as the "all-events test." These events need not occur at the same time or in the same year. The determination of whether income is accruable is based on information available to the taxpayer at the end of the tax year.3 Expenses are deductible generally in the year in which • All events have occurred that establish the fact of liability; • The amount of the liability can be determined with reasonable accuracy;4 and • Economic performance has occurred.5 These general rules are subject to modification by a number of specific provisions of the Code, regulations and other pronouncements.

§6.02 INCOME RECOGNITION

§6.02(a) Fixed Right To Receive Income The seminal case that illustrates the operation of the accrual method of accounting with respect

1 U.S. v. Anderson, 292 U.S.422, at 440 (1926). 2 Reg.. §§1.446-(c)(1)(ii) and 1.451(a). This rule differs from the financial accounting rule which provides that income is recognized at the time of performance giving rise to income, e.g., when services are performed or goods shipped. 3 H.L.S. Excavating v. Commissioner, 44 T.C.M. (CCH). 4 U.S. v. Anderson P. Chauncey, 5AFTR5674 (U.S. 1926); Koehring v. U.S., 25 AFTR 70-634 (U.S. 1970). 5 Reg.. §§.1.446-1(c)(1)(ii) and 1.461-1(a)(2); Section 461(h).

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to income is Spring City Foundry Co. v. Commissioner,6 in which the Supreme Court stated

… keeping accounts and making returns on the accrual basis, as distinguished from the cash basis, import that it is the right to receive and not the actual receipt that determines the inclusion of the amount in gross income. When the right to receive an amount becomes fixed, the right accrues.7

In Spring City, the taxpayer kept its books on the accrual method. From March 1920 to September 1920, the taxpayer sold goods to a customer who became indebted to the taxpayer in the amount of $39,983.27, represented by an open account and unsecured notes. In the latter part of 1920, the customer found itself in financial straits. Efforts at settlement failed. The customer filed for bankruptcy and a receiver was appointed. In the spring of 1922, the receiver paid to the customer’s creditors, including the taxpayer, a dividend of 15 percent and, in 1923, a second and final dividend of 12&1/2 percent. The taxpayer argued before the Supreme Court that in 1920 the customer’s debt was worthless and, therefore, was not recognizable as gross income in that year. The Supreme Court disagreed, holding that the taxpayer’s right to the amount due was a fixed right in 1920 and, therefore, should have been included in the taxpayer’s gross income for that year. As a practical matter, the IRS will take the position that the right to receive income for an accrual method taxpayer becomes fixed at the earlier of: • The required performance, • The date payment becomes due, or • The date payment is made.8 In determining whether a right to receive income has become fixed, a number of factors should be considered, including • Any agreement of the parties, • The substance of the transaction, • The time when services are to be rendered or when property is to be delivered, • Whether contingencies or conditions exist, and • Whether a disputed or acknowledged liability exists. §6.02(b) Conditions Precedent A condition precedent is a condition that is precedent to the existence of a contract or to the inception of an immediate obligation to perform a contract previously made. Conditions precedent will often prevent the accrual of income.9 Conditions precedent preventing the accrual of income the following:

6 292 U.S. 182 (1934). 7 Id. at 184-85. 8Rev. Rul. 74-607, 1974-2 C.B. 149. See also, Johnson v. Commissioner, aff’d in part, rev’d in part, 184 F.3d 786 (8th Cir. 1999) 9 Ballentine’s Law Dictionary (1969).

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• Goods sold on approval,10

• Goods rejected under the UCC or goods sold on a C.O.D. basis,11 and • Disputes that remain unresolved. Likewise, where a taxpayer's right to income is conditioned on the approval of a third party and that approval is not yet obtained, the income will not be considered to have accrued.12 On the other hand, some conditions precedent will not prevent the accrual of income. For example, the need to perform a mathematical calculation will not prevent accrual.13 Similarly, in Charles Schwab Corp. v. Commissioner, 14 the Supreme Court held that a brokerage house must accrue commission income on the securities trade date and not the settlement date. The Court said executing a customer’s order on trade date was a condition precedent that fixed the taxpayer’s right to receive a commission. The fact that there had to be ministerial functions performed between trade and settlement dates was not sufficient to prevent the accrual of income. The fact that an executed trade could be canceled before settlement did not make the taxpayer’s right to the commission indefinite or contingent. §6.02(c) Conditions Subsequent A condition subsequent is a condition in a contract which fulfills liability upon the contract and operates to defeat or annul the liability upon subsequent failure of the other party to comply with its terms.15 Unlike a condition precedent, a condition subsequent does not prevent a taxpayer from accruing income.16 Conditions subsequent occur where • The taxpayer is required to return any amount that has been received, or • The taxpayer loses the right to receive income.17 Restrictions placed on a fund after a transaction has taken place constitute a condition subsequent, which does not affect the rights of a taxpayer at the point of sale. Income will accrue regardless.18 §6.02(d) Passage Of Title And Business Practice The passage of title to goods and the business practice of the taxpayer play an important role 10 Ringmaster, Inc. v. Commissioner, 21 T.C.M. (CCH) 1024 (1962), where income did not accrue since the buyer had not committed to purchase goods until he approved them as meeting specifications. 11 Rev. Rul. 70-68, 1970-1 C.B. 122. 12 United States v. Safety Car Heating and Lighting Co., 297 U.S. 88 (1936); Mutual Tel. Co. v. U.S., 204 F.2d 160 (9th Cir. 1953). 13 Resale Mobile Homes, Inc. v. Commissioner, 965 F.2d 818 cert. denied, 506 U.S. 874(1992). See also, Perry Funeral Home, Inc. v. Commissioner, 86 T.C.M. (CCH) 713 (2003), where the taxpayer, Perry entered into preneed funeral contracts and received payments in advance of death for goods and services to be provided later at the contract beneficiary's death. These payments were refundable at the contract purchaser's request, pursuant to State law, at any time until the goods and services were furnished. Perry, an accrual basis taxpayer, included these payments in income not in the year of receipt but in the year in which the goods and services were provided. 14 107 T.C. 282(1996), aff’d, 161 F.3d 1231 (9th cir. 1998), cert denied, 528 U.S. 822 (1999). 15 Ballentine’s Law Dictionary (1969). 16 J.J. Little & Ives Co. v. Commissioner, 25 T.C.M. (CCH)372 (1966); Ballentine’s Law Dictionary (1969). 17 See, e.g., Western Oaks Building Corp.v. Commissioner, 49 T.C. 365 (1968). 18 See, e.g., Western Oaks Building Corp., 49 T.C. 365 (1968).

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in determining when an item of income should accrue. Reg. §1.446-1(c)(1)(ii)(C) provides, in part:

No method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. The method used by the taxpayer in determining when income is to be accounted for will generally be acceptable if it accords with generally accepted accounting principles, is consistently used by the taxpayer from year to year, and is consistent with the Income Tax Regulations. For example, a taxpayer engaged in a manufacturing business may account for sales of the taxpayer's product when the goods are shipped, when the product is delivered or accepted, or when title to the goods passes to the customers[italics added], whether or not billed, depending on the method regularly employed in keeping the taxpayer's books.

While no single factor is controlling, the passage of title is the most significant factor to be considered in determining whether income has accrued to the taxpayer.19 §6.02(e) Amount Realized The amount realized by a cash basis taxpayer is significantly different from the amount realized by an accrual method taxpayer. When a cash basis taxpayer receives a promissory note, for example, the cash basis taxpayer either reports the fair market value of the instrument under Section 1001(c) of the Code, or nothing at all (if the cash equivalency doctrine is applicable and its application dictates that income should not be recognized). In contrast, the fair market value of a note received by an accrual method taxpayer from a solvent maker is irrelevant in determining the amount realized under the accrual method. The IRS has held that when an accrual method taxpayer receives a long-term obligation for property he must realize the face amount of the obligation, plus any money received.20 §6.02(f) Doubts About Collectability An accrual method taxpayer does not accrue income on an item where there is a reasonable doubt as to its collectability.21 The doubt may be established because of financial condition, insolvency, or other circumstances affecting the obligation. This exception appears to be inconsistent with the Spring City Foundry decision, but it is infrequently applied.22

19 See, e.g., Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26 (1988). Also, in Pacific Grape Products Co. v. Commissioner 219 F.2d 862 (9th Cir. 1955), rev’g 17 T.C. 1097 (1952), the Court held a fruit canner may accrue income on undelivered orders received and deduct estimated costs where income from the annual pack could be accurately ascertained and the practice had been used by the industry for years. 20 Rev. Rul. 79-292,1979-2 C.B. 287. 21 See, Clifton Mfg. Co. v. Commissioner, 137 F.2d 290 (4th Cir. 1943) and Commercial Solvents Corp. v. Commissioner, 42 T.C. 455 (1964), acq. 1965-1 C.B. 4. In Corn Exchange Bank v. U.S., 37 F.2d 34 (2d Cir. 1930), the Court said "[a] taxpayer, even though keeping his books upon an accrual basis, should not be required to pay a tax on accrued income unless it is good and collectible, and where it is of doubtful collectibility or it is reasonably certain it will not be collected, it would be an injustice to the taxpayer to insist on taxation." See also Jones Lumber Co. v. Commissioner, 404 F.2d 764 (6th Cir. 1969). 22 But see, Procacci v. Commissioner, 94 T.C. 397, 416, n10 (1990), where the Court stated: The "reasonable expectancy" doctrine relates to the accrual method of accounting, under which a taxpayer includes an income item in gross income when all the events have occurred which fix the right to receive the income and its amount can be determined with reasonable accuracy. However, if it is reasonably certain that the income will not be collected in the tax year or within a reasonable time thereafter, the taxpayer is justified in not accruing the item. It is important to note that the implication of this statement is that an amount may not have to be accrued where the

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§6.02(g) Nonaccrual-Experience Method For Services Receivable Congress, in recognizing the hardship to an accrual method taxpayer in receipt of an arguably uncollectible item, enacted Code Section 448(d)(5). This section provides that an accrual method taxpayer is not required to accrue that portion of amounts due for services rendered which the taxpayer deems unlikely to be collected from its past experience.23

The application of the non-accrual experience method involves several steps.

(1) A ratio of bad debts (net of recoveries) to gross receivables is computed for the six-year period ending with the current year (or for the period of the taxpayer and/or predecessor’s existence, if shorter). A taxpayer may petition the IRS to utilize a shorter computation period where the make-up of its receivables has changed dramatically.

(2) If the taxpayer elects to apply the non-accrual experience method utilizing a separate

receivable system, the taxpayer applies the calculated bad debt percentage to each receivable outstanding at year end and that portion is neither recognized as income nor added to basis. Any difference between the basis of the receivable and the amount ultimately collected is recognized as income or as a bad debt in the year of collection.

(3) If the taxpayer elects to apply the non-accrual experience method utilizing a periodic

system, the taxpayer maintains a reserve balance equal to the calculated bad debt percentage multiplied by the outstanding year-end receivable balance. Bad debts and recoveries are charged or credited to the reserve.

For taxable years ending after March 9, 2002, the non-accrual experience method applies only to amounts received for “qualified services” or by certain “small businesses.” “Qualified services” are services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. Other service businesses may use the non-accrual experience method only if the average annual gross receipts of the business do not exceed $5 million. For example, if a lawyer’s experience indicates that only $96,000 out of every $100,000 of his invoices receivable are collected, the lawyer will accrue only $96 of income when he sends out a bill for $100. If the full $100 is paid, however, the lawyer must include the additional $4 when received. A plumbing repair business using the accrual method, on the other hand, could use the non-accrual experience method only if its annual average gross receipts did not exceed $5 million.24

§6.03 PREPAID INCOME §6.03(a) Generally Prepaid income issues arise in connection with

collection of the item is anticipated and the time of collection only will be delayed. 23 The use of the reserve method for bad debts was generally repealed effective for post-1986 tax years. The non-accrual experience method, however, is not available to accounts on which interest is charged or to activities involving the lending of money, the sale of goods, or the acquisition of receivables from other persons, regardless of whether other persons earned the receivables through the rendering of services themselves. Section 448(d)(5). 24 One has to wonder how many taxpayers will use this exception since they are more likely than not use the cash method of accounting.

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