1. The Accrual Method of Accounting

2. Georgia School-Book Depository

3. Source of payments for books

4. When was the money earned?

5. Was there a reasonable expectancy of payment?

6. Under the accrual method, revenue is recorded when products are sold, services are provided, or enterprise sources are used, not when payment is received.

7. Imagine a daughter running a business like the one in Georgia School Book Depository. Her father is an investor. At the end of the year there has been $40 in expenses. No revenue has been received. The state fund owes the business $60k.

8. If the father asks how did we do our first year, what is the most accurate response? A. We lost $40k. B. We lost $40k but next year will be better. C. We made $20K.

9. If I am an accrual basis taxpayer and perform services for you in year 1 and get paid in year 2, I have income in year 1.

10. It is the right to receive the income, not its actual receipt, that determines inclusion.

11. Accrual basis for tax accounting differs in some important ways from financial accounts, such as advanced receipts of prepaid income.

12. As the Supreme Court has written, these two systems of accounting have different objectives. Financial accounting needs to prevent management, shareholders, etc. from being misled. Tax accounting aims at equitable collection of revenue and protecting the public fisc. Unlike financial accounting, treasury does not aim at understatement of income if a matter is in doubt.

13. The accrual method does not call for income to be accrued when a contract is executed.

14. Events generating the obligor’s liability will not have occurred. The liability of a lessor or employer is contingent upon compliance with the obligations under the agreement. Events generating the obligor’s liability will not have yet occurred.

15. Interest accrues only over time, not when the note is signed.

16. Distinguish doubt about validity of a claim from doubt about its collectibility.

17. Doubt as to validity of the claim generally prevents accrual.

18. Doubts as to whether a claim will be collected generally does not prevent accrual.

19. There is a narrow exception for insolvency.

20. We do not include amounts in income if the claim is in doubt UNLESS WE HAVE THE CASH. That is, the claim of right doctrine applies to accrual basis taxpayers for tax accounting purposes, even tho a disputed claim would not be accrued for financial accounting purposes.

21. Accrual basis taxpayers generally include prepaid income in income when paid.

22. See the AAA case.

23. There are some statutory and regulatory exceptions to the rule requiring inclusion of prepaid income. Sec. 456 for membership organizations. Sec. 455 for prepaid subscription income. Rev. Proc. 71-21 for deferral into the next year

24. The accrual method seeks to match costs of producing revenue to the recognition of that revenue.

25. Reg. sec. 1.461-1(a)(2) gives the rule for deductions by accrual basis taxpayers: An expense is deductible for the taxable year in which all the events have occurred which determine the fact of liability and the amount thereof can be determined with reasonable accuracy.

26. Of course, there is debate about “all events” and “reasonable accuracy.”

27. In General Dynamics the Supreme Court held that the all events test requires the filing of a claim before an employer could deduct costs for a self-insured reimbursement medical plan.

28. NOTE: For both accrual and cash-basis taxpayers, if an expenditure creates an asset with a useful life beyond the close of the taxable year, the expenditure will not all be deducted in that year; it will be capitalized.

29. For deductions under the accrual method, section 461(h) adds a requirement of “economic performance” for deductibility.

30. Accrual of Income and Expenses Include amounts in income: When all events have occurred that fix the right to receive the income; and The amount of the income can be determined with reasonable accuracy. Deduct amounts as an expense when: All events have occurred that establish the fact of liability; and The amount of liability can be determined with reasonable accuracy; Economic performance requirement of section 461(h) has been satisfied.

31. Why did Congress add the economic performance requirement for deductions? Concern that taxpayers were deducting currently the full amount of payments to be made over a long period of time and not just the present value. That is, the concern was time value of money

32. Example: Worker’s compensation claim. Worker has suffered a long- term injury. Fact of liability is established. Worker will get $50k a year for life and life expectancy is known to be 20 years. Amount of liability can be determined with reasonable accuracy. Before sec. 461(h), employer would argue for deduction of $1,000,000 in year 1 Sec. 461(h) prevents this result.

33. Example: Reclamation costs Mining company has stripped land. Under state law, it must restore the land. Fact of liability is established. Assume that the cost of reclamation can be determined with reasonable accuracy. The reclamation will take many years. Before sec. 461(h), the mining company would argue for deduction of full costs in year 1. Sec. 461(h) prevents this result.

34. See handout on Sec. 461(h).

35. Section 461(h) also eliminates any uncertainty about how to treat more mundane deduction issues under the all events test.

36. Example: Fixed and determinate obligation to pay carpet cleaner for services to be provided next year. Can company deduct the amount of the obligation this year? Does company have to wait until service are provided next year, since obligation is contingent on receipt of services?

37. Example: Company signs lease with a fixed and determinate amount for use of property for next year. Can company deduct the amount of the obligation this year? Does company have to wait until space is provided next year, since obligation is contingent on use of space?

38. Section 461(h) makes it clear that no deduction can be taken until economic performance occurs.

39. Note: Even prior to section 461(h), other provisions, such as requirement of a clear reflection of income under sec. 446, might have postponed such deductions.