CHANGING ACCOUNTING METHODS

In some cases, businesses find it desirable to
change from one accounting method to another.
Changing accounting methods requires formal approval
of the IRS, but new guidelines adopted in 1997
make the procedure much easier for businesses. A
company wanting to make a change must file Form
3115 in duplicate and pay a fee. A copy should be
attached to the taxpayer’s income tax return and the
other copy must be sent to the IRS Commissioners.
Any company that is not currently under examination
by the IRS is permitted to file for approval to
make a change.
Applications can be made at any time
during the tax year, but the IRS recommends filing as
early as possible. Taxpayers are granted automatic
six-month extensions provided they file income taxes
on time for the year in which the change is requested.
The amended tax returns using the new accounting
method must also be filed within the six-month extension
period. In considering whether to approve a request
for a change in accounting methods, the IRS
looks at whether the new method will accurately reflect
income and whether it will create or shift profits
and losses between businesses.
Changes in accounting methods generally result
in adjustments to taxable income, either positive or
negative. For example, say a business wants to change
from the cash basis to the accrual basis. It has accounts
receivable (income earned but not yet received,
so not recognized under the cash basis) of $15,000,
and accounts payable (expenses incurred but not paid,
so not recognized under the cash basis) of $20,000.
Thus the change in accounting method would require
a negative adjustment to income of $5,000. It is important
to note that changing accounting methods
does not permanently change the business’s long-term
taxable income, but only changes the way that income
is recognized over time.
If the total amount of the change is less than
$25,000, the business can elect to make the entire
adjustment during the year of change. Otherwise, the
IRS permits the adjustment to be spread out over four
tax years. Obviously, most businesses would find it
preferable for tax purposes to make a negative adjustment
in the current year and spread a positive adjustment
over subsequent years. If the accounting change
is required by the IRS because the method originally
chosen did not clearly reflect income, however, the
business must make the resulting adjustment during
the current tax year. This provides businesses with an
incentive to change accounting methods on their own
if they realize that there is a problem.
FURTHER READING:
The Entrepreneur Magazine Small Business Advisor. New
York: Wiley, 1995.