This document provides an overview of tax accounting methods and concepts. It discusses the cash method of accounting, which recognizes income when cash is received and expenses when paid. The document provides examples of constructive receipt, where a taxpayer has income even if not yet received in cash. It also briefly mentions the accrual method and hybrid accounting methods. The document appears to be an introductory chapter on tax accounting from a textbook.

1. Chapter 13
Tax Accounting
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2. Chapter 13 Exhibits
1. Computation of Taxable Income
2. Net Tax Liability
3. Accounting Periods
4. Election of the Tax Year
5. Partnerships
6. Partnership Accounting Period—Examples
7. Corporations, Estates, and Trusts
8. Change of Accounting Periods
9. IRS Permission or Consent
10. Exceptions to Permission Requirements
11. Short Tax Years
12. Short-Period Tax
13. Alternative Method
14. Short-Period Example
Chapter 13, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 88

3. Chapter 13 Exhibits
15. Accounting Methods
16. Cash Method
17. Constructive Receipt
18. Cash Basis Taxpayer Examples
19. Deductibility of Expenses
20. Limitations on Use of Cash Method
21. Accrual Method
22. Accrual Basis Taxpayer Examples
23. Prepaid Income and Expenses
24. Separate Sources of Income
25. Hybrid Methods
26. Change of Accounting Methods
27. Adjustment—Voluntary/Required Change
28. Change in Accounting Method Example
Chapter 13, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 88

4. Chapter 13 Exhibits
29. Inventories
30. Valuation of Inventory
31. Cost Methods
32. Uniform Capitalization Rules (UNICAP)
33. Cost Allocation Procedures
34. Simplified Retail Method
35. Inventory and UNICAP
36. Simplified Production Method
37. Lower-of-Cost-or-Market (LCM) Method
38. LCM Example
39. Valuation of Inventory Items
40. Inventory Valuation Example
41. Inventory Valuation Example—FIFO
42. Inventory Valuation Example—LIFO
Chapter 13, Exhibit Contents C CCH Federal Taxation Basic Principles 4 of 88

5. Chapter 13 Exhibits
43. Inventory Valuation Example—Weighted Average Cost
44. Dollar-Value LIFO Method
45. Double Extension Method
46. Dollar Value LIFO Example
47. Dollar Value LIFO Example—2009
48. Dollar Value LIFO Example—2010
49. Dollar Value LIFO Example—2011
50. Simplified Dollar-Value LIFO Method
51. Simplified Dollar-Value LIFO Example
52. Estimates of Inventory Shrinkage
53. Long-term Contracts
54. Capitalization of Expenses
55. Percentage-of-Completion Method
56. Modified Percentage-of-Completion Method
Chapter 13, Exhibit Contents D CCH Federal Taxation Basic Principles 5 of 88

6. Chapter 13 Exhibits
57. Completed Contract Methods
58. Long-term Contracts Example
59. Installment Sales
60. Computation of Gain
61. Installment Sale Example
62. Dispositions of Installment Obligations
63. Disposition of Installment Obligation—Example
64. Repossessions of Personal Property
65. Repossessions of Real Property
66. Personal Property Repossessions—Example
67. Real Property Repossessions—Example
68. Advantages and Disadvantages of Installment Method
Chapter 13, Exhibit Contents E CCH Federal Taxation Basic Principles 6 of 88

7. Computation of Taxable Income
Individuals S Corporations
Income Broadly Conceived Income Broadly Conceived
Less: Exclusions Less: Exclusions
Gross Income Gross Income
Less: Deductions for Adjusted Gross Income Less: Deductions
Adjusted Gross Income Ordinary Income
Less: Deductions from Adjusted Gross Income
Taxable Income
Estates and Trusts
Income Broadly Conceived
C Corporations Less: Exclusions
Income Broadly Conceived Gross Income
Less: Exclusions Less: Deductions
Gross Income Taxable Income
Less: Deductions
Routine
Special
Taxable Income
Chapter 13, Exhibit 1 CCH Federal Taxation Basic Principles 7 of 88

8. Net Tax Liability
Individuals, C Corporations, and Estates and Trusts
Gross Tax Liability
Less: Credits
Net Tax Liability
Less: Prepayments
Net Tax or Refund Due
Chapter 13, Exhibit 2a CCH Federal Taxation Basic Principles 8 of 88

9. Net Tax Liability
 Many of the income, deductions, and credit concepts
you have learned in first 12 chapters apply to all
entities
 However, there are numerous and substantial
differences
Chapter 13, Exhibit 2b CCH Federal Taxation Basic Principles 9 of 88

10. Accounting Periods
 Tax year - calendar year or fiscal year on the basis of
which taxable income is determined
 May not exceed 12 months
 Calendar year - ends on December 31
 Fiscal year - ends on last day of any month other than
December
 Taxpayer must correlate accounting, financial, and
business practices with the fiscal year used for tax
returns
 Tax return is required for a fractional part of a year
 Known as a short tax year
Chapter 13, Exhibit 3 CCH Federal Taxation Basic Principles 10 of 88

11. Election of the Tax Year
 New taxpayer may adopt any tax year without
obtaining prior approval of IRS in first year.
 First tax year must be adopted on or before time for
filing the initial return
 Taxpayers who do not have books must use the
calendar year
 Sole proprietors
 Must use same period for business tax reporting
purposes that they use for their personal books
Chapter 13, Exhibit 4 CCH Federal Taxation Basic Principles 11 of 88

12. Partnerships
 Must use same tax year as that of its partners who have a
majority interest
 If partners owning a majority interest have different tax years
 Partnership must adopt same tax year as that of its principal
partners
 Principal partner - a partner having ≥5 percent interest in
partnership profits or capital
 When neither condition is met
 Partnership must use a year that results in least aggregate
deferral of income to partners
 Partnership income is considered to be earned by partners on the
last day of partnership’s tax year
Chapter 13, Exhibit 5 CCH Federal Taxation Basic Principles 12 of 88

13. Partnership Accounting Period Examples
1. X and Y form XY Partnership. X owns 60% of XY,
so XY must use X’s tax year.
2. A, B and C form ABC Partnership. They are equal
owners. A and B are calendar taxpayers and C is a
5/31 year-end taxpayer. ABC must use the calendar
year.
Chapter 13, Exhibit 6a CCH Federal Taxation Basic Principles 13 of 88

14. Partnership Accounting Period Examples
M (40%), N (40%) and O (20%) form MNO Partnership. They have the following
tax year ends:
M: December 31
N: April 30
O: June 30
MNO must use a 12/31 year end based as follows:
Possible Tax Year Ends
4/30 6/30 12/31
Months Months Months
Partner Interest Partner Year End Deferred Total Deferred Total Deferred Total
M 40% 12/31 8 3.2 6 2.4 0 0.0
N 40% 4/30 0 0.0 10 4.0 4 1.6
O 20% 6/30 2 0.4 0 0.0 6 1.2
3.6 6.4 2.8
December 31 year end has the least aggregate deferral.
Chapter 13, Exhibit 6b CCH Federal Taxation Basic Principles 14 of 88

15. Corporations, Estates, and Trusts
 Newly organized C corporation may select any tax year
 May differ from that of the shareholders
 S corporation generally required to be a calendar year
 Estate may adopt any tax year
 Trusts must use calendar year
Chapter 13, Exhibit 7 CCH Federal Taxation Basic Principles 15 of 88

16. Change of Accounting Periods
 In general, prior approval must be obtained
 Usually obtained if there are substantial business
reasons for change
 Usually involves a short-period tax year
Chapter 13, Exhibit 8 CCH Federal Taxation Basic Principles 16 of 88

17. IRS Permission or Consent
 Taxpayer must file an application on Form 1128
 On or before the 15th day of third calendar month
following the end of short year
 Should show that there is a substantial business
purpose for change and that any tax cost to IRS is
insignificant
 To prevent substantial distortion of income, an
agreement between taxpayer and IRS is required
 If approval is granted, taxpayer must file an income tax
return for short period
Chapter 13, Exhibit 9 CCH Federal Taxation Basic Principles 17 of 88

18. Exceptions to Permission Requirements
 An individual whose income is derived solely from wages,
salaries, interest, dividends, capital gains, pensions and
annuities, or rents and royalties
 May change from the fiscal year to calendar year
 Newly married individual
 May adopt accounting period of other spouse without prior
approval
 All partnerships, S corporations, and personal service
corporations that conform their tax years to their owners’ tax
year
 Other corporations have more restrictions to their annual
accounting period without prior approval
Chapter 13, Exhibit 10 CCH Federal Taxation Basic Principles 18 of 88

19. Short Tax Years
 Separate return is filed for short period beginning with
day following the close of old tax year and ending with
day preceding first day of new tax year
 The procedures are as follows:
1. Annualize short-period income
2. Determine tax on the annualized income
3. Determine short-period tax
Chapter 13, Exhibit 11 CCH Federal Taxation Basic Principles 19 of 88

20. Short-Period Tax
 Determine annualized income (AI) for short-period
income (SPI):
AI = SPI x (12/# months in short period)
 Determine tax (T) on annualized income:
From rate schedules
 Determine short-period tax (SPT):
SPT = T x (# months in short period/12)
Chapter 13, Exhibit 12 CCH Federal Taxation Basic Principles 20 of 88

21. Alternative Method
 Annualization may result in inequities to taxpayer
 An exception to general rule may result in less tax:
 Determine taxable income for the 12-month period beginning on
the first day of the short period
 Determine the tax on the taxable income for this 12-month
period
 Alternative short-period tax ASPT) =
Tax on 12-month period × [ Taxable income for short
period/Taxable income for 12-month period]
 Short-period tax computed in Step 3 cannot be less than it would
have been if it had been computed on short-period taxable income
without placing it on an annualized basis
Chapter 13, Exhibit 13 CCH Federal Taxation Basic Principles 21 of 88

22. Short-Period Example
X Corporation uses a calendar year
In 2012 it changed its accounting period to one ending on 4/30
Taxable income for 1/1/12-12/31/12 is $50,000
Taxable income for 1/1 – 4/30 is $24,000
AI = $24,000 x (12/4) = $72,000
T = $13,500
SPT = $13,500 x (4/12) = $4,500
Does alternative apply? Yes, as follows.
1. TI = $50,000
2. Tax = $7,500
3. ASPT = $7,500 x ($24,000/$50,000) = $3,600
4. (Tax on SPTI not annualized = $3,600), so ASPT = $3,600
So X Corporation’s short-period tax = Lesser of $4,500 or $3,600 = $3,600
Chapter 13, Exhibit 14 CCH Federal Taxation Basic Principles 22 of 88

23. Accounting Methods
 Must clearly reflect income.
 Income should be reflected with as much accuracy as
standard methods of accounting practice permit
 If method does not clearly reflect income
 Tax computation is to be made under a method that IRS
agrees will clearly reflect income
 The two most commonly used overall methods:
(1) Cash method and
(2) Accrual method
 Special treatment is accorded various types of revenue (e.g.,
installment sales) and many types of expenses (e.g., bad debts)
Chapter 13, Exhibit 15 CCH Federal Taxation Basic Principles 23 of 88

24. Cash Method
 Vast majority of individuals and many businesses use it
 Income recognized in tax year when cash and/or cash
equivalents are actually or constructively received
 Expenses generally deductible in tax year paid unless
they are attributable to more than one year
 Cash equivalents may take many different forms
Chapter 13, Exhibit 16 CCH Federal Taxation Basic Principles 24 of 88

25. Constructive Receipt
 Income constructively received in tax year in which:
 It is credited to the taxpayer’s account,
 Set apart for the taxpayer, or
 Made available to the taxpayer to draw upon
 If the taxpayer’s control of its receipt is not subject to
substantial limitations or restrictions
 The payer must:
 Have ability to pay,
 Set aside funds for payments, and
 Not place substantial restrictions on taxpayer’s ability to access
funds (or property)
 If these conditions are met, then taxpayer cannot deliberately turn
back on income and thus select year of reporting
Chapter 13, Exhibit 17 CCH Federal Taxation Basic Principles 25 of 88

26. Cash Basis Taxpayer Examples
1. X received a $1,000 check on 12/28/2011 but did not
cash it until 1/2/2012. X has constructive receipt on
12/28/2011.
2. On 12/15/2012, Y completed a job for Z, Z gave Y a
$9,000 check. Y returned the check and asked Z to give
it to him on 1/3/2013. Y has constructive receipt on
12/15/2012.
3. A performs a service for B. B gives a 100 shares of stock
worth $6,000. A has income of $6,000 at time of receipt.
The stock’s FMV is a cash equivalent.
Chapter 13, Exhibit 18 CCH Federal Taxation Basic Principles 26 of 88

27. Deductibility of Expenses
 Does not coincide with the recognition of income
under cash method
 Expenses are recognized in year they are paid
 Some expenditures are recognized as an expense
over the asset’s life
 May be “paid” in cash or in property
 Not by note of the taxpayer even if secured by
collateral
Chapter 13, Exhibit 19 CCH Federal Taxation Basic Principles 27 of 88

28. Limitations on Use of Cash Method
 Three types of taxpayers cannot use cash method of accounting for tax purposes:
1. C corporations
2. Partnerships which have a C corporation as a partner
3. Tax shelters
 Small businesses can use cash method of accounting if have
 Average annual gross receipts of $5 million or less over the past three years
 The three-year period does not include current tax year in which
determination is being made
 Gross receipts:
 Deduct sales returns and allowances from gross receipts
 Exclude dividends, interest, gross rents, other income, and net gains and
losses from sales of capital and business assets
 Qualified personal service corporation may use the cash method of accounting
Chapter 13, Exhibit 20 CCH Federal Taxation Basic Principles 28 of 88

29. Accrual Method
 Income recognized in year:
 All events that determine right to receive income have occurred
 Amount can be determined with reasonable accuracy
 Expenses recognized in year:
 Legal obligation to make payments comes into existence
 All events that determine fact of the liability have occurred
 Amount can be determined with reasonable accuracy
 All events test not met until economic performance with respect to
item has occurred
 Economic performance occurs if liability arises because a
service or property is provided to taxpayer
 Taxpayer must keep adequate books
Chapter 13, Exhibit 21a CCH Federal Taxation Basic Principles 29 of 88

30. Accrual Method
 Income recognized when:
 Unconditional right to receive it
 Amount is determinable with reasonable accuracy
 Amount is collectible
 If taxpayer’s right to receive is dependent upon future events
 Postpone income recognition until those contingencies occur or
lapse
 If real doubt and uncertainty exist as to whether amount due will
ever be collected
 Postpone income recognition
Chapter 13, Exhibit 21b CCH Federal Taxation Basic Principles 30 of 88

31. Accrual Basis Taxpayer Examples
1. Joe performed accounting work for Jerry. The agreed upon price was
$20,000 and payment was due 30 days after completion. Joe finished
the work on 7/8/12. Joe recognizes $20,000 on 7/8/12.
2. Assume the same as #1 except Jerry contests the quality of the work
performed and has indicated that he will not pay any amount. Since the
amount is not determinable, Joe does not recognize income on 7/8/12.
Joe will recognize income when his claim against Jerry is reasonably
determinable.
3. Jen performs legal work for ABC Company. In return, she receives
rights to buy 10,000 shares of ABC Company if it goes public (currently
it is not in the process of making an initial public offering). Jen does not
recognize income when she receives the rights because the rights are
contingent on ABC Company going public and there is no indication
that this will happen.
Chapter 13, Exhibit 22a CCH Federal Taxation Basic Principles 31 of 88

32. Accrual Basis Taxpayer Examples
4. On 10/9/11, Ed signs a contract to perform legal services for Z Co. and
receives $30,000 payment. The contract requires that Ed be available for
30 hours of consulting over the next three years. Under the claim of right
doctrine, Ed must recognize $30,000 on 10/9/11.
5. Assume the same facts as #4 except the contract period ends on 10/9/12.
Ed may use his accrual method and recognize income as he performs the
services.
Chapter 13, Exhibit 22b CCH Federal Taxation Basic Principles 32 of 88

33. Prepaid Income and Expenses
 Generally taxable in year received
 Accrual-basis taxpayers may elect to recognize prepaid subscription income
over subscription period
 Applicable to all prepaid subscription income
 Membership organization that receives prepaid dues may elect to recognize
income over time period it has a liability to render these services unless
income relates to a liability that extends for more than 36 months
 Accrual-basis taxpayers can deduct interest only in period in which use of the
money occurs
 Accrual-basis taxpayers may include prepayment for services in gross
income in year of receipt
 If certain conditions are met, the income may be spread over year of
receipt and/or the following year (prepaid service income method)
 To qualify for prepaid service income method, taxpayer must perform all
services under an agreement by end of tax year following year of receipt
Chapter 13, Exhibit 23 CCH Federal Taxation Basic Principles 33 of 88

34. Separate Sources of Income
 Taxpayer with two or more separate and distinct
businesses
 Different accounting method may be used for each
business
 Must maintain separate books and records
 May not shift profits and losses between businesses
via inventory adjustments, sales, purchases, or
expenses
Chapter 13, Exhibit 24 CCH Federal Taxation Basic Principles 34 of 88

35. Hybrid Methods
 Many combinations of permissible accounting methods
may be used
 But a taxpayer’s choice is not unlimited
 If cash method is used for income, it must also be
used for expenses
 If accrual method is used for expenses, it must also
be used for income
 Accrual method is required if inventories are an
income-producing factor
Chapter 13, Exhibit 25 CCH Federal Taxation Basic Principles 35 of 88

36. Change of Accounting Methods
 IRS permission must be obtained
 Major changes in accounting method include:
1. Change to or from cash-basis method
2. Change in method of valuing inventory
3. Change from accrual method to a long-term contract method or vice
versa
4. Change involving the adoption, use, or discontinuance of any other
specialized method of computing income, such as the crop method by
farmers
5. Certain changes in computing depreciation or amortization
6. Change for which the Code or Regulations specifically require consent
 If taxpayer’s method does not clearly reflect income, then IRS may
prescribe a method which does
 Change in method does not include correction of mathematical and posting
errors, or of errors in the computation of tax liability
Chapter 13, Exhibit 26 CCH Federal Taxation Basic Principles 36 of 88

37. Adjustment – Voluntary/Required Change
 Adjustments must be made in year of change to prevent items
from being duplicated or entirely omitted
 Net adjustment = sum of positive and negative adjustments
 Adjustment period for taxpayer-initiated changes that result in a
positive adjustment is four years
 Tax year of change is first year
 If adjustment is less than $25,000, may elect a one-year
adjustment period
 Adjustment period is one year for negative adjustments
 A positive adjustment due to a change initiated by IRS generally
is recognized over the four-year period as noted above
 However, IRS can require that it be recognized over a shorter
time period
Chapter 13, Exhibit 27 CCH Federal Taxation Basic Principles 37 of 88

38. Change in Accounting Method Example
Kim Co. is a cash basis, calendar year taxpayer. It changed to the accrual method in 2012 and
determined its net income as follows:
Sales $800,000
Cost of goods sold 500,000
Gross profit 300,000
Expenses 100,000
Net Income $200,000
On 12/31/2011, it had $30,000 in inventory, accounts receivable of $23,000 and $29,000 in accounts
payable.
Kim Co.s net adjustment to Net income is $24,000, based as follows:
Positive adjustment for ending inventory $30,000
Positive adjustment for ending accounts receivable 23,000
Negative adjustment for ending accounts payable (29,000)
Net adjustment $24,000
Thus, it can add $6,000 ($24,000/4) to income in 2012, 2013, 2014, and 2015 or add $24,000 to the
$200,000 in 2012.
Chapter 13, Exhibit 28 CCH Federal Taxation Basic Principles 38 of 88

39. Inventories
 Must use the accrual method of accounting if inventories
are an income-producing factor
 Cost of goods sold:
 Recognized when inventory sold
 Equals:
Opening inventory
+ Inventory purchased or produced
- Ending inventory
 Value of ending inventory a function of:
 (1) What costs are included
 (2) Cost flow assumptions made
Chapter 13, Exhibit 29 CCH Federal Taxation Basic Principles 39 of 88

40. Valuation of Inventory
 Two fundamental requirements for valuation of
inventory:
1. must conform as nearly as possible to best
accounting practice in the trade or business
2. must clearly reflect income
 Inventory may be valued at cost or lower-of-cost-or-
market
 If LIFO method used, then the taxpayer cannot use
lower-of-cost-or-market
 Lower-of-cost-or-market must be applied to each item
in inventory
Chapter 13, Exhibit 30 CCH Federal Taxation Basic Principles 40 of 88

41. Cost Methods
 Cost of merchandise purchased equals:
Invoice prices
- Trade discounts
+ Incidental costs incurred to acquire the goods
 Cost of merchandise produced includes the cost of direct
materials, direct labor, and indirect costs
 Manufacturers must use absorption costing (full costing) to
value inventories
 Indirect costs that must be capitalized include repairs,
maintenance, utilities, rent, and indirect labor and materials.
 §263A expands definition of includible costs by requiring
most entities (especially manufacturers) to use uniform
capitalization (UNICAP) rules
Chapter 13, Exhibit 31 CCH Federal Taxation Basic Principles 41 of 88

42. Uniform Capitalization Rules (UNICAP)
 Generally applies to:
 Real or personal property produced by taxpayer
 Real or personal property acquired by taxpayer for resale
 Under UNICAP, indirect costs include:
1. Factory repairs and maintenance; utilities; rent; depreciation,
amortization, and depletion; small tools; and insurance
2. Indirect labor and production supervisory labor; administrative costs;
indirect materials and supplies; rework, scrap, and spoilage; storage
and warehousing costs; purchasing costs; handling, processing,
assembly, repacking costs; and quality control and inspection costs
3. Taxes (other than income taxes)
4. Deductible contributions to pension, profit-sharing, stock bonus, or
annuity plans
5. Interest, but only for real property, long-lived property, or property
requiring more than two years to produce
Chapter 13, Exhibit 32 CCH Federal Taxation Basic Principles 42 of 88

43. Cost Allocation Procedures
 Once total additional §263A costs are identified, next step in costing
inventory is to allocate these costs
 Direct capitalized costs:
 Associated with specific production activities and products and
allocated to them accordingly
 Taxpayer may use any method which reasonably allocates such costs
 Indirect costs allocated to activities and products using one of three
methods:
a) Specific identification (costs are specifically identified with activities
or products that directly benefit from the costs)
b) Standard costing (costs are allocated to products based upon
established standards)
c) Burden rates (costs are allocated based on direct labor hours, direct
labor costs, and similar expenses)
Chapter 13, Exhibit 33 CCH Federal Taxation Basic Principles 43 of 88

44. Simplified Retail Method
 May elect to use to allocate costs under §263A
 Fully capitalize costs for:
1. Off-site storage and warehousing
2. Purchasing
3. Handling, processing, assembly
 Amount of mixed service costs (general and administrative
costs) allocated requires two steps:
1. Determine amount of mixed service costs that are
additional §263A costs
2. Allocate this amount to ending inventory
Chapter 13, Exhibit 34a CCH Federal Taxation Basic Principles 44 of 88

45. Simplified Retail Method
 Amount of mixed service costs included under §263A is
determined by multiplying such costs by ratio of:
1. Total labor costs included in off-site, storage,
purchasing, and handling cost to
2. Total labor costs incurred in taxpayer’s business,
excluding the labor included in the mixed service costs
 Once amount is determined, then allocated to ending
inventory by multiplying amount in ending inventory that
was purchased during year by the ratio of
1. Total additional §263A costs to
2. Taxpayer’s total purchases during year
Chapter 13, Exhibit 34b CCH Federal Taxation Basic Principles 45 of 88

46. Inventory and UNICAP
 X Co. uses FIFO for its inventory. During the year it incurred:
Storage costs = $200,000,
Purchasing costs = $300,000, and
Handling and processing costs = $100,000
Labor costs included in amounts above = $180,000
Mixed service costs = $250,000
Total labor costs, excluding amounts included in mixed service costs = $2,000,000
• X’s beginning inventory (excluding additional Code Sec. 263A costs) = $1,000,000
• Total purchases = $7,000,000
• Ending inventory = $1,500,000 (excluding additional Code Sec. 263A costs)
• Since X Co. uses the FIFO method, the full $1,500,000 of ending inventory is considered purchased during the year
 X Co.’s ending inventory i= $1,633,350, consisting of :
Original cost of $1,500,000
+ Capitalized additional Code Sec. 263A resale costs of $133,350 (determined below)
• First, determine mixed service costs considered additional Code Sec. 263A costs using the labor ratios:
 Labor ratio = $180,000/$2,000,000 = 9%
 Mixed service costs considered additional Code 263A costs = 9% × $250,000 = $22,500
• Next, determine total additional Code Sec. 263A and allocate to ending inventory (using the additional Code Sec. 263A
costs to purchases ratio)
 Costs to purchase ratio = $622,500/$7,000,000 = 8.89%
 Additional Code Sec. 263A costs allocated to ending inventory = 8.89% × $1,500,000 = $133,350
Chapter 13, Exhibit 35 CCH Federal Taxation Basic Principles 46 of 88

47. Simplified Production Method
 Taxpayers may elect to use simplified production method to allocate capitalized
costs for property produced
 Cannot be used for property acquired for resale and for property produced by
taxpayer for use in its business
 Additional §263A costs allocated based on an absorption ratio and the allocation
requires two steps
First, compute the absorption ratio -- this is the ratio of:
1. Total additional §263A costs incurred during the year to
2. Total §471 costs incurred during the year
Second – additional §263A costs capitalized equals:
Absorption ratio x amount of §471 costs incurred during the year which are
included in the taxpayer’s ending inventory
 If taxpayer uses FIFO, then absorption ratio is applied to §471 costs included
in ending inventory
 If taxpayer uses LIFO, then absorption ratio is applied to §471 costs included
in this year’s increase in inventory (the incremental layer)
Chapter 13, Exhibit 36 CCH Federal Taxation Basic Principles 47 of 88

48. Lower-of-Cost-or-Market (LCM) Method
 Ending inventory may be written down to a lower
market value unless taxpayer is using LIFO
 Lower cost or market must be applied to each item of
inventory
Chapter 13, Exhibit 37 CCH Federal Taxation Basic Principles 48 of 88

49. LCM Example
Tom Co. uses LCM for inventory purposes
Cost and market information follows:
Item Cost Market LCM
A $10,000 $5,000 $5,000
B 14,000 18,000 14,000
C 6,000 4,000 4,000
Total $30,000 $27,000 $23,000
Its ending inventory is written down from $30,000 to $23,000
Chapter 13, Exhibit 38 CCH Federal Taxation Basic Principles 49 of 88

50. Valuation of Inventory Items
 May use one of four cost flow assumptions to value their
inventories:
 Specific identification
 First-in, first-out (FIFO)
 Last-in, first-out (LIFO)
 Weighted average
 Does not have to agree with actual physical flow of goods
 Must receive IRS approval to use LIFO
 If LIFO is used for tax purposes then also must be used for
financial reporting purposes
Chapter 13, Exhibit 39 CCH Federal Taxation Basic Principles 50 of 88

51. Inventory Valuation Example
Tati Co. sells widgets. Following is a review of its inventory and
purchases for the year
1/1: 2,000 units in beginning inventory @ $20
5/6: 1,000 units purchased @ $22
7/10: 1,500 units @ $24
11/15: 500 units @ $23
Tati Co. sold 4,000 units during the year for $200,000
What is Tati Co.’s gross profit under FIFO, LIFO and weighted
average inventory valuation systems?
Chapter 13, Exhibit 40 CCH Federal Taxation Basic Principles 51 of 88

52. Inventory Valuation Example - FIFO
Sales $200,000
Inventory 1/1 $40,000
Purchases 69,500
Available for sale $109,500
Ending inventory
500@ $24 $12,000
500@ $23 11,500 23,500
Cost of goods sold 86,000
Gross profit $114,000
Chapter 13, Exhibit 41 CCH Federal Taxation Basic Principles 52 of 88

53. Inventory Valuation Example - LIFO
Sales $200,000
Inventory 1/1 $40,000
Purchases 69,500
Available for sale $109,500
Ending inventory
1,000@ $20 20,000
Cost of goods sold 89,500
Gross profit $110,500
Chapter 13, Exhibit 42 CCH Federal Taxation Basic Principles 53 of 88

54. Inventory Valuation Example—Weighted
Average Cost
Sales $200,000
Inventory 1/1 $40,000
Purchases 69,500
Available for sale $109,500
Ending inventory
$109,500/5,000 = $21.90
1,000@ $21.90 21,900
Cost of goods sold 87,600
Gross profit $112,400
Chapter 13, Exhibit 43 CCH Federal Taxation Basic Principles 54 of 88

55. Dollar-Value LIFO Method
 Increase in LIFO value is determined by:
 Comparing the total dollar value of beginning and
ending inventories at base-year (first LIFO year) prices
 Then converting any dollar-value increase to current
prices by means of an index
 Allowed to determine base-year dollars through the use of
government indexes
 Several price index methods are permitted
 Double extension method is used most frequently
Chapter 13, Exhibit 44 CCH Federal Taxation Basic Principles 55 of 88

56. Double Extension Method
1. Determine opening inventory at base-year prices (the prices in
effect when LIFO was adopted)
2. Determine ending inventory at base-year prices
3. Compute the difference
 The result is either an increase (increment) or a decrease
(decrement)
4. Determine a price index to value increment, if any
 Index equals ending inventory at current prices/ending
inventory at base-year prices
5. Adjust inventory “layers” for any increment or decrement
 Every increment represents a new layer
 Any decrement uses up most recently added layer or layers
first
Chapter 13, Exhibit 45 CCH Federal Taxation Basic Principles 56 of 88

57. Dollar Value LIFO Example
Jenn Co started business in 2011 and uses the LIFO method. Inventory
information follows:
1/1/2011: inventory = $10,000 (base period, index = 1.0)
inventory (actual prices) inventory (base-year prices)
12/31/2011 $26,000 $21,000
12/31/2012 $30,000 $16,000
12/31/2013 $40,000 $29,000
What amount did Jenn Co. use to value its ending inventory in 2011, 2012, and
2013?
Chapter 13, Exhibit 46 CCH Federal Taxation Basic Principles 57 of 88

58. Dollar Value LIFO Example - 2011
1/1/2011 Index 12/31/2011
1/1/2011 inventory $10,000 1.0 $10,000
2011 increase 11,000 1.2381 13,619
Ending LIFO inventory $21,000 $23,619
Keeping prices constant, the increment in inventory = $11,000 ($21,000 - $10,000)
Index = $26,000/$21,000 = 1.2381
Thus, Jenn Co. valued its ending inventory on 12/31/2011 at $23,619
Chapter 13, Exhibit 47 CCH Federal Taxation Basic Principles 58 of 88

59. Dollar Value LIFO Example - 2012
1/1/2012 Index 12/31/2012
1/1/2011 base inventory $10,000 1.0 $10,000
Remaining 2011 increase 6, 000 1.2381 7,429
Ending LIFO inventory $16,000 $17,429
Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)
Thus, Jenn Co. valued its ending inventory on 12/31/2012 at $17,429
Chapter 13, Exhibit 48 CCH Federal Taxation Basic Principles 59 of 88

60. Dollar Value LIFO Example - 2013
1/1/2013 Index 12/31/2013
1/1/2011 base inventory $10,000 1.0 $10,000
Remaining 2011 increase 6, 000 1.2381 7,429
2013 increase 13,000 1.3793 17,931
Ending LIFO inventory $29,000 $35,360
Keeping prices constant, the increment in base inventory = $6,000 ($16,000 - $10,000)
Index = $40,000/$29,000 = 1.3793
Thus, Jenn Co. valued its ending inventory on 12/31/2013 at $35,360
Chapter 13, Exhibit 49 CCH Federal Taxation Basic Principles 60 of 88

61. Simplified Dollar-Value LIFO Method
 May elect to use simplified dollar-value LIFO method, but then
must be used to value all LIFO inventories
 May elect for any year in which average annual gross receipts
for preceding three years do not exceed $5 million
 Taxpayer groups inventory into pools for each major category in
the applicable government price index provided by Bureau of
Labor Statistics
 Each pool is separately adjusted using appropriate government
index
 Do not compute base period prices
 Use year-end inventory values and determine an assumed base
period value by applying the government price index
 If resulting base period value exceeds opening inventory value at
base period prices, then increment is valued using same index
Chapter 13, Exhibit 50 CCH Federal Taxation Basic Principles 61 of 88

62. Simplified Dollar-Value LIFO Example
Andy Inc. uses the simplified dollar-value LIFO method.
Relevant inventory information follows:
CPI
2012: 1.10
2013: 1.14
Inventory – base year prices
2012: $420,000
2013: $500,000
What ending inventory value will Andy Inc. use for 2013?
Chapter 13, Exhibit 51a CCH Federal Taxation Basic Principles 62 of 88

63. Simplified Dollar-Value LIFO Example
2012 inventory value $420,000
2013 increase in inventory 64,727*
2013 year-end inventory value $484,727
*2013 increase in inventory:
Ending inventory at assumed base-year prices = $500,000 x (1.1/1.14) = $482,456
Increase at 2012 base prices = $482,456 - $420,000 = $62,456
Increase at 2013 base prices = $62,456 x (1.14/1.1) = $64,727
Chapter 13, Exhibit 51b CCH Federal Taxation Basic Principles 63 of 88

64. Estimates of Inventory Shrinkage
 Permits a business to determine its year-end closing
inventory by using estimates for shrinkage (e.g., loss due to
theft)
 Year-end physical count not necessary if:
 Normally take a physical count of inventories at each
business location on a regular and consistent basis and
 Make proper adjustments to inventories and to
estimating methods to extent estimates differ from actual
shrinkage.
Chapter 13, Exhibit 52 CCH Federal Taxation Basic Principles 64 of 88

65. Long-Term Contracts
 Any contract for manufacture, building, installation, or
construction of property if such property is not completed within
the taxable year into which contract is entered
 Two alternatives:
(1) Percentage-of-completion method (or modified
percentage-of-completion method in some cases), and (2)
Completed-contract method (in limited circumstances)
 Method selected must be used for all long-term contracts in
same trade or business
 All cost associated with contract are capitalized and deducted as
profits are recognized
Chapter 13, Exhibit 53 CCH Federal Taxation Basic Principles 65 of 88

66. Capitalization of Expenses
 The following expenses must be capitalized:
1. Cost recovery of assets employed for work on specific
contracts
2. Pension costs representing current service costs
3. General and administrative expenses relating to specific
contracts
4. R&D expenses with respect to specific contracts
5. Scrap and spoilage costs
Chapter 13, Exhibit 54 CCH Federal Taxation Basic Principles 66 of 88

67. Percentage-of-Completion Method
 Report income under the contract annually based on estimated progress
 Percentage of completion =
 allocated costs to the contract and direct costs incurred by the close of the
year/estimated total contract costs
 Income reported for year = Total contract price x Percentage
 Must use a look-back method in year contract is completed
 Compare the actual completion level to the claimed level
 Redetermine taxable income and tax liability accordingly
 Interest is charged on any underpayment and is received for any overpayment
 Long-term contracts completed within two years of contract commencement are
exempt from look-back method if gross contract price does not exceed lesser of
$1,000,000 or 1 percent of taxpayer’s average gross receipts for the previous three
years
 Many elect not to apply the look-back method for long-term contracts completed
during year and in all subsequent years if actual contract taxable income is within 10
percent of estimated taxable income under percentage-of-completion method (using
estimated contract price and costs)
Chapter 13, Exhibit 55 CCH Federal Taxation Basic Principles 67 of 88

68. Modified Percentage-of-Completion Method
 Available for contracts less than 10 percent complete at
end of year
 May elect to defer reporting any income from contract
until at least 10 percent of work is completed
Chapter 13, Exhibit 56 CCH Federal Taxation Basic Principles 68 of 88

69. Completed Contract Methods
 No income until final completion of contract
 All costs are accumulated and recognized at
completion
 Only small construction contractors and home
construction contractors can use
 Those whose average gross receipts for three
preceding tax years do not exceed $10,000,000
Chapter 13, Exhibit 57 CCH Federal Taxation Basic Principles 69 of 88

70. Long-Term Contracts Example
James Co. is a small construction contractor.
In 2012 it entered into a two-year building contract with Dan Co.
Contract price is $4,000,000 and expected costs are $3,000,000.
2012 actual costs: $1,500,000
2013 actual costs: $1,200,000
What gross profit will James Co. report in 2012 and 2013 under the
percentage-of-completion method and the completed-contract
method?
Chapter 13, Exhibit 58a CCH Federal Taxation Basic Principles 70 of 88

71. Long-Term Contracts Example
Percentage-of-completion method
2012 2013
Gross revenue* $2,000,000 $2,000,000
Actual costs 1,500,000 1,200,000
Gross profit $500,000 $800,000
*2012: ($1,500,000/$3,000,000) x $4,000,000 = $2,000,000
2013: $4,000,000 - $2,000,000 = $2,000,000
Chapter 13, Exhibit 58b CCH Federal Taxation Basic Principles 71 of 88

72. Long-Term Contracts Example
Completed-contract method
2012 2013
Gross revenue $0 $4,000,000
Actual costs 0 2,700,000
Gross profit $0 $1,300,000
Chapter 13, Exhibit 58c CCH Federal Taxation Basic Principles 72 of 88

73. Installment Sales
 Disposition of property where at least one payment is received after
the close of tax year in which disposition occurs
 May be used by cash-basis taxpayers as a means to defer gain
recognition or to spread gain recognition over several tax periods
 May not be used if property is disposed of at a loss
 Does not change character of gain (capital or ordinary)
 Any depreciation recapture under §1245 and §1250 recognized in year
of sale
 Not available to all taxpayers
 Must use installment method for tax purposes if taxpayer disposes
property under an installment contract and disposition qualifies for
installment method
 May make an irrevocable election not to use installment method
Chapter 13, Exhibit 59 CCH Federal Taxation Basic Principles 73 of 88

74. Computation of Gain
Step 1. Determine gross profit from the sale
Step 2. Determine contract price
 Generally equals amount seller will receive
 Can never be less than gross profit
Step 3. Compute gross profit percentage
 Gross profit percentage = Gross profit/Contract
price
Step 4. Determine gain recognized in year of sale
 Equals: Payments received × Gross profit
percentage
Chapter 13, Exhibit 60 CCH Federal Taxation Basic Principles 74 of 88

75. Installment Sale Example
 Susan sold property (capital asset) for $500,000 (after
all transaction costs) in 2012
 She acquired the property five years ago for $200,000
 There is a $50,000 liability on the property
 The buyer assumes the liability
 Susan will receive $300,000 in 2012 and $150,000 in
2013
 What income (gain) will Susan report in 2012 and
2013?
Chapter 13, Exhibit 61a CCH Federal Taxation Basic Principles 75 of 88

76. Installment Sale Example
Gain on sale: $500,000 - $200,000 = $300,000
Contract price: $500,000 - $50,000 = $450,000
Gross profit percentage: $300,000/$450,000 = 66.67%
2012 income: $300,000 x 66.67% = $200,000 LTCG
2013 income: $150,000 x 66.67% = $100,000 LTCG
Total income recognized: $300,000 LTCG
Chapter 13, Exhibit 61b CCH Federal Taxation Basic Principles 76 of 88

77. Installment Sale Example
 Susan sold property for $500,000 (after all transaction
costs) in 2012
 She acquired the property five years ago for $200,000
 Total depreciation subject to §1245 recapture taken was
$30,000
 There is a $50,000 liability on the property
 The buyer assumes the liability
 Susan will receive $300,000 in 2012 and $150,000 in 2013
 What income (gain) will Susan report in 2012 and 2013?
Chapter 13, Exhibit 61c CCH Federal Taxation Basic Principles 77 of 88

78. Installment Sale Example
Gain on sale: $500,000 - $200,000 = $300,000
Contract price: $500,000 - $50,000 = $450,000
§1245 gain recognized on sale: $30,000
Gross profit percentage: ($300,000-$30,000)/$450,000 = 60%
2012 income: $300,000 x 60% = $180,000 §1231 gain (and
$30,000 §1245 gain)
2013 income: $150,000 x 60% = $90,000 §1231 gain
Total income recognized: $300,000
Chapter 13, Exhibit 61d CCH Federal Taxation Basic Principles 78 of 88

79. Dispositions of Installment Obligations
 Must determine obligation’s AB and gain or loss on
disposition
 AB of installment obligation equals
 Face amount of obligation in excess of income that
would have been reported if obligation had been
paid in full
 Gain/loss = amount realized if obligation is sold (or
obligation’s FMV if it is disposed of other than by sale)
- AB
 Character of gain/loss is based on property sold under
installment method
Chapter 13, Exhibit 62 CCH Federal Taxation Basic Principles 79 of 88

80. Disposition of Installment Obligation—
Example
Tom sold land (§1231 asset) in 2011 for $100,000
His basis in the land was $30,000
He received $25,000 in 2011 and $35,000 in 2012
He sold the installment obligation in 2013 for $23,000
What is Tom’s gain (loss) on the sale of the installment
obligation in 2013?
Chapter 13, Exhibit 63a CCH Federal Taxation Basic Principles 80 of 88

81. Disposition of Installment Obligation—
Example
2011:
Realized gain: $100,000 - $30,000 = $70,000
Gross profit percentage: $70,000/$100,000 = 70%
Income reported in 2011: $25,000 x .7 = $17,500 §1231 gain
-----------
2012:
Income reported: $35,000 x .7 = $24,500 §1231 gain
-----------
2013:
Adjusted basis of installment obligation: $40,000 - $28,000 = $12,000
Income reported from sale of installment obligation: $23,000 - $12,000 =
$11,000 §1231 gain
Chapter 13, Exhibit 63b CCH Federal Taxation Basic Principles 81 of 88

82. Repossessions of Personal Property
 A taxable event.
 Gain or loss equals:
 Difference between FMV of property repossessed
and AB of installment obligation
 Any costs incurred during repossession increase AB of
installment obligation.
 Character of gain or loss recognized is same as
character of gain or loss recognized on original sale
 Basis of repossessed property is its FMV
Chapter 13, Exhibit 64 CCH Federal Taxation Basic Principles 82 of 88

83. Repossessions of Real Property
 Loss is not recognized
 Gain recognized is lesser of:
 (1) Cash and FMV of property received from buyer in excess
of gain previously recognized by holder of installment
obligation or
 (2) Gain not yet recognized by holder of installment
obligation (deferred gross profit), reduced by repossession
costs
 Character of gain is same as that recognized under original
sale of property
 Basis of repossessed real property
 AB of installment obligation, increased by repossession costs
and by any gain recognized from repossession
Chapter 13, Exhibit 65 CCH Federal Taxation Basic Principles 83 of 88

84. Personal Property Repossessions—Example
Kim sold a painting in 2011 for $80,000
She acquired the painting in 2004 for $20,000
Kim received $20,000 in 2011 and the remainder was due
in 2012
Kim was unable to collect the $60,000, and repossessed
the painting in 2013 when it was worth $50,000
She incurred $1,000 in repossession fees
What are the tax consequences of the repossession?
Chapter 13, Exhibit 66a CCH Federal Taxation Basic Principles 84 of 88

85. Personal Property Repossessions—Example
2011:
Realized gain: $80,000 - $20,000 = $60,000
Gross profit percentage: $60,000/$80,000 = 75%
Income reported in 2011: $20,000 x .75 = $15,000 LTCG
----------
2012:
Nothing reported
----------
2013:
Adjusted basis of installment obligation: $60,000 - $45,000 = $15,000
Adjusted basis for repossession purposes = $15,000 + $1,000 = $16,000
Income reported from repossession: $50,000 - $16,000 = $34,000 LTCG
Kim’s basis in the painting = $50,000
Chapter 13, Exhibit 66b CCH Federal Taxation Basic Principles 85 of 88

86. Real Property Repossessions—Example
Gary sold land in 2011 for $200,000
He bought the land in 2005 for $60,000
He received $50,000 in 2011 and the balance was due in
2012
Gary was unable to collect the $150,000, and in 2013 he
repossessed the land when it was worth $190,000
Repossession fees were $5,000
What are the tax consequences of the repossession?
Chapter 13, Exhibit 67a CCH Federal Taxation Basic Principles 86 of 88

87. Real Property Repossessions—Example
2011:
Realized gain: $200,000 - $60,000 = $140,000
Gross profit percentage: $140,000/$200,000 = 70%
Income reported in 2011: $50,000 x .70 = $35,000 LTCG
----------
2012:
Nothing reported
----------
2013:
Adjusted basis of installment obligation: $150,000 - $105,000 = $45,000
(1) Excess of payments received – gain reported in previous years: $50,000 - $35,000 =
$15,000
(2) Gain not yet reported: $150,000 x .7 = $105,000
Income reported from repossession: lesser of [(1) or (2)] – repossession fees
= lesser of $15,000 or ($105,000 - $5,000) = $15,000 LTCG
Gary’s basis in the painting = $45,000 + $5,000 + $15,000 = $65,000
Chapter 13, Exhibit 67b CCH Federal Taxation Basic Principles 87 of 88

88. Advantages and Disadvantages of
Installment Method
Advantages Disadvantages
1. Tax liabilities deferred until 1. Default risk and potential
proceeds are available collection costs
2. Marginal tax rates may decline in 2. In periods of inflation - loss of
purchasing power
future years 3. Taxes deferred but so are
3. Interest income, to some extent, collections
may be converted to capital gains 4. Marginal tax rates may increase
by charging a lower interest rate during collection years
and a higher price (but the imputed 5. Although the holding period in the
interest rules affect this) year of sale determines whether the
4. Since the seller finances the transaction is short-term or long-
purchase, sales are more easily term, the character of the gain is
made determined in the year of
collection
6. Depreciation recapture takes place
in the year of sale
Chapter 13, Exhibit 68 CCH Federal Taxation Basic Principles 88 of 88