For instance, in any case in which it is necessary to use an inventory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method. . . . . A taxpayer is deemed to have received items of gross income which have been credited to or set apart for him without restriction. . . . . On the other hand, appreciation in value of property is not even an accrual of income to a taxpayer prior to the realization of such appreciation through conversion of the property. .. (Art. 23, as amended by T. D. 2873, June 24, 1919.)

It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so. Among the essentials are the following:

(1) In all cases in which the production, purchase or sale of merchandise of any kind is an income-producing factor inventories of the merchandise on hand (including finished goods, work in process, raw materials and supplies) should be taken at the beginning and end of the year and used in computing the net income of the year;

(2) Expenditures made during the year should be properly classified as between capital and income, that is to say, that expenditures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account; and

(3) In any case in which the cost of capital assets is being recovered through deductions for wear and tear, depletion or obsolescence any expenditure (other than ordinary repairs) made to restore the property or prolong its useful life should be charged against the property account or the appropriate reserve and not against current expenses. (Art. 24.)

PERIOD FOR WHICH NET INCOME IS COMPUTED.

REGULATIONS. Net income must be computed with respect to a fixed period. Usually that period is twelve months and is known as the taxable year. . . . . The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation shall be made in such a manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for. If the taxpayer does not regularly employ a method of accounting which clearly reflects his income, the com

putation shall be made in such Commissioner clearly reflects it. Each year's return, so far as practicable, both as to gross income and deductions therefrom, should be complete in itself, and taxpayers are expected to make every reasonable effort to ascertain the facts necessary to make a correct return. . . . The expenses, liabilities or deficit of one year can not be used to reduce the income of a subsequent year. A person making returns on an accrual basis has the right to deduct all authorized allowances, whether paid in cash or set up as a liability, and it follows that if he does not within any year pay or accrue certain of his expenses, interest, taxes or other charges, and makes no deduction therefor, he can not deduct from the income of the next or any subsequent year any amounts then paid in liquidation of the previous year's liabilities. A loss from theft or embezzlement occurring in one year and discovered in another is deductible only for the year of its occurrence. Any amount paid pursuant to a judgment or otherwise on account of damages for personal injuries, patent infringement or otherwise, is deductible from gross income when the claim is put in judgment or paid, less any amount of such damages as may have been compensated for by insurance or otherwise. If subsequently to its occurrence, however, a taxpayer first ascertains the amount of a loss sustained during a prior taxable year which has not been deducted from gross income, he may render an amended return for such preceding taxable year, including such amount of loss in the deductions from gross income, and may file a claim for refund of the excess tax paid by reason of the failure to deduct such loss in the original return. . . . . (Art. III.)

manner as in the opinion of the (Art. 22.)

CASH OR ACCRUAL METHOD OF COMPUTING NET INCOME.Under "definitions" the 1918 law contains the following:

LAW. Section 200. The term "paid," for the purposes of the deductions and credits under this title, means "paid or accrued" or "paid or incurred," and the terms "paid or incurred" and "paid or accrued" shall be construed according to the method of accounting upon the basis of which the net income is computed under section 212.

The foregoing provisions are much more positive in tone than the permissive clauses included in the 1916 law and have been interpreted by the regulations so as to require the accrual basis for tax purposes when that method is used in the ac

counts.

REGULATION.

"Paid" is to be construed in each instance in the light of the method used in computing net income, whether on an accrual or a receipt basis. . . . . (Art. 1533.)

....

All well-conducted business concerns attempt to make their books reflect actual net income for their accounting periods. When this is done in good faith the income tax return should exactly agree with the books.

Individuals do not, as a rule, keeps books, and when they do their so-called accounts consist usually of cash records. But when reasonably accurate accounts are kept the taxpayer is more than repaid for the trouble involved. They assist economy and encourage thrift. Without accurate accounts an income tax cannot be satisfactorily assessed. The Commissioner will be justified in directing that every taxpayer be required to keep a clear record of gross income as it accrues and of expenses as they are incurred.

Nothing can be more obvious than the proposition that true "net income" cannot be determined by looking over one's cash account. Even day-laborers, many of whom now receive taxable incomes, often do not receive their wages in the period when earned. It is not intended to suggest that taxpayers of this class should be required to prepare a return on the accrual basis; but if the wage-earner, whose wages for December, 1919, amounting to $200, were not received by him until January, 1920, desires to include the $200 in his 1919 returns, he should be encouraged to do so.

CHANGING FROM CASH TO ACCRUAL METHOD.-Where a taxpayer who has kept his books on a cash basis desires to change to an accrual basis, he must first secure the consent of the Commissioner. It would be most improper to change more than once unless the reasons were extremely cogent.'

19

In the long run the government is not likely to gain or lose anything by permitting a single change from one method to the other, but if shifting back and forth were freely permitted it

T. D. 2433, January 8, 1917.

might easily develop into a scheme of wholesale evasion.

It is desirable for the taxpayer who contemplates a change in his method of reporting, to restate his accounts as of the beginning of the taxable year as well as at the end, and thus put all the current year's earnings and expenses on an accrual basis.

REGULATION. (3) A taxpayer who changes the method of accounting employed in keeping his books for the taxable year 1919 or thereafter, shall before computing his income upon such new basis for purposes of taxation secure the consent of the Commissioner. Application for permission to change the basis of the return20 shall be made at least thirty days in advance of the date of filing return and shall be accompanied by a statement specifying the classes of items differently treated under the two systems and specifying all amounts which would be duplicated or entirely omitted as a result of the proposed change. . . . .21 (Art. 23, as amended by T. D. 2873, June 24, 1919.)

[Former Procedure] The notice had to be given thirty days before due date of return on present basis, and thirty days before due date on proposed basis.

[Former Procedure] Portions of this Treasury decision dealing with 1918 procedure are as follows:

"(2) For the taxable year 1918 the true income, computed under the Revenue Act of 1918 and-where the taxpayer keeps books of account-in accordance with the method of accounting regularly employed in keeping such books, shall in all cases be entered in the return, even though this results in apparent omissions or duplications of particular items of income or expense. In the ordinary case such omissions and duplications are more apparent than real and are likely to counterbalance one another, so that the change in the basis of reporting calls for no material adjustment. Where, however, the method previously employed by the taxpayer in determining his income subject to the tax is materially different from the method regularly used by the taxpayer in keeping his accounts, or where for any reason the basis of reporting income subject to tax is changed the taxpayer should attach to his return a separate statement setting forth for the taxable year and for the preceding year the classes of items differently treated under the two systems, specifying in particular all amounts duplicated or entirely omitted as the result of such change. Where for example a taxpaper who, prior to 1918, has reported on the so-called receipts basis, is compelled under the above rule to report on the so-called accrual basis, he should include in the separate statement the following information:

"First, (a) expenses paid before the end of the taxable year 1917, but not accrued at that date; (b) income accrued at the end of the taxable year 1917, but not received at that date; (c) expenses accrued at the end of the taxable year 1917, but not paid at that date; (d) income received before the end of the taxable year 1917, but not accrued at that date; and

INVENTORIES. The provision of the 1918 law regarding inventories marks a great advance from the condition of five years ago. Under the 1909 and 1913 laws the use of inventories was permitted in certain cases without the authority of any specific permission in the law and in spite of some doubt as to its legality. The 1918 law gives the Commissioner power to require inventories "whenever necessary clearly to determine the income of any taxpayer" and specifies that the basis shall "conform as nearly as may be to the best accounting practice in the trade or business."

Fortunately, the determination of "best accounting practice" is not difficult. Briefly defined, the term means accounts and methods which correctly reflect the true financial position of a concern as to net worth and earnings and such advice relating thereto as will prevent the proprietors or executives from deceiving themselves. The effect of federal income tax legislation upon accounting practice is interesting. Prior to 1909, conservative business men usually understated rather than overstated their net earnings, while ignorant and dishonest business men overstated them. After the enactment of the 1909 law, which imposed a tax on net earnings, the dishonest men began to understate their earnings and the honest and conservative men tended to overstate their earnings in their desire to comply fully with the tax requirements.

"Second, similar items as of the end of the taxable year 1916. "If in the opinion of the Commissioner such information indicates that the returns for any previous years did not reflect the true income, amended returns for such years will be required.

"(4) Bank discounts. Banks which in the past have treated discount as income before it was actually earned and during the taxable year 1918 have placed the discount account upon an accrual basis, will be required to submit the information called for in paragraph 2 above and submit an amended return for the taxable year 1917, and will be permitted to submit (or the Commissioner may require) amended returns for all prior years during which the taxpayer was subject to tax. Additional taxes for prior years found to be due upon such re-examination will be paid upon the basis of the amended returns in the ordinary way. Where it appears that prior taxes have been paid in excess of the amount properly due, such excess will to the extent possible be credited against future income and profits taxes under the provisions of section 252 of the Revenue Act of 1918." (Art. 23, as amended by T. D. 2873, June 24,