SERVICE PROVIDES 'PERIODIC SYSTEM' OF ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS RECEIVABLE RELATING TO THE PERFORMANCE OF SERVICES.

Notice 88-51

Background.

The purpose of this notice is to provide guidance to taxpayers regarding the nonaccrual-experience method of accounting allowed under section 448(d)(5) of the Internal Revenue Code.

Section 448(d)(5) of the Code provides that any person using an accrual method of accounting with respect to amounts to be received for the performance of services by such person shall not be required to accrue any portion of such amounts which (on the basis of experience) will not be collected (the "nonaccrual-experience method"). The provisions of section 448(d)(5) do not apply to any amount if interest is required to be paid on such amount or if there is any penalty for failure to timely pay such amount.

On June 16, 1987, proposed and temporary regulations interpreting section 448 were published in the Federal Register (52 FR 22764, T.D. 8143). Section 1.448-2T provides guidance with respect to the nonaccrual-experience method under section 448(d)(5). Under the nonaccrual-experience method, a taxpayer does not recognize as gross income the estimated uncollectible amount of each receivable. Upon collecting the account receivable, the taxpayer recognizes additional gross income reflecting the amount collected which the taxpayer did not initially expect to collect. Further, the taxpayer may not deduct as a bad debt under section 166 any amount which the taxpayer did not previously take into income under the nonaccrual- experience method with respect to a wholly or partially worthless account receivable.

Nonaccrual-Experience Method and Periodic System.

Section 1.448-2T(e)(3) requires the taxpayer to separately apply the nonaccrual-experience method to each of its accounts receivable that is eligible for such method (the "separate receivable system"). The legislative history of section 448 provides that "the Secretary of the Treasury may provide a periodic system of accounting for billings, that, on the basis of experience, will not be collected where the periodic system results in the same taxable income as would be the case were each receivable recorded separately." H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 608 (1985).

In the preamble to T.D. 8143, the Internal Revenue Service, while noting that the regulations did not provide a periodic system, specifically invited comment on the operation of any such system for applying the nonaccrual-experience method, including the manner of accounting for wholly or partially worthless debts under that system. The Internal Revenue Service received several taxpayer submissions in response to the request for comment. The submissions suggested specific methods of implementing the periodic system and urged the Service to allow such a system in order to avoid administrative complexities and costs associated with the separate treatment of each account receivable under the nonaccrual-experience method. Accordingly, this notice provides a periodic system for using the nonaccrual-experience method (the "periodic system"). The present separate receivable system under section 1.448-2T(e)(3) continues to be available as an alternative to taxpayers using the nonaccrual- experience method.

The Periodic System.

The periodic system applies the nonaccrual-experience method of accounting through a method somewhat similar to a reserve method. The periodic system is based on the aggregate amount of accounts receivable to be received by the taxpayer for the performance of services. A taxpayer using the periodic system must establish an account representing the aggregate amounts that the taxpayer estimates will not be collected with respect to all of its accounts receivable in that trade or business eligible for the nonaccrual- experience method ("eligible" accounts receivable), based on the six- year moving average formula provided in section 1.448-2T(e)(2). At the end of the taxable year, the taxpayer must adjust the amount in the account to reflect the aggregate amount that the taxpayer estimates will not be collected on the accounts receivable outstanding at year-end. The taxpayer must offset the amount of the year-end adjustment by an adjustment increasing or decreasing gross income, as appropriate. Thus, the taxpayer must offset an adjustment increasing the amount of the account for uncollectible amounts by an adjustment decreasing gross income. Similarly, the taxpayer must offset an adjustment decreasing the amount of the account by an adjustment increasing gross income.

The periodic system requires the taxpayer to charge directly to bad debt expense wholly or partially worthless accounts receivable which it charges off during the taxable year. In determining the amount charged to bad debt expense for those worthless accounts receivable, the taxpayer must disregard the estimated uncollectible amounts pertaining to the accounts receivable. Similarly, the taxpayer must disregard the estimated uncollectible amounts of accounts receivable when it accounts for the collection of those receivables.

The periodic system further requires the taxpayer to use the six-year moving average formula to estimate the total amount that it will not collect on all of its eligible accounts receivable outstanding at the end of the taxable year, including receivables outstanding at the end of the prior taxable year. In contrast, the separate receivable system requires the taxpayer to determine only once the amount of a particular receivable it expects not to collect using the nonaccrual-experience method, regardless of the term of the particular receivable.

Example of Periodic System.

The following example illustrates the periodic system under the nonaccrual-experience method.

(a) X, a calendar-year accrual-method taxpayer, changes to the nonaccrual-experience method of accounting for its first taxable year beginning after December 31, 1986. As of January 1, 1987, X has 10 eligible accounts receivable, each with a $1,000 face amount, for a total accounts receivable balance of $10,000. Under the six-year moving average formula, X estimates that it will not collect 10% ($1,000) of the $10,000 total amount due as of January 1, 1987. (The $1,000 amount equals the section 481(a) adjustment for X's change in method of accounting to the nonaccrual-experience method for 1987. See section 1.448-2T(g).) During 1987, X (i) determines that one account receivable on hand at January 1, 1987, is wholly worthless; (ii) collects in full eight of the accounts receivable on hand at January 1, 1987; (iii) does not write off or collect the remaining account receivable on hand at January 1, 1987, which remains on hand at December 31, 1987; and (iv) provides additional services which generate 19 new eligible accounts receivable on hand as of December 31, 1987, each with a $1,000 face amount, thus otherwise recognizing gross income of $19,000.

(b) Under the periodic system, X must charge bad debt expense for $1,000 with respect to the account receivable that X determines is wholly worthless. (In contrast, X must charge bad debt expense for $900 under the separate receivable system.) In addition, under the periodic system, X must reduce accounts receivable by $8,000 for the eight accounts receivable that X collected in full. (In contrast, under the separate receivable system, X must reduce accounts receivable by $7,200 and increase gross income by $800.)

(c) Assume that X applies the six year moving average formula to all X's accounts receivable at December 31, 1987, and estimates that 9% of those receivables are uncollectible. Thus, the account for the aggregate amounts that X estimates are uncollectible must equal $1,800 (9% of $20,000). Under the periodic system, X must increase the balance in the account for aggregate estimated uncollectible amounts from $1,000 to $1,800. Thus, X must increase the account for aggregate estimated uncollectible amounts by $800 and decrease gross income by $800. (In contrast, under the separate receivable system, X calculates the estimated uncollectible amounts only with respect to new accounts receivable on hand at year-end and adjusts gross income accordingly. Thus, X does not recognize $1,710 of gross income for the $19,000 of new accounts receivable recognized in 1987.)

(d) Under the periodic system, the net taxable income which X recognizes in 1987 is $10 more than the net taxable income which X would recognize under the separate receivable system. This $10 increase in net taxable income under the periodic system results from a positive $910 difference in gross income under the periodic system for the accounts receivable that X generated during 1987, reduced by the $800 difference in treatment under the periodic system for the eight accounts receivable that X collected in full in 1987, and further reduced by the $100 difference in treatment under the periodic system for the account receivable charged off during 1987. Therefore, X's net balance reflected in the accounts receivable and reserve account at December 31, 1987, is $10 more under the periodic system than under the separate receivable system.

Treatment of Periodic System.

The taxpayer's use of the separate receivable system or the periodic system is a method of accounting under all provisions of the Code. Thus, for example, a taxpayer using the separate receivable system or the periodic system for a particular trade or business may not change its method of accounting to the other system for that trade or business unless it obtains the consent of the Commissioner to the change. Nevertheless, a taxpayer who used the separate receivable system for its taxable years beginning in 1987 may automatically change its method of accounting to the periodic system for its taxable year beginning in 1988. The taxpayer may effect the automatic change in method of accounting by (i) establishing an account (with a "credit" balance) under the six-year moving average formula representing estimated uncollectible amounts for all eligible accounts receivable on hand at the beginning of its 1988 taxable year; (ii) increasing (i.e., "debiting") its accounts receivable on hand at the beginning of its 1988 taxable year by the amount described in clause (i); and (iii) applying the periodic system to all activities occurring in 1988 and thereafter.

In addition, a taxpayer may change to the periodic system of accounting under the provisions of section 1.448-2T(h), which presently apply to taxpayers using the separate receivable system. Thus, for example, an accrual-method taxpayer may change to the periodic system for its first taxable year beginning after December 31, 1986. Similarly, a taxpayer changing from the cash method to an overall accrual method of accounting under section 448 may change to the periodic system for the year in which it changes to an overall accrual method of accounting. All other provisions of the regulations apply equally to taxpayers using the nonaccrual-experience method, whether they use the separate receivable system or the periodic system. Thus, for example, the regulatory provisions governing the availability of the nonaccrual-experience method to a taxpayer's various accounts receivable apply equally to the separate receivable and periodic systems.

The Internal Revenue Service recognizes that the use of the periodic system may result in small differences in taxable income in comparison to the results achieved by the use of the separate receivable system, particularly in years when the taxpayer's bad debt experience changes. The taxpayer may use the periodic system in spite of the resulting differences if it consistently maintains its use of the periodic system.

Administrative Pronouncement.

This document serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

For Further Information

For further information contact Katherine Lee Wambsgans, Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 202/566-3288 (not a toll-free number).