SECTION 5. METHODS OF

ACCOUNTING (§ 446)

absorption ratio election (§ 1.263A–2(b)), but does not include any other reasonable allocation method within the meaning of § 1.263A–1(f)(4).

(v) a taxpayer required or wanting to use a special method of accounting, unless the taxpayer is permitted to change automatically to the special method under this revenue procedure. A special method of accounting is a method that deviates from the normal tax accounting rules, such as the method of accounting for advance payments pursuant to either Rev. Proc. 71–21 (1971–2 C.B. 549), or § 1.451–5, the installment method of accounting under § 453, or a long-term contract method, such as the percentage of completion method or the completed contract method;

(vi) a taxpayer required to change to an overall accrual method under § 448 and eligible to make the change under § 1.448–1(h)(2). See § 1.448–1(h)(2), which provides an automatic consent procedure for a taxpayer changing for the first taxable year that it is subject to § 448. See also § 1.448–1(h)(1), which provides that § 1.448–1(h) does not apply to a change required under any Code section (or regulations thereunder) other than § 448 (for example, a taxpayer with inventories); or

(vii) a taxpayer engaged in two or more trades or businesses, unless the taxpayer uses or adopts the same overall accrual method for each such trade or business.

(2) Section § 481(a) adjustment .

.01 Cash or hybrid method to accrual method .

(1) Description of change and scope .

(ii) a taxpayer that is required to change to an overall accrual method under § 448, but is ineligible to make the change under § 1.448–1(h)(2) (relating to the “first § 448 year”).

(b) Inapplicability . This change does not apply to:

(i) a farmer; (ii) a cooperative organization described in § 501(c)(12), 521, or 1381;

(iii) an individual taxpayer, except for activities conducted as a sole proprietorship;

(iv) a taxpayer required to use an inventory method of accounting, unless:

(A) the taxpayer is using or adopts a proper inventory method under § 471 and the regulations thereunder, the taxpayer is a small reseller within the meaning of § 1.263A–3(a), and, if the taxpayer has production activities, the taxpayer’s production activities qualify under the de minimis presumption of § 1.263A–3(a)(2)(iii);

(B) the taxpayer is using or adopts a proper inventory method under § 471 and the regulations thereunder, the taxpayer is a reseller eligible to use the simplified resale method under § 1.263A– 3(d), and the taxpayer is using or adopts a proper method under that section for the year of change;

(C) the taxpayer is a producer of real or tangible personal property described in § 1.263A–2, and is using both a proper inventory method under § 471 and the regulations thereunder and a proper capitalization method under § 263A and the regulations thereunder; or

(D) the taxpayer is a producer of real or tangible personal property described in § 1.263A–2, is using or adopts a proper inventory method under § 471 and the regulations thereunder, and adopts a UNICAP method or methods specifically described in the regulations. A “UNICAP method specifically described in the regulations” includes the specific identification method (§ 1.263A–1(f)(2)), the burden rate method (§ 1.263A–1(f)(2)), the standard cost method (§ 1.263A–1(f)(3)), the direct reallocation method (§ 1.263A– 1(g)(4)(iii)(A)), the step-allocation method (§ 1.263A–1(g)(4)(iii)(B)), the simplified service cost method (§ 1.263A–1(h)), or the simplified production method without the historic

(a) Applicability . This change applies to:

(i) a taxpayer that wants to change to an overall accrual method, or to an overall accrual method in conjunction with the recurring item exception under § 461(h)(3), from the cash receipts and disbursements method (cash method), or from a hybrid method (the use of a combination of accounting methods under which an item or items of income or expense are reported on the cash method and another item or other items of income or expense are reported on an accrual method); or

January 22, 2002 361 2002–3 I.R.B.

be modified to account for the amount of any additional deduction.

(3) Change to a special method of accounting . If a taxpayer that wants to change to an accrual method in conjunction with a change to a special method of accounting is not permitted to make the change under this revenue procedure, the taxpayer may request to make both changes only by filing one application under the provisions of Rev. Proc. 97–27 (1997–1 C.B. 680). Only one user fee will be required for these changes.

(4) Coordination with section 13.01 of the APPENDIX for short-term obliga- tions . If a taxpayer subject to § 1281 wants to change its method of accounting under this section 5.01 of the APPENDIX and, as part of the change, is changing its method of accounting for interest income on short-term obligations, then the change for interest income on short-term obligations should be made under section 13.01 of the APPENDIX of this revenue procedure and not under this section 5.01 of the APPENDIX.

.02 Multi-year service warranty con- tracts .

(a) A short-term consumer loan is described in Rev. Proc. 83–40, provided:

(i) the loan is a self-amortizing loan that requires level payments, at regular intervals at least annually, over a period not in excess of five years (with no balloon payment at the end of the loan term); and

(ii) the loan agreement between the borrower and the lender provides that interest is earned, or upon the prepayment of the loan interest is treated as earned, in accordance with the Rule of 78s method.

(b) In general, the Rule of 78s method allocates interest over the term of a loan based, in part, on the sum of the periods’ digits for the term of the loan. See Rev. Rul. 83–84 (1983–1 C.B. 97) for a description of the Rule of 78s method.

(c) In general, the constant yield method allocates interest and original issue discount over the term of a loan based on a constant yield. See § 1.1272– 1(c) for a description of the constant yield method. The Rule of 78s method generally front-loads interest as compared to the constant yield method.

(d) Rev. Proc. 83–40 was obsoleted because, under §§ 1.446–2 and 1.1272–1 (which were effective for debt instruments issued on or after April 4, 1994), taxpayers generally must account for stated interest and original issue discount on a debt instrument (loan) by using a constant yield method. As a result, the

for that amount by prorating (or amortizing) it over the life of the insurance policy (whether the cash method or an accrual method of accounting is used to account for service warranty transactions).

.04 Interest accruals on short-term consumer loans — Rule of 78s method .

(1) Description of change and scope . This change applies to a taxpayer that wants to change its method of accounting from the Rule of 78s method to the constant yield method for stated interest (including stated interest that is original issue discount) on short-term consumer loans described in Rev. Proc. 83–40, 1983–1 C.B. 774, which was obsoleted by Rev. Proc. 97–37 (1997–2 C.B. 455). However, this change only applies to loans issued on or after the first day of the taxpayer’s first taxable year that begins on or after January 1, 1999.

(2) Background .

(1) Description of change and scope .

3115 is waived and a statement in lieu of the Form 3115 is authorized for this change. The statement must be identified at the top as follows: “CHANGE TO THE SERVICE WARRANTY INCOME METHOD UNDER SEC- TION 5.02 OF THE APPENDIX OF REV. PROC. 2002–9.” The statement must set forth the information required under section 6.03 of Rev. Proc. 97–38, except that the statement under section 6.03(2) (that the taxpayer agrees to all of the terms and conditions of the revenue procedure) also should refer to Rev. Proc. 2002–9. (c) A taxpayer changing to the service warranty income method of accounting under section 5.02 of this APPENDIX must satisfy the annual reporting requirement set forth in section 6.04 of Rev. Proc. 97–38.

.03 Multi-year insurance policies for multi-year service warranty contracts — Description of change and scope .

(1) Applicability . This change applies to a manufacturer, wholesaler, or retailer of motor vehicles or other durable consumer goods that wants to change its method of accounting for insurance costs paid or incurred to insure its risks under multi-year service warranty contracts to the method described in section 5.03(3) of this APPENDIX. Multi-year service warranty contracts to which this change applies include only those separately priced contracts sold by a manufacturer, wholesaler, or retailer also selling the motor vehicles or other durable consumer goods (to the ultimate customer or to an intermediary) underlying the contracts. The classification of goods as “durable consumer goods” for purposes of this change depends on the common usage of the goods, rather than the purchaser’s actual intended use of the goods.

(2) Inapplicability . This change does not apply to a taxpayer that covers its risks under its multi-year service warranty contracts through arrangements not constituting insurance.

(3) Description of method . If a taxpayer purchases a multi-year service warranty insurance policy (in connection with its sale of multi-year service warranty contracts to customers) by paying a lump-sum premium in advance, the taxpayer must capitalize the amount paid or incurred and may only obtain deductions

(a) Applicability . This change applies to an eligible accrual method manufacturer, wholesaler, or retailer of motor vehicles or other durable consumer goods that wants to change to the service warranty income method described in section 5 of Rev. Proc. 97–38 (1997–2 C.B. 479). Under the service warranty income method, a qualifying taxpayer may, in certain specified and limited circumstances, include a portion of an advance payment related to the sale of a multi-year service warranty contract in gross income generally over the life of the service warranty obligation.

(b) Inapplicability . This change does not apply to a taxpayer outside the scope of Rev. Proc. 97–38.

(2) Manner of making the change .

(a) This change is made using a cutoff method, under which the taxpayer begins the use of the service warranty income method for all qualified advance payment amounts received in the year of change and thereafter. See section 2.06 of this revenue procedure.

(b) In accordance with § 1.446– 1(e)(3)(ii), the requirement of § 1.446– 1(e)(3)(i) to file an application on Form

2002–3 I.R.B. 362 January 22, 2002

Rule of 78s method is no longer an acceptable method of accounting for federal income tax purposes.

(e) Notwithstanding §§ 1.446–2 and 1.1272–1, as a matter of administrative convenience, the Service will allow a taxpayer to use the Rule of 78s method for stated interest on short-term consumer loans described in Rev. Proc. 83–40 if the loans were issued prior to the first day of the taxpayer’s first taxable year that begins on or after January 1, 1999.

(3) Manner of making the change. This change applies to loans issued on or after the first day of the taxpayer’s first taxable year that begins on or after January 1, 1999. As a result, any § 481 adjustment will be computed only with respect to those loans.

.05 Small taxpayers changing to over- all cash method.

(1) Description of change. This change applies to a taxpayer (other than a taxpayer described in § 448(a)(3)) with “average annual gross receipts” (as defined in section 5.01 of Rev. Proc. 2001–10, 2001–2 I.R.B. 272) of $1,000,000 or less that wants to change to the overall cash method of accounting as described in Rev. Proc. 2001–10.

(2) Scope limitations inapplicable. The scope limitations in section 4.02 of this revenue procedure do not apply to this change.

(3) Manner of making the change. Taxpayers making this change are urged to consult Rev. Proc. 2001–10 for additional guidance on the computation of the § 481(a) adjustment and the completion of the application.

(4) Automatic changes to treating inventoriable items as nonincidental materials and supplies under Rev. Proc. 2001–10. A taxpayer desiring to make both this change and the change to treating inventoriable items as materials and supplies that are not incidental under § 1.162–3 (see section 9.03 of the APPENDIX of this revenue procedure) may file a single application for both changes.

(4) Manner of making the change.

for amounts to be received for the performance of services by the taxpayer which (on the basis of experience) will not be collected.

(2) Inapplicability. This change does not apply to any amount:

(a) if interest is required to be paid on such amount; or

(b) if a penalty is imposed for failure to timely pay such amount.

(3) Scope limitations inapplicable. The scope limitations in section 4.02 of this revenue procedure are not applicable to this change.

SECTION 5A. TAXABLE YEAR OF INCLUSION (§ 451)

.01 Accrual of interest on nonperform- ing loans.

5A.01 of this APPENDIX must do so for all of its loans.

(2) Section 481(a) adjustment. In general, the § 481(a) adjustment for a method change under section 5A.01 of this APPENDIX represents the amount of qualified stated interest, on the taxpayer’s nonperforming loans outstanding as of the beginning of the year of change, that should have been accrued under §§ 451 and 1.451–1(a) and was not accrued. Interest for which the taxpayer, as of the beginning of the year of change, has no reasonable expectation of payment is not taken into account in determining the amount of the § 481(a) adjustment.

.02 Cash advances on insurance com- missions.

(1) Description of change.

(1) Description of change and scope.

(a) This change applies to an insurance company that wishes to change its method of accounting for cash advances on commissions paid to its agents from deducting a cash advance in the taxable year in which the advance is paid to the agent to deducting a cash advance in the taxable year in which the advance is earned by the agent. This change applies only to cash advances qualifying as loans under Rev. Proc. 2001–24 (2001–10 I.R.B. 788). An insurance company making this change must comply with all other applicable provisions of Rev. Proc. 2001–24. (b) An agent of an insurance company making this change is granted consent to change the agent’s method of accounting to report cash advances in the year earned rather than in the year paid, so long as the agent’s change in method of accounting is consistent with the insurance company’s reporting. No separate filing is required by an agent.

(2) Year of change. This change applies only to the insurance company’s first or second taxable year beginning after December 31, 1999.

(3) Scope limitations inapplicable. The scope limitations in section 4.02 of this revenue procedure do not apply.

(a) The insurance company must attach to the application a statement that complies with section 4.03 of Rev. Proc. 2001–24. (b) This change is effected on a cutoff basis. See section 2.06 of this revenue

.06 Nonaccrual-experience method .

(1) Applicability. This change applies to a taxpayer using an overall accrual method that wants to change, and is eligible to change, to the nonaccrualexperience method of accounting under § 448(d)(5) and regulations thereunder

(a) This change applies to an accrual method taxpayer that is a bank as defined in § 581 (or whose primary business is making or managing loans) and wants to change its method of accounting to comply with §§ 451 and 1.451–1(a) for qualified stated interest (as defined in § 1.1273–1(c)) on nonperforming loans.

(b) Section 1.451–1(a) requires income to be accrued when all the events have occurred that fix the right to receive the income and the amount thereof can be determined with reasonable accuracy. A taxpayer may not stop accruing qualified stated interest on a nonperforming loan for federal income tax purposes merely because payments on the loan are overdue by a certain length of time, such as 90 days, even if a federal, state, or other regulatory authority having jurisdiction over the taxpayer permits or requires that the overdue interest not be accrued for regulatory purposes.

(c) Under §§ 451 and 1.451–1(a), a taxpayer must continue accruing qualified stated interest on any nonperforming loan until either (i) the loan is worthless under § 166 and charged off as a bad debt, or (ii) the interest is determined to be uncollectible. In order for interest to be determined uncollectible, the taxpayer must substantiate, taking into account all the facts and circumstances, that it has no reasonable expectation of payment of the interest. This substantiation requirement is applied on a loan by loan basis.

(d) A taxpayer that changes its method of accounting under section

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procedure. If the insurance company previously changed its method of accounting for cash advances from “loan” to “earned cash advances” and that change resulted in a § 481(a) adjustment that has not been fully included in the insurance company’s taxable income, the insurance company must include the remaining § 481(a) adjustment in taxable income in the year of change. Similarly, if the insurance company previously changed its method of accounting for cash advances from “loans” to “earned cash advances” and that change resulted in a § 481(a) adjustment that has not been fully included in the agent’s reported income, the insurance company must include the remaining § 481(a) adjustment on the agent’s applicable Form 1099–MISC, Miscellaneous Income, or Form W–2, Wage and Tax Statement, for the year of change.

.03 Advance rentals — description of change and scope . This change applies to a taxpayer that wishes to change its method of accounting for advance rentals (other than advance rentals subject to § 467 and the regulations thereunder) to include such advance rentals in gross income in the taxable year received. See § 1.61–8(b).