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Tax Accounting Myths
George Mundstock
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TAX ACCOUNTING MYTHS
GEORGE MUNDSTOCK
COPYRIGHT 2013'
The rules that control the timing of the recognition of items of
revenue and expense for federal income-tax purposes-tax accounting-
have received little attention in the last two Presumably, this is
due in some measure to the time value of money being less interesting in
the recent low-interest-rate environment. With so little recent public
discussion, many tax lawyers' understanding of tax accounting rests on
historical myths that are no longer true. For example, many tax lawyers
think that financial accounting's Generally Accepted Accounting
Principles ("GAAP")3 are not relevant to tax accounting because GAAP
I Professor Stephen Shay provided much appreciated comments-for which he deserves no blame.
2 Over the last two decades-as a consequence of an unfortunate Supreme Court opinion-the rules
that control the capitalization of expenditures were given considerable attention. Until 1992, most thought that
only asset-related expenditures were subject to capitalization. See George Mundstock, Taxation of Business
Intangible Capital, 135 U. PA. L. REv. 1179, 1228-33 (1987). Then, in INDOPCO, the Supreme Court held that
any expenditure associated with a future benefit can be capital, without regard to whether the expenditure relates
to an asset. INDOPCO, Inc. v. Comm'r, 503 . 79, 86-88 (1992) (Blackmun, J.). Because it is possible to
view any expenditure as having some future benefit, INDOPCO could have disallowed almost all deductions. See
Mundstock, supra, at 1229-30. Treasury responded with regulations that (re)adopt the asset-related requirement.
Treas. Reg. § (a)-4(b) (2004). So, basically, the law went full circle.
The biggest financial accounting scandal of the last twenty years likely was Enron. Enron's biggest
accounting problem was breathtakingly abusive mark-to-market accounting. Kuir EIcIinNwAiLo, CONSPIRACY
or= Foois 54-61, 300-01, 375, 405 (2005); BEiTiANY MCLEAN & PiniuR ELKINi), Tint SMAlEn'sr Guys IN -IE
Room 39-42 (2003). But, Enron's transactions with non-consolidated related parties (that also were not
accounted for using the equity method) got the most press. Paul Healy & Krishna Palepu, The Fall of Enron 17 J.
ECON. PERSP. 3, 10-11 (2003). There is a tax lesson here: Tax law also needs better related-party rules,
particularly in the international context. George Mundstock, The Borders of . Tax Policy and .
Competitiveness, 66 U. MIAMI L. REv. 737, 752-53 (2012). These concerns are beyond the scope of this article,
however.
3 GAAP only applies necessarily to financial statements of public companies. See 15 . § 77s(b)
(2012). The biggest trade association of accountancy, the American Institute of Certified Public Accountants
("AICPA"), recently proposed its own set of rules for private firms. The Financial Reporting Framework for
Small- and Medium-Sized Entities (Am. Inst. ofCertified Pub. Accountants 2013), available at .
org/InterestAreas/FRC/AccountingFinancialReporting/PCFR/DownloadableDocuments/FRF-SME/FRF-
. The AICPA sells its proposal as simpler than GAAP, but the AICPA proposal's real
advantage over GAAP is that the proposal provides more flexibility-read, manipulability-to private businesses.
FASB's parent organization, the Financial Accounting Foundation, recently created the Private Company
Council, which competes with the AICPA project. Michael Cohn, FAF Ushers in New FASB and GASB Laders
with New Web Site, and Reignites Dispute with AICPA, ACCOUNTING TODAY (July 1, 2013), available at http://
html?ET=webcpa:e7330:405181a:&st=email.
27
28 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
rests on the principle of "conservatism." This has not been true since
2010. Many tax lawyers think that the only situation where GAAP
controls tax accounting is under the LIFO-conformity requirement.' In
fact, in many important cases, this is just not true. For example, an
accrual-basis taxpayer's basic accounting for core items of revenue and
expense can be controlled by GAAP. GAAP and tax provided bad
accounting for employee stock options because both assumed that most
such options were too difficult to value. Since 2006, however, GAAP has
rejected the no-value myth and requires valuation of employee stock
options. Tax law should follow. This article explores these and other tax-
accounting myths.'
I. GAAP: CONSERVATIVE IN PIUNCIPLE No
One of the most famous quotations in the tax-accounting literature is
from Justice Blackmun's opinion in Thor Power
Consistently with its goals and responsibilities, financial
accounting has as its foundation the principle of conservatism,
with its corollary that "possible errors in measurement [should]
be in the direction of understatement rather than overstatement of
net income and net assets."' [T]he accountant's conservatism
cannot bind the Commissioner in his efforts to collect taxes.'
Now this is just wrong-if only as a matter of general principles.
The now-rejected GAAP principle of conservatism, as Justice
Blackmun noted, arose out of the auditing process. A business's
management keeps the books and prepares the financial statements. The
"outside" Certified Public Accountant ("CPA") then audits the financial
statements. First, the auditor engages in detective work (the audit process)
to satisfy herself that the facts shown on the books are true. Second, the
auditor must satisfy herself that management's financial statements present
4 . S 472(c) (2012).
s The myths addressed in this article are false. It must be noted-however annoyingly pedantically-
that a myth is not necessarily false. A myth is something believed based on a common cultural understanding so
as to be accepted without regard to whether it is true or false. MERRIAM-WEBsrER DICIONARY, available at
6 [Court's Footnote 18:] "AICPA Accounting Principles Board, Statement No. 4. Basic Concepts and
Accounting Principles Underlying Financial Statements of Business Enterprises, 1 171 (1970), reprinted in 2 APB
Accounting Principles 9089 (1973). See Sterling, Conservatism: The Fundamental Principle of Valuation in Traditional
Accounting, 3 ABACUS 109-113 (1967)."
Thor Power Tool Co. v. Comm'r, 439 . 522, 542-43 (1979).
TAX ACCOUNTING MYTHS
the information on these books in accordance with GAAP in all material
regards. If so, the CPA can certify (attest to) the statements.'
In this process, management has skin in the game. Usually,
management wants to look like it is doing the best job possible in running
the reporting business. This can create irrational exuberance.
Conservatism was intended to put a balancing thumb on the scale.
Accountants were supposed to be less optimistic about the business. By
such push and pull, it was hoped, financial statements would serve their
users
But, conservatism presented its own problems. Managements are not
always overly optimistic. For example, they might want to make things
look bleak so that they can buy the stock of the reporting business at a low
price, say in a management-buyout transaction. More generally, there are
many people who stand to be hurt by accounting conservatism. Stock
sellers want the highest price possible. Conservatism could encourage low
prices. Conservatism also enabled managements to hide profits now and
book them later when it would benefit the For these
reasons, in 2010, the Financial Accounting Standards Board ("FASB"), in
a Statement of Financial Accounting Concepts, flatly rejected
conservatism as a continuing principle of financial accounting:
Deliberately reflecting conservative estimates of assets, liabilities,
income, or equity sometimes has been considered desirable to
counteract the effects of some management estimates that have
been perceived as excessively optimistic. However, even with the
prohibitions against deliberate misstatement that appear in the
existing frameworks, an admonition to be prudent is likely to lead
to a bias. Understating assets or overstating liabilities in one
period frequently leads to overstating financial performance in
later periods-a result that cannot be described as prudent or
neutral."
This 2010 Concepts Statement, while the highest possible authority
on . GAAP concepts, did not, in and of itself, change any of the FASB
8 GioRkGE MUNiDsTOCK, A FINANCE APiRoACI TO ACCOUNTING FOR LAWYERS 9-11, 100 (2d ed.
2006).
9 Id.
10 The classic way to do this is with a "cookie-jar" reserve (out of which profits can be pulled when
management wants a treat). See MUNDSTOCK, supra note 8, at 234-41.
" Statement of Financial Accounting Concepts No. 8 1 (Fin. Accounting Standards Bd. 2010).
2013]1 29
30 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
rules that apply to actual financial statements. 1 2 All of the old substantive
rules that are based on conservatism, such as the generous ability to write
down assets that concerned Justice Blackmun in Thor Power, continue in
force." But, presumably, as indicated in the just-quoted FASB
pronouncement, over time FASB will update its substantive rules that are
based on conservatism. For example, the new GAAP rules for sales with
multiple deliverables, discussed below, move away from the older, more
conservative, regime." As a consequence, the tax law no longer can
operate on the assumption that GAAP rules always are conservative. Most
interestingly, if GAAP develops as expected, the case against using GAAP
books for tax purposes-tax/book conformity-will become
considerably weaker."
II. GAAP Is NOT RELEVANT TO TAXEs, EXCEPT IN THE
REAL WORLD
The quotation from Justice Blackmun above also suggests that, in
general, GAAP is not particularly relevant in tax-accounting matters.'"
That is overwhelmingly the opinion of the courts.' 7 But, as a practical
12 A tax lawyer might be interested to know that, in 2009, FASB compiled all of is highest-level rule
pronouncements, the Statements of Financial Accounting Standards ("SFAS"), in the new Accounting Standards
Codification. Now, FASB's most authoritative new rules are published in Accounting Standard Updates, which
amend the Accounting Standards Codification. The old SFASs have no continuing authority. The Emerging
Issues Task Force of FASB ("EITF") examines technical matters that need relatively rapid attention. Consensus
positions of the EITF were published as EITF Abstracts. EITF consensuses now are reflected in the Accounting
Standards Codification and can be found in the Meeting Minutes of the EITF, which are available on FASB's
website. FASB Accounting Standards Codification Notice to Constituents (): About the Codification 7 (Fin.
Accounting Found. 2012), available at
3 FASB Accounting Standards Codification 330-10-35, 350-20-35, 360-10-35 (Fin. Accounting
Standards Bd. 2013), available at .
14 Infra text accompanying notes 37 to 38.
Is See generally John McClelland & Lillian Mills, Weighing Benefits and Risks of Taxing Book Income, 114
TAX Not is 779 (2007); Linda Beale, Book-Tax Conformity and the Corporate Tax Shelter Debate: Assessing the
Proposed Section 475 Mark-to-Market Safe Harbor, 24 VA. TAX Riv. 301, 309-86 (2004); Lee Sheppard, Financial
Accounting Conformity: Not the Silver Bullet, 101 TAX NOTEs 676 (2003) (were the tax law to reflect GAAP
conservatism, it would effectively repeal the corporate income tax).
16 Section 446(a) provides that a taxpayer's tax accounting method must be "the method of accounting
on which the taxpayer regularly computes his income in keeping his books." . S 446(a) (2012). This has
been interpreted, however, to require only that the business's books and records contain all information required
to apply the tax accounting method. SrEPHEN F. GERTZMAN, FEDERAi. TAX ACCOUNTING 1 [1] (1994 &
2012 Supp.). Additionally, Section 446(b) requires a tax accounting method to "clearly reflect income." .
§ 446(b) (2012). This also has not been interpreted to require that tax accounting follow GAAP. George
Mundstock, The Tax Import of the FASBIASB Proposal on Lease Accounting, 32 VA. TAX Rv. 461, 469-70 (2013).
i7 , supra note 16, .
TAX ACCOUNTING MYTHS
matter, GAAP has been read into tax-accounting rules that control the
timing of huge amounts of income, such as those controlling when
prepaid income is taxed and when accruals are allowed to be deducted.
This idea is explored immediately below.
A. Prepaid Income (Advance Payments)
Along with Thor Power, other particularly well-known tax accounting
cases include the "Trilogy" of Supreme Court cases dealing with the
timing of the taxation of prepaid income received by an accrual-basis
taxpayer: Automobile Club of Michigan," AAA," and
Collectively, these cases hold that an accrual-basis taxpayer is taxed upon
receipt of prepaid income even though, under GAAP, such income
cannot be booked upon receipt, and must be deferred, because it has not
yet been earned. The results in these cases are so inconsistent with
reality-after all, a prepayment is a loan to be paid off with goods or
services 2-that the government has been sprinting away from the Trilogy
ever since.
As to the sale of goods, a 1971 Treasury regulation 22 basically adopts
GAAP for tax purposes. The regulation allows the taxation of
prepayments to be deferred until the goods are delivered, which is the
time at which the revenue is booked under GAAP (and thus when the
cost-of-goods-sold expense is booked for tax and financial accounting
purposes). Specifically, section -5(b)(1)(ii)(a) of the regulations
allows a taxpayer to defer sale-of-goods revenue until "no later than the
time such advance payments are included in gross receipts for purposes of
all of his reports (including consolidated financial statements) to
shareholders, partners, beneficiaries, other proprietors, and for credit
purposes . . . ." With sales of inventory for substantial advance payments,
however, which is an important application of the regulation, the
18 Auto. Club of Mich. v. Comm'r, 353 . 180 (1957).
19 Am. Auto. Assoc. v. United States, 367 . 687 (1961).
20 Schlude v. Comm'r, 372 . 128 (1963).
21 A closely-related case is Indianapolis Power. Comm'r v. Indianapolis Power & Light Co., 493 . 203
(1990) (tax years 1974-77). It tries to distinguish between "advance payments," which are taxable as received, and
"deposits," which are not so taxable, since viewed as loans ab initio. Justice Blackmun noted that the parties
expect deposits to be returned in cash, while advance payments are expected to be paid in services or non-cash
property. The amounts in controversy were deposits-based on the Court's assumptions as to the expectations of
the parties-even though the Court acknowledged that this was inconsistent with the actual practice. Id. at 211-
14.
22 Treas. Reg. § -5 (1971).
312013]
32 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
maximum deferral is two tax
Thus the Trilogy cases do not apply to the principal type of revenue
for many businesses, sale-of-goods revenue, albeit, for just two years. For
example, in fiscal year 2012, 66% of General Electric's (including GE
Capital Services) book revenue was from the sale of 4
Beyond this regulation, the IRS administratively permits accrual-basis
taxpayers to use GAAP deferral for most other types of prepaid revenue
for one year. Revenue Procedure 71-2125 announced a practice of
allowing taxpayers to defer the taxation of prepaid income that is deferred
under GAAP for one year. In the practice's current implementation,
Revenue Procedure 2004-34,26 the IRS allows one year of deferral with
respect to advance payments for a wide variety of items, including
prepayments for the following categories:
(a) services;
(b) the sale of goods (other than for the sale of goods for which
the taxpayer uses a method of deferral provided in -
5 (b) (1) (ii));
(c) the use (including by license or lease) of intellectual property
(d) the occupancy or use of property if the occupancy or use is
ancillary to the provision of services. . .
(e) the sale, lease, or license of computer software;
. . . and
(j) any combination of items described [above].27
Basically, for almost every conceivable type of prepaid income (that does
not involve finance or the rental of tangible property), if GAAP allows
deferral, one year of deferral is allowed for tax
23 Id. at § -5(c)(1). A cost-of-goods-sold deduction is then allowed. Id.
24 General Electric Co., Annual Report (Form 10-K), 92 (Feb. 26, 2013).
25 1971-2 . 549.
26 Rev. Proc. 2004-34, 2004-1 . 991, amended by Rev. Proc. 2011-18, 2011-1 . 443; Rev. Proc.
2013-29, 2003-33 . 141.
27 Id. (3).
28 Id. . In Indianapolis Power, supra note 21, at 204, the taxpayer wanted many years of deferral.
Presumably one year of deferral would have been available under Revenue Procedure 71-21, the predecessor of
Revenue Procedure 2004-34. See supra notes 26 to 27.
TAX ACCOUNTING MYTHS
B. Multiple Deliverables
The rules for deferral of prepaid income apply interestingly to an
accounting issue that has received considerable attention in the financial-
accounting context during the last decade: revenue from a sale with
multiple deliverables. 29 FASB relaxed conservatism, which had interesting
tax consequences.
The classic example of a sale with multiple deliverables is Apple selling
an When a customer buys an iPhone, the customer is buying
from Apple (usually through a wireless carrier) multiple items (the phone,
the software thereon, the right to software updates, and the right to
customer service)."' The obvious question is when the associated revenue
is recognized for GAAP and tax purposes. Before the 2009 changes to
GAAP,32 revenue from a sale with multiple deliverables was recognized
pro rata over the longest possible period unless the seller had "objective
evidence" to support breaking the sale into the component, separately
deliverable, pieces-most importantly, so as to recognize the allocated
sale-of-goods revenue earlier than otherwise, upon delivery of the
goods." Objective evidence consisted of sales of the pieces separately by
the reporting business or sales of very similar items separately by third
parties. Apple does not sell any part of the iPhone package separately
and views nothing sold by others as similar to any deliverable involved in
the sale of an iPhone. Under pre-2009 GAAP, this meant that Apple
recognized revenue from iPhone sales pro rata over two 1 In
contrast, for example, under the pre-2009 rules, Microsoft was able to
book much of the revenue on its sales with multiple deliverables early by
using objective evidence to break a sale in the separate deliverables. 6
29 See Marie Leone, New Revenue-Recognition Rules: The Apple of Apple's Eye? CFO (Sept. 16, 2009),
available at 2984368?f=rsspage.
30 Id.
31 Id. This article dodges the dicey issue of whether the "sale" of software is treated as a sale or license
for tax purposes. But, an iPhone sale involves a tangible iPhone, so that the transaction clearly involves, inter alia,
a sale of a good.
32 Minutes of the Sept. 9-10, 2009 Meeting of the FASB Emerging Issues Task Force, 84-102 (Fin.
Accounting Standards Bd.), available at
FASB%2FDocumentC%2FDocumentPage&cid= 1176156480875.
3 Software Revenue Recognition, Statement of Position 97-2 (Am. Inst. of Certified Pub.
Accountants), available at 176156405418&pid=
1218220137031. On this issue, the AICPA beat FASB to the punch.
34 Id.
3s Apple Inc., Annual Report (Fomi 10-K), 63 (Oct. 27, 2009).
36 Microsoft Corp., Annual Report (Form 10-K), 38-39 (uly 30, 2010).
2013] 33
34 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
Then, FASB moved away from conservatively requiring objective
evidence to divide up a sale with multiple deliverables. Now, a seller such
as Apple can use best estimates to break a sale down into pieces. This
change alone gave Apple, for fiscal year 2009, a 31% increase in total gross
margin (total net revenues less total cost of sales)-from $ billion to
$ billion-and a 44% increase in profit-a $ billion increase.
This move away from GAAP conservatism involved serious money!
This change in GAAP had some interesting tax ramifications. In
many cases, such as with Apple, most or all of the consideration with
respect to a sale with multiple deliverables is received before it may be
recognized under 9 Thus all revenue would be taxed up front
under the Trilogy cases, even for accrual-basis taxpayers. But for sales
involving bundled software and services, Revenue Procedure 2004-34
makes deferral available. The revenue procedure contains examples in
n FASB Accounting Standards Codification, supra note 13, Subtopic 605-25.
38 Apple Inc., Amended Annual Report (Form 10-K/A), 34-37 (Jan. 25, 2010). The higher percentage
increase in profits than in gross margin was due to the additional revenue bearing no additional expenses other
than taxes.
Because of the considerable publicity given well in advance to Apple's accounting change, the
announcement of the huge spike in earnings had negligible effect on the price of its stock. Associated Press,
Ahead of the Bell: Apple Shares Rise (an. 26, 2010), available at
01/26/ahead of thebell-apple sharesrise/.
A tax lawyer might ask whether Apple's restated 2009 earnings reflected not only 2009 sales but also
profit on prior-year sales that had been deferred under the old accounting method. That would be the tax result.
. § 481 (2012). Under GAAP, however, when an accounting method is changed, rather than a current
adjustment so that all income is booked once and only once (the tax rule), a reasonable number of prior-year
financial statements are restated. FASB Accounting Standards Codification, supra note 13, 250-10-50-1. Before
and after a change in GAAP methods, each year stands on its own. Under these circumstances, the increase in
Apple's 2009 GAAP earnings as a consequence of the change seems shockingly large. After all, the pre-change
2009 earnings included large amounts with respect to earlier year sales of iPhones (albeit relatively little for 2009
sales), while the post-change 2009 earnings mostly reflected 2009 sales (albeit almost the entire amount thereof).
For the change to be so large, 2009 iPhone sales would have had to have been considerably larger than prior years'
sales. In fact, they had increased 93%. Apple Amended Report, supra, at 10.
This illustrates a general point about accounting rules: Averaging and consistency reduce the impact
of accounting rules. In comparing the results of two, different, accounting rules for the same item, if the two
rules both are applied consistently from year to year, in a given year, their internal year-to-year differences offset,
so that the difference between the two in a given year is an average (across the years) difference. See
MUNDSTOCK, supra note 8, at 118-20. Under these circumstances, the details of the applicable accounting rules
have the most impact with respect to businesses that change from year to year, such as growing and contracting
businesses. Id. Apple's iPhone business was growing, so that the accounting rules applicable thereto made a big
difference. The tax flip-side of averaging is that unwarranted deferral allowed a growing business will not be
recaptured until the business starts shrinking.
39 Matt Philips, Apple Earnings: The iPhone Accounting Issue, WSJ BLOGS (Jan. 25, 2010), available at
TAX ACCOUNTING MYTHS
which the tax accounting follows GAAP on the issue of breaking the sale
into pieces."() And the revenue procedure allows taxpayers to divide a
transaction into a piece for which deferral is allowed and a piece for which
it is not, so as not to disqualify the entire transaction-so long as this
division can be done on the basis of "objective criteria."' Separate sales
of the pieces satisfy the "objective criteria" 2 So, for
example, Microsoft can defer services and software licensing revenue
associated with the sale of an 3
This leaves open the treatment of Apple and other beneficiaries of the
2009 GAAP change. If, unlike Apple, only software and services were
involved and the business was applying the revenue procedure to the
transaction as a whole, the GAAP acceleration also would have sped up
the taxation." This is tremendously interesting, because it illustrates how
the tax law can benefit as GAAP becomes less conservative.
Some businesses, like Apple, however, sell goods along with
deliverables covered by the revenue procedure. Lacking "objective
criteria," these sales presumably were not covered by the revenue
procedure (because goods are involved) or section -5 (because
services are involved). All revenue was thus taxed up front under the
Trilogy cases. Now, however, GAAP has increasingly relaxed rules
regarding the evidence required to separately account for multiple
deliverables. Arguably, this new GAAP now contains "objective criteria."
If so, the acceleration of GAAP revenue could paradoxically defer the
taxation of the transactions. Regardless, this is not troubling, because the
results of applying the Trilogy cases here are so harsh. It does border on
the use of estimates, however, which so troubled Justice Blackmun in Thor
Power.
Accounting for sales with multiple deliverables illustrates how things
have changed in tax accounting. Rules are needed for new transactions,
and GAAP adapts by becoming less conservative. The tax law then
benefits by following GAAP.
40 Rev. Proc. 2004-34, supra note 26, § (Examples 18 through 22).
41 Rev. Proc. 2004-34, supra note 26, § (4)(A).
42 Rev. Proc. 2004-34, supra note 26, § (4)(C).
4 See Microsoft, supra note 36, at 8, 49.
44 Section 446(e), generally, and Revenue Procedure 2004-34, specifically, provide rules for a change in
a tax accounting nethod. . § 446(e) (2012); Rev. Proc. 2004-34, supra note 26, § 8.
2013] 35
36 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
C. Accrued Expenses
GAAP also controls many real-world deductions of accrual-basis
taxpayers. The "economic-performance" test of section 461(h), enacted
in 1984, was supposed to prevent this. In fact, due to the recurring-item
exception of section 461(h)(3), the 1984 legislation expanded GAAP's tax
role.
Before 1984, most tax experts thought that a tax deduction was not
allowed for estimated amounts to be paid in the future, particularly such
an amount as to which the identity of the actual payee was not yet known.
For example, in the above quotation from Thor Power, Justice Blackmun
rejected tax deductions based on 5 Only completed transactions
justify a tax deduction. Notwithstanding this near consensus, in 1984, a
few judicial opinions (and presumably-then-well-known, pending
controversies46) had shaken this ' Also, in that time of high interest
rates, there was a concern for overstated current deductions with respect
to future amounts that were not discounted to reflect the time value of
8 in response, Congress enacted section 461(h) in 1984, which
prevents taxpayers from deducting an amount until "economic
performance." 49 Under the 1984 limit, before a deduction is allowed,
there must be a real (., not executory) transaction, such as the payment
45 Supra text accompanying note 7.
46 Ford Motor famously settled personal injury lawsuits by agreeing to "structured settlements":
promising defendants annuity payments over time. Ford immediately deducted the total amount thereof (with no
discounting to reflect the time value of money or hidden interest). This caused the current tax savings to exceed
the present value of the promised future payment. See Ford Motor Co. v. Comm'r, 71 209 (6th Cir. 1995)
(rejecting such deduction for tax year 1980). In Hughes Properties, the Supreme Court allowed the taxpayer, a
casino, a current tax deduction for estimated future payoffs to be made on "progressive" slot machines attributable
to play on the machines during the current year. (The more that a progressive slot machine is played during a year
without a winner, the bigger the payoff in the later year when there ultimately is a winner.) Hughes Props., Inc.
v. United States, 5 Cl. Ct. 641 (1984), affd, 760 1292 (Fed. Cir. 1985), afd, 476 . 593 (1986)
(Blackmun, J.).
47 . Rep 98-432, Part 2, at 1252-53 (1984).
48 . Rep 98-432, Part 2, at 1253-55 (1984). Some tax lawyers do not appreciate how sensitive
GAAP is to the time value of money. See, , MICiAEL LANG, Eiiiorr MANNING & MONA HYMEL, FEDERAL
TAx AccouNriNG 37 (2d ed. 2011) ("Financial accounting ... has historically had one very serious defect: It
has ignored the time value of money . . . ."). Since 1971, GAAP has required adjustment of obligations with a
term in excess of one year to reflect hidden interest. Interest on Receivables and Payables, Accounting Principles
Board Opinion No. 21 (Am. Inst. ofCertified Pub. Accountants 1971) (codified at FASB Accounting Standards
Codification, supra note 13, Subtopic 835-30). However, the rules for allowances (reserves), a product of
conservatism, do not expressly deal with the time value of money. See id. Topic 450.
4 . § 461(h) (2012).
2013] TAX ACCOUNTING MYTHS 37
of
To prevent undue disruption in taxpayers' tax-accounting practices,
however, the 1984 Act's Conference Comirttee added a "recurring
item" exception5 ' to the economic-performance To be
"recurring," an item need only repeat periodically. Additionally, to
qualify for the exception, an item must be either (i) "immaterial" or (ii)
such that the early deduction effects better "matching."5 4 The regulations
indicate that GAAP is vital in applying the materiality and matching
requirements, but does not always control. 5
Under the recurring-item exception, for example, a manufacturer can
deduct year-end additions to GAAP allowances (reserves) (i) with respect
to payments expected on discount coupons and (ii) with respect to returns
expected. These can be large amounts. John Wiley & Sons reported total
fiscal year 2012 (net) revenue of $218 million, while the total amount of
the allowance for returns at the end of the year was $36 6 So,
so Id.
st Id. at § 461(h)(3). There is a potential reason that the exception applies only to recurring items. If an
item occurs every year, the amount thereof stays constant from year to year, and the item is accounted for
consistently from year to year, then the accounting method for the item has no impact on a given year. See supra
note 38. The exception is not limited to such situations, however. See Treas. Reg. § -5(b)(3) (as amended
in 1995).
In addition to being recurring, another requirement for deducting an item early under Section
461(h)(3) is that economic performance with respect thereto occurs by the earlier of (i) 8-1/2 months after the
end of the year or (ii) when the taxpayer files its return for year. Treas. Reg. § -5(b)(1)(ii) (as amended in
2001). The idea seems to be that the taxpayer must know that economic performance has occurred before
claiming a deduction. See . Rep. No. 98-861, at 873 (1984) (Conf Rep.). The statute also contains a
consistency requirement, as does GAAP. . § 461(h)(3)(A)(iii) (2012); Statement of Financial Accounting
Concepts No. 8., supra note 11, QC22.
52 . Rep. No. 98-861, at 873 (1984) (Conf. Rep.).
53 Treas. Reg. § -5(b)(3) (as amended in 1995).
5 . § 461(h)(3)(A)(iv) (2012).
5s Treas. Reg. %§ -5(b)(4), (5) (as amended in 1995). These regulations are supported by language
in the 1984 Conference Committee report. . Rep. No. 98-861, at 873-74 (1984)(Conf. Rep.). As to
materiality, since 1984, when Section 461(h) was enacted, accountancy's approach has evolved so as to take into
account more subjective factors (and thus to make it less relevant to the Section 461(h) issue). See SEC Staff
Accounting Bulletin: Codification of Staff Accounting Bulletins Topic (2011) [hereinafter SAB
Codification].
56 John Wiley & Sons, Inc., Annual Report (Form 10-K), 53, 57 (June 26, 2012). Note that the $36
million is the year-end allowance. This likely contains some amount for expected returns with respect to sales
made in years before 2012, so that the $36 million likely is larger than the reduction in 2012 revenue.
Unfortunately, annual reports usually do not provide detail as to the adjustments to the returns allowance.
Nevertheless, the $36 million illustrates the scale. The 2011 year-end allowance was $49 million. (The reduction
in 2012 likely was due to a large amount of returns during the year.) The example was chosen because textbook
publishers are known to have a high volume of returns.
38 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
basically, for many normal business deductions, GAAP trumps economic
performance.
1. (Nonqualfied) Compensatory Stock Options: What's Old Is New
Again
A corporation's compensation amount (expense or capital item) when
it rewards employees with (call) options on its stock has caused problems
for both GAAP and the tax system-and for the same reason: Non-
traded options can be hard to value. Historically, the different approaches
taken by the two accounting regimes gave businesses the best possible
outcome under both (no GAAP expense, ever, and the largest conceivable
tax deduction)." FASB, in response to abuse during the tech bubble,
finally adopted reasonable GAAP. FASB recognized that, due to
developments in finance modeling, it is possible to approximately value
options." Tax law should follow GAAP and eliminate current law's
unjustifiable loophole. In this highly public context, for the tax law to
respect GAAP estimates-and thereby reject the myth that such options
cannot be valued-would be an unconditional win.
In a typical compensatory-stock-option transaction, a corporate
employer grants (awards) an employee an option to buy the employer's
stock at the current market price (sometimes adjusted over time by some
market index). The option cannot be exercised for some (vesting) period,
say three years. All of the option might vest at the end of the vesting
period (cliff vesting) or the amount of stock covered by the option might
vest proportionately over the vesting period. If the employee's
employment terminates before the end of the vesting period, all unvested
rights lapse. The option may lapse after the first possible exercise day or
may continue for some period thereafter. Usually, any stock acquired by
exercise is transferable (to the extent that other shares of the employer
are) .
57 Infra text accompanying notes 62 to 63 and 67 to 69.
58 Infra text accompanying notes 64 to 66.
s See Buimmu o LABOR STATrISTICS, NATIONAL COMPENSATION SuRviiY: GIossAcY OF
EMPLOYEE BENEFITf TERMs (2011), available at LucAN
BaBCUK & JESsE FRIDi, PAY Wrionour PERIORMANCE 137-73 (2004). In 2005, it came to light that
thousands of companies seemed to have backdated the grant of compensatory options to a date when the stock
prices were lower so that the recipient employees received more. About 150 companies amended their financial
statements to correct the error. Twelve executives were convicted of criminal backdating. See Peter Latuman,
Backdating Scandal Ends With a Wiinper, . TIMEs DEALBOOK (Nov. 11, 2010), available at http://dealbook.
11/11/backdating-scandal-ends-with-a-whimper/.
TAX ACCOUNTING MYTHS
It is important to distinguish between two separate aspects of a
compensatory-stock-option transaction. First, the employee invests in the
employer By accepting the option instead of cash, the
employee gets a long position in the corporation. That investment
increases in value when the company's stock goes up in (forward) value.
Second, the transaction involves 1 The receipt of the
option is intended as payment for services. Also, to the extent that the
employee's good work increases the value of the company, the associated
increase in the value of the option also is compensatory. The key to good
accounting here is to carefully distinguish and separately account for the
two aspects.
An example illustrates these points: A company grants a call option to
an employee. The option vests five years after the day it is granted. After
the five years, the employee can buy 1,000 shares of the company's stock
for $100 a share, the market value on the day of the grant. The employee
stays with the company for the five years and exercises the option at a time
when the stock is trading at $225 a share. The employee buys $225,000
worth of stock for $100,000, so as to be in a position to make an
immediate $125,000 profit.
Economically, the employee earned the option over the five-year
vesting period. The option had value at the time of grant, say $10,000.
(Even though the stock was then trading at the exercise price ($100 a
share), the right to lock in that price for five years has real value, although
that value can be hard to determine without a market for the option (or
similar options).) By taking the option instead of cash, the employee is
investing in the company. The $120,000 increase in the value of the
option is in most cases just a return on the investment in the option. Of
course, a particularly effective employee may be able to increase the value
of the company's stock so that some of the $120,000 increase in the value
of the option is attributable to her services.
Under GAAP as in effect prior to 2006, the transaction was viewed as
involving only investment. As a consequence, no expense of any kind was
booked. At the time of grant, the real cost of the compensation was hard
to value and contingent and so not Later, the exercise of the
60 Comil. on Accounting Procedure, Compensation Involved in Stock Option and Stock Purchase
Plans, Accounting Research Bulletin No. 43, Chapter 13, Section B, M 4, 5. (Am. Inst. of Certified Pub.
Accountants 1954) [hereinafter ARB 43], available at
9620.
62 Id. at 3.
62 Accounting for Stock-Based Compensation, Statement of Financial Accounting Standards No. 123,
2013] 39
40 UNIVERSITY OF MIAMI BUSINESS LAW REVIEW [Vol. 22:27
option to buy stock for less than its market value at such time was a capital
3 There is no cash expense, just the dilution of the other
shareholders. Future earnings per share would be reduced, but there was
no expense, per se.
The tech bubble changed things. The public realized that most of the
earnings of tech companies would have been eliminated had stock
compensation been reflected on their income 4 First, the
International Accounting Standards Board required that options be valued
at the time of grant and that such amount treated as compensation pro rata
over the vesting period (with appropriate adjustments if the employee
leaves and the option rights forfeit).6 s Then, under this political cover,
FASB adopted the same basic regime, effective in So, now,
compensation treatment for the initial value of the option is booked
(although any compensatory aspect of the increase in value of the option
over the vesting period still is not treated as compensation). In the
example above, the employer is treated as incurring $10,000 of wages over
the five-year vesting period. Exercise has no impact on the income
statement.
In contrast, the tax rules for (non-qualified) compensatory stock
options have been stable for a very long ' The tax law takes the
opposite approach as pre-2006 GAAP and treats the transaction as entirely
compensatory. Unless the option is transferable and of a type that is
readily valuable (., publicly traded), there is no compensation income or
expense at the time of 8 At exercise (assuming that the stock
5 (Fin. Accounting Standards Bd. 1995), available at
FASB%2FPage%2FPreCodSectionPage&cid=1218220137031#fasl25; Accounting for Stock Issued to
Employees, Accounting Principles Board Opinion No. 25 (Am. Inst. of Certified Pub. Accountants 1972) 5,
10, available at ARB 43, supra note 60, 1| 8.
63 ARB 43, supra note 60, 8.
64 Michelle Kessler, Tech Finns Balk at Expensing Options, USA TODAY (July 29, 2002), available at http:/
/ .
65 Share-Based Payment, International Financial Reporting Standard 2, 110 (Int'l Accounting Standards
Bd. 2004), available at
66 Share-Based Payment, Statement of Financial Accounting Standards No. 123 (revised 2004), IM 11,
69 (Fin. Accounting Standards Bd. 2004), available at
pagename=FASB%2FPage%2FPreCodSectionPage&cid=1218220137031#fasl25.
67 For a complete analysis of current law and its development, see BoRis I. BirrKER & LAWRENCE
LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES AND Girrs (2012). As to qualified options, which
are not discussed in this article, see . § 422 (2012). A qualified option provides tax benefits to the employee
at the cost of the employer's deduction. Id.
68 . § 83(e)(3) (2012); Treas. Reg. %§ -7 (as amended in 2004), -1(b)(5)(i)(A) (as
amended in 2007).
TAX ACCOUNTING MYTHS
acquired is transferable), the entire purchase discount afforded by the
option is compensation income and expense (provided that the
compensation otherwise would be deductible)."9 Lapse has no tax effect.
The tax law conservatively waits to the last instant to value the option,
thereby effectively ignoring the investment aspect of the transaction. In
the example, at exercise, the employer has a $125,000 deduction and the
employee has $125,000 of income.
This tax regime is, at best, On the deduction side,
the employer is allowed to treat the entire value of the option as
compensation at the time of exercise. Most of that value should not be
viewed as compensation because it is in fact a return on the very real
investment by the employee in the employer. A deduction is deferred
until exercise (or later if the compensation is capitalized), but it seems
unlikely that such deferral exactly reduces the present value of the
deduction to equal that of a deduction for only the compensatory portion
of the transaction. In the stylized example, a $125,000 deduction in the
fifth year is considerably more valuable than $10,000 spread over five
years. The employee is taxed on the entire value of the option at exercise
as ordinary income (rather than capital gain), even though some of the
profit represents a return on an investment. In the example, $115,000 of
the $125,000 profit can be viewed as capital gain.
As to employers, the tax law should follow the lead of the new GAAP
rules." Since 2007, Senator Carl Levin has periodically introduced a bill
that would require that the tax deduction of an employer (accrual or cash-
basis) conform to that on the employer's "report or statement" of
"income, profit, or loss." 72 Under the bill, in the example above, the
employer would be limited to a deduction of $10,000 spread over five
years. The bill has garnered support from, among others, the AFL-CIO
and Citizens for Tax 3
The Levin bill's new deduction limit seems poorly targeted. Many
69 . % 83(a), (h) (2012); Treas. Reg. § -7 (as amended in 2004).
70 For a general critique of the defects in current law, see Daniel Halperin, A Fairer and More Effective
Approach to Deferred Compensation, 103 TAX Nons 1187, 1187-90 (2004).
7i Exercise would have no tax impact. The GAAP rules also would improve the taxation of restricted
stock, but there has been no change in GAAP here for some time, so that restricted stock is not considered in this
article.
72 See, ., S. 1375, 112th Cong. § 2 (2011); S. 2116, 110th Cong, § 2 (2007). These bills would not
change the tax treatment of the employee.
73 Press Release, Levin-Brown Bill Would End Corporate Stock Option Tax Break, Reduce Deficit by
$25 Billion (July 15, 2011), available at
would-end-corporate-stock-option-tax-break-reduce-deficit-by-25-billion#.
2013] 41
42 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
public companies have statements in addition to GAAP financials. Which
control? Private companies have the luxury of keeping the current
overstated deduction, with little business impact, simply by using the
current tax accounting on their non-GAAP 1
A better first pass would apply the new limit to accrual-basis corporate
employers and not to cash-basis employers. As a general matter, accrual-
basis corporations already deal with the complexities of accrual
accounting and so are best situated to deal with the burden of proper
accounting for stock-option compensation. Today, most corporations are
required to use an accrual ' Thus, under the suggested rule, very
few employers would be subject to GAAP-like accounting. If there is
concern that this would be an unfair additional relative preference for the
corporations already allowed to use the cash method, a possible rule for
these employers might be for the IRS to provide tables for valuing the
options so as to apply the general rule. The tables could be based on the
total exercise price and the term of the 1 Conversely, given how
broadly the accrual method applies today, exceptions may once again be
needed for accrual-basis corporations for which valuing an option might
be too burdensome. Again, IRS tables could be provided as a substitute
for real valuations.
Virtually all employees use the cash method of accounting for tax
purposes with respect to their employment. The economics of option
compensation suggest that the compensatory aspect should be taxed using
the new GAAP accounting. Employees would be taxed under their
employers' method of accounting, which means accrual of compensation
for all involved. This regime would tax employees prior to the receipt of
the cash with which to pay the tax, which generally does not happen with
cash-basis But current law taxes exercise, at which time the
7 The AICPA proposal for a financial accounting regime for smaller firms, discussed supra note 3,
expressly adopts the old GAAP rule-no expense ever-for stock option compensation. Am. Inst. of Certified
Pub. Accountants, supra note 3, 1 . This presumably reflects a judgment that valuing options is too
burdensome for such firms.
75 A corporation must use an accrual method of accounting for tax purposes unless either (i) it is a
personal service corporation, (ii) it has less than $5 million in annual gross receipts, or (iii) it is a qualified farming
business. . § 448 (2012).
76 The key missing input to this valuation is the riskiness of the stock, which is the heart of the valuation
problem that led to old GAAP and the current tax law. Section -7(b) (3) of the regulations identifies that the
three key inputs required to value an option are (i) the value of the underlying property, (ii) the duration of the
option, and (iii) the riskiness of the underlying property. Treas. Reg. § -7(b)(3) (as amended in 2004).
n GERTZMAN, supra note 16, , .
7s Id. at [2].
TAX ACCOUNTING MYTHS
employee still has no cash with which to pay the tax, so the proposal
would create no new hardship. For example, SPRINT (the
communications company) famously got bad press when its CEO used a
questionable tax shelter in an attempt to defer his tax on the exercise of his
stock 1 Permitting employees to pay the tax (plus interest) at a
later time, say at exercise, can mitigate any hardship arising out of the early
taxation."
The amount treated as investment profit under GAAP could be taxed
as capital gain on exercise as under current law. But, the current tax at
exercise is based on the view that this is compensation income. If viewed
as investment profit, exercise should not be taxable, per se, because call-
option exercise generally is not taxable." The acquired stock would have
a basis equal to the already-taxed compensation income (plus any further
amount paid for the stock).8 2 All investment profit would be taxed as
capital gain when the stock itself is sold. If the option lapses, a capital loss
would be allowed for the amount previously taxed as compensation
But, arguably, current GAAP still does not provide for perfect
accounting. If the employee is in a position to increase the price of the
employer's stock, some of the amount treated as investment profit under
GAAP (in the example above, some portion of the $115,000 profit on the
option) can be viewed as compensation-analogously to, say, cash-
incentive compensation based on profits. After all, a classic justification
for stock-based compensation is to reward employees for performance.
How best to determine the compensation portion of option profit is not,
however, obvious. Consequently, at this juncture, it seems best to adopt
the view of accountancy that any profit on the option itself is not
compensation.
79 David Cay Johnston & Jonathan Glater, Tax Shelter Is Worrying Sprint's Chief . TIMiS (Feb. 6,
2003), available at
80 For example, Section 444 allows taxpayers to defer the taxation of income by using certain otherwise
not allowable tax years, but requires an interest charge determined under Section 7519. . § 444 (2012).
There would be no need for a mechanism like current Section 83(b), which, in the case of most property
compensation, but not options (that are not of a type that is publicly traded), allows taxpayers to choose early
taxation in exchange for being able to put a low value on the property.
si JAMS Eusnci & Ti-oMAs , FiDERAL INCOME- TAXATION OF CORPORATIONS AND
S1-IAREllOLDERs 1 (2013).
82 Id.
83 Id.
2013] 43
44 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
III. WHAT CONDITION CONDITIONs ARE IN
Changes in how state law and GAAP view conditions upon
obligations that are provided for in private contracts also should change
how an accrual-basis taxpayer accounts for revenue. An accrual-basis
taxpayer reports income when "all events" that are required to fix the
taxpayer's right to the income have occurred." "All events" does not
mean absolutely all events, however. A contractual condition upon
completion of a revenue-generating transaction may be viewed as an
event. The courts and the IRS, however, have limited the circumstances
in which contractual conditions justify deferral of income. Under their
analysis, only "conditions precedent" must have occurred for income to
be recognized. "Conditions subsequent" do not prevent income
S1 85
recognition.
As a matter of contract-law theory, the 1981 Restatement (Second) of
Contracts eliminated the distinction between a "condition precedent" and
a "condition subsequent."" The Reporter's Notes to the Restatement
indicate that this change was based on analysis originally presented by
Justice Holmes in The Common Law," which was first published in 1881.
There, Justice Holmes observed as follows:
84 Treas. Reg. S -1(a) (as amended in 1999). The "all events" test also applies for purposes of
determining the proper time to accrue a liability with respect to an expense. Treas. Reg. § -1(a)(2) (1960).
For that liability to result in a deduction, however, the expense also must satisfy the "economic performance" and
other requirements, so that the "all events" test is less interesting in the deduction context. Id. For this reason,
this article focuses on the income side.
8 See generally BriFKEt. & LOKKEN, supra note 66, ; GERTiZMAN, supra note 16,
[1][a][i]; George L. White, BNA Tax Management Portfolios . Income Series: Income Tax Accounting 570-
3rd: Accounting Methods - General Principles T (2009); discussion infra notes 89 to 91 and accompanying
text.
86 RESTATEMENT (SECOND) OF CON TRACTs % 224, 230 (1981) [hereinafter RESTATEMENT]. As a
matter of contract law, the practical effect of the old distinction was that a party suing on a contract was required
to plead and prove that "conditions precedent" were satisfied, while a defendant raised "conditions subsequent."
RESTATEMENT, supra, § 224 (Reporter's Notes); OI-UVcmR WENDELL HOiLMES, JR., TiHE COMMON LAW 316-18
(1881), reprinted ini OIVER WENDELL HOLMES, JR., THiE COMMON LAW AND OTiHR WRITINGs (1982).
There is a formal distinction between events that must occur for a liability to arise (roughly the old "condition
precedent," now just a "condition") and events that can discharge a liability (roughly the old "condition
subsequent," now with no special name). RESTATEMENT, supra, %§ 224, 230; HOLMES, supra, at 318. Using the
distinction can help understand the meaning of a contract. Id. But, the distinction is irrelevant in actually
deciding contract cases: If either type of event happens (or does not happen, depending upon how the
requirement is drafted), there is no contract liability, period. RESTArEMENT, supra, %§ 224, 230; HO-LMrs, supra,
at 316-318.
87 RESTATEMENT, supra note 86, 5 224 (Reporter's Notes).
TAX ACCOUNTING MYTHS
But all conditions are precedent . . . to the existence of the
plaintiffs cause of action. . . . When a man sues, the question is
not whether he has had a cause of action in the past, but whether
he has one then."
An example illustrates the tax stakes: A high-end loudspeaker
manufacturer sells only online. Consumers will not buy expensive
loudspeakers without first listening to them. The manufacturer could deal
with this very real problem by using either of two different contractual
arrangements. In the first, the manufacturer would sell a pair of speakers
to a retail customer, shipping new speakers on the day after receiving the
order. Title to the speakers would pass upon delivery. The manufacturer
would take the customer's credit-card information, but promise not to bill
for thirty days. The customer would have thirty days to return the
speakers in good condition to get full credit.
The second contractual arrangement, which involves "loaning"
speakers, is slightly different: New speakers would be shipped on the day
after an order is received. But in this second case, title would stay with the
manufacturer. The customer would be required to return the speakers in
good condition within thirty days, unless, before the end of the thirty
days, it notifies the manufacturer that it wants to buy the speakers. As a
consequence, the buyer would bear the practical benefits and burdens
with respect to the speakers upon delivery even though legal title stays
with the manufacturer. The manufacturer would keep the customer's
credit-card information as security. If the customer exercises its option to
buy the speakers, title would at that time pass and the credit card would be
charged.
Obviously, these two arrangements are very similar. Yet, under
current law, they are subject to different tax treatment. In the first, the
manufacturer has gross income upon delivery (or shipment)" of the
speakers. The unconditional right of return is merely a "condition
subsequent," which is not relevant to the determination of gross
8 HOLMES, supra note 86, at 317.
8 The current tax regulations give manufacturers some flexibility between reporting revenue front a sale
of a good (when there is no "condition precedent" to getting paid) upon (i) delivery or (ii) shipment, so long as
the method used for tax purposes also is used on the taxpayer's books and is acceptable under generally accepted
accounting principles. Treas. Reg. § -1(c)(1)(ii)(C) (1960). In 1999, the SEC made clear that revenue is to
be booked for financial accounting purposes upon "delivery" (when "the seller has substantially accomplished
what it must do pursuant to the terms of the arrangement. . . ."). Revenue Recognition in Financial Statements,
SEC Staff Accounting Bulletin No. 101, 64 Fed. Reg. 68936, 17 Part 211 (Dec. 9, 1999). This should
have reduced taxpayers' tax-accounting flexibility under the regulation.
2013] 45
46 UNIVERSITY OF MIAMI BUSINESS LAWREVIEW [Vol. 22:27
0 In contrast, in the second case, the manufacturer can defer the
gross income. The customer's decision whether it really wants the
speakers is a "condition precedent" to "all events" that fix the
manufacturer's right to the income having '
Since a 1999 . Staff Accounting Bulletin, GAAP has treated the
two contractual arrangements in this example the same: Revenue is
booked only after the thirty days, when it is clear that the customer really
wants the loudspeakers. 92 The SEC accounting staffs view is that such
transactions so closely resemble a consignment that they should have the
same accounting treatment as a consignment.
Here, the tax law should adopt the basic approach of the SEC but take
a less conservative tack: When an accrual-basis taxpayer has done what it
is required to do to earn income (transferred possession of a good,
performed services), a contractual "condition precedent" should not defer
the income earned. 94 This new rule could be adopted by Congress,
although the Treasury should be able to do the same by way of
Pending such change, the courts and the IRS should be
mindful not to further expand the consequences of the merely formal
distinction between a "condition precedent" and a "condition
subsequent."
90 Bigler v. Comm'r, 95 .(CCH) 1525, 1526-27 (2008); Harkins v. Comm'r, 81 .(CCH)
1547, 1550 (2001); Keith v. Comm'r, 115 . 605, 616-18 (2000); Charles Schwab Corp. v. Comm'r, 107
. 282, 291-96, affd, 161 1231, 1231 (9th Cir, 1998); Contl Illinois Corp. v. Comm'r, 58
.(CCH) 790, 795 (1989), affd, 998 513, 521 (7th Cir. 1993), cer. denied, 510 . 1041 (1994); J. J.
Little & Ives Co. v. Conmi'r, 25 .(CCH) 372, 392-93 (1966).
1 See Perry Funeral Home, Inc. v. Comm'r, 86 .(CCH) 713, 719 (2003); Yapp Corp. v.
Comm'r, 63 .(CCH) 3155, 3156-57 (1992); Hallmark Cards, Inc. v. Comm'r, 90 . 26, 32-33 (1988);
Ringmaster, Inc. v. Comm'r, 21 .(CCH) 1024, 1029-30 (1962), dismissed per curiam, 319 860, 860
(8th Cir. 1963); Florence Mills, Inc. v. Comm'r, 9 . 579, 583 (1927), acq. VII-1 . 11 (1928); Webb
Press Co. v. Comm'r, 9 . 238, 242 (1927); Webb Press Co. v. Conmm'r, 3 . 247, 253 (1925), acq. VI-
1 . 6 (1927); Rev. Rul. 2003-3, 2003-1 . 252. Note that "conditions precedent" can be involved in the
sale of services as well as in the sale of goods. For example, an engineering services contract can provide that the
work product must be satisfactory to the customer. Frequently title has not passed with respect to goods in the
"condition subsequent" cases, but title passage actually represents a distinct tax issue.
92 StaffAccounting Bulletin No. 101, supra note 89.
93 Id.
94 In a sale of goods, this time also would be when the cost of goods sold is deducted, of course.
9s See generally Mayo Found. for Educ. & Med. Research v. United States, 131 S. Ct. 704, 711-14
(2011); Littriello v. Comm'r, 484 372, 376-78 (7th Cir. 2007).
2013] TAX ACCOUNTING MYTHS 47
IV. CONCLUSION
Tax accounting frequently is arcane. But, given the amount of money
involved, tax's timing rules merit real and immediate attention. Recent
changes in GAAP and contract law should motivate revisiting a number of
important tax-accounting rules.
University of Miami Law School
Institutional Repository
1-1-2014
Tax Accounting Myths
George Mundstock
Recommended Citation
