in (3) above; (e) amounts received through accident or health insurance, or under Workmens' Compensation acts as compensation for personal injuries or sickness and the amount of any damages received, whether by suit or agreement on account of such injuries or sickness (f) income of any person derived from the operation of a public utility to be acquired, constructed, operated or maintained by such person, pursuant to a contract made with the state, territory or the District of Columbia, or any political subdivision of a state or territory prior to September 8, 1916, in excess of the part thereof to which such person is entitled under such contract.105 Since June 25, 1918, no assessment of any federal tax may be made on any allotments, family allowances, compensation or death or disability insurance payable under the War Risk Insurance Act of September 2, 1914, as amended, even though the benefit accrued before that date.106 A more complete discussion of exemptions of income is contained in the several chapters dealing with the respective kinds of income enumerated.

Reporting Income on Basis of Book Entries. The 1916 Law extended to individuals or corporations keeping accounts upon any basis other than that of actual receipts and disbursements, unless such other basis did not clearly reflect his or its income, the privilege of making returns upon the basis upon which the accounts were kept, in which case the tax was computed upon the income as so returned. This privilege was subject, however, to regulations made by the Commissioner, which regulations might limit the right as the Commissioner saw fit.107 Taxpayers not keeping books in accordance with standard systems of

105 Revenue Act of 1918, §§ 213 and 233. Every person owning obligations, securities or bonds the interest upon which is exempt must submit a statement in his return showing the amount of such obligations, securities and bonds owned by him and the income received therefrom.

106 Reg. 45, Art. 71.

107 Revenue Act of 1916, § 8 (g) and 13 (d).

accounting were required to report their income on the basis of actual receipts and payments, but where books were kept in accordance with standard systems of accounting, or in conformity with the requirements of some federal, state or municipal authority having supervision over the taxpayer, returns might be made on the basis upon which such books were kept, provided the books were so kept and the return so made as to reflect the true net income of the corporation for each year.108 The Revenue Act of 1918 changes the privilege of reporting income upon the basis of book entries to a requirement that income be so reported. It is expressly provided that net income shall be computed in accordance with the method of accounting regularly employed in keeping the books of a taxpayer; if no such method of accounting has been so employed or if the method of accounting does not clearly reflect income the computation is to be made upon such hasis and in such manner as in the opinion of the Commissioner of Internal Revenue does clearly reflect income.109 Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. The method of accounting will not, however, be regarded as clearly reflecting income, unless all items of gross income and all deductions are treated with reasonable consistency. The two systems cannot overlap; a taxpayer may not report in part on the accrual and in part on the cash basis.110

METHODS OF ACCOUNTING. It is recognized that no uniform method of accounting can be prescribed for all tax

108 T. D. 2433. In this ruling the Treasury Department placed certain limitations upon the extent to which reserves might be set up and deducted. These limitations are discussed in the chapters on deductions. While the language of the ruling refers particularly to corporations, there seems to be no reason why it should not be applicable to individuals as well.

109 Revenue Act of 1918, § 212 (b); Reg. 45, Art. 22. See Chapter 34 on Returns.

110 Reg. 45, Art. 23. Maryland Casualty Company v. U. S., 52 Ct. Cls. 201. This case is now No. 395 on the docket of the United States Supreme Court.

F. T.-21

payers, 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; (a) 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 recoverd 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.111

CHANGING FROM A CASH TO AN ACCRUAL BASIS. There seems to be no prohibition in the Revenue Act of 1918 against changing from a cash to an accrual basis, or vice versa; but it seems that approval of the return filed on the new basis by the Commissioner is necessary as it is within his province to determine if the change results in reflecting the taxpayer's true net income, particularly for the year in which the change occurs. The reporting of net income on the basis of book entries is no longer a privilege, but in computing net income a taxpayer follows the method regularly employed in keeping his books.112

111 Reg. 45, Art. 24; Reg. 33 Rev., Arts. 127, 128.

112 Revenue Act of 1918, § 212 (b). Under the 1916 Law it was ruled that the change from a cash to an accrual basis and vice versa

ACCRUED CHARGES. Under the 1916 Law it was permissible for a corporation which accrued on its books, monthly or at other stated periods, amounts sufficient to meet fixed annual or other charges, to deduct the amount so accrued, provided the accruals approximated as nearly as possible the actual liabilities for which the accruals were made, and income from fixed and determinable sources accruing to the corporation was returned on the same basis.113 "Paid," or "actually paid," as referring to deductions, did not necessarily contemplate that there should be an actual disbursement in cash or its equivalent. If the amount involved represented an actual expense or element of cost in the production of the income of the year, it was properly deductible, even though not actually disbursed in cash, provided it was so entered upon the books of the company as to constitute a liability against its assets and provided further that the income was also returned upon an accrued basis. If in the course of its business, a corporation credited the accounts of individuals, firms, or corporations with the amount of any expenses, interest, rentals, wages, etc., due them, thereby making them subject to the personal drawings of such creditors, or if expenses actually incurred were vouchered in definite amounts, the amounts so credited or vouchered might be treated as paid, and if the amounts so credited or vouchered were expenses incurred concurrently with and in the production of the income of the year, they might be allowably deducted therefrom. The deduction of any accrued charges which if paid in cash or otherwise would not be deductible was not permitted.114

might be effected at any time, provided the method adopted be consistently followed from year to year (Letter from Treasury Department dated December 17, 1918; I. T. S. 1918, ¶ 3709).

113 T. D. 2433.

114 Reg. 33 Rev., Art. 126. Note the use of the words "paid or incurred" and "paid or accrued" in regard to the deductions permitted under the Revenue Act of 1918 (Revenue Act of 1918, §§ 214 and 234). "The terms 'paid or incurred' or 'paid or accrued' shall

CHARGED AGAINST CURRENT EARNINGS. All expenses, including interest, taxes, and other necessary charges, incidental and necessary to the creation or production of the gross income or properly chargeable against the same, being deductible from the gross income, whether paid in cash or entered on the books as a liability, could not, if unpaid, be carried forward to be deducted from the gross income of a subsequent year.115

EACH YEAR'S RETURN COMPLETE. Net income must be computed with respect to a fixed period.116 Each year's return, under the 1916 Law, both as to income and deductions therefrom, is required to be complete within itself. Charges, of whatever character, against income. could not be cumulative. They were required to be deducted from the income of the year in which incurred, or not at all. The expenses, liabilities, or deficit of one year could not be used to reduce the income of a subsequent year. The deductions were required in all cases to be such as were authorized and within the limits fixed by law.117 PREVIOUS YEAR'S CHARGES NOT DEDUCTIBLE. A corporation having the right to deduct all authorized allowances, whether paid in cash or set up as a liability, it follows that if it did not within any year pay or accrue certain of its expenses, interest, taxes, or other charges, and made no deduction therefor, it can not deduct from the income of the next or subsequent year any amounts then paid in liquidation of the previous year's liabilities.118 If, however, a corporation discovers or detects expenses or liabilities which were due and payable during a preceding year, it is permissible for it to make an amended return for the year to which such expense or liability applied, include

be construed according to the method of accounting upon the basis of which the net income is computed under Section 212." (Revenue Act of 1918, § 200.)

115 Reg. 33 Rev., Art. 127.

116 Reg. 45, Art. 22.

117 Reg. 33 Rev., Art. 127.

118 Reg. 33 Rev., Art. 128.