credited to any such reserve was in excess of the reasonable or probable needs for which the reserve was created, the excess would be disallowed as a deduction and restored to income. In no event are sinking funds or other reserves set up to meet additions, betterments or other capital obligations allowed as deductions. Reserves to meet losses contingent upon shrinkage in values, losses from bad debts, losses from capital investments, etc., are not allowable as deductions, since such losses are only deductible when definitely determined as a result of a closed or completed transaction and actually charged off.9

Methods of Accounting. Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income.10 It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so. Among the essentials are the following: (1) In all cases in which the production, purchase or sale of merchandise of any kind is an income-producing factor inventories of the merchandise

8 The Treasury Department has always held, in the case of corporations, that it was immaterial whether deductions, except for taxes and losses, were evidenced by actual disbursements in cash, or evidenced in such other ways as to be properly acknowledged by the corporate officers and so entered on the books of the corporation as to constitute a liability against the assets, except that taxes were deductible only when actually paid, and not merely entered as a charge, and losses when actually sustained in the year charged off. But as to taxes, this rule seems to have been changed in the case of corporations electing under the 1916 Law to report according to their books, by the ruling that corporations which accrued on their books, monthly or at other stated periods, amounts sufficient to meet fixed annual or other charges, might deduct from their gross income the amount so accrued, provided such accruals approximated as nearly as possible the actual liabilities for which the accruals were made, and provided that in cases wherein deductions were made on the accrual basis, income from fixed and determinable sources accruing to the corporation was returned, on the same basis. (T. D. 2433.) Corporations keeping books of account on an accrual basis were permitted to deduct from gross income accrued interest for the year when shown as a charge against accrued income upon the corporate books of account. (T. D. 2625.)

9 T. D. 2433.

10 Reg. 45, Art. 23.

on hand (including finished goods, work in process, raw materials and supplies) should be taken at the beginning and end of the year and used in computing the net income of the year; (2) expenditures made during the year should be properly classified as between capital and income, that is to say, that expenditures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account; and (3) in any case in which the cost of capital assets is being recovered through deductions for wear and tear, depletion or obsolescence any expenditure (other than ordinary repairs) made to restore the property or prolong its useful life should be charged against the property account or the appropriate reserve and not against current expenses.11

CONSOLIDATED RETURNS. A discussion of the subject of the filing of consolidated returns by affiliated corporations and the computation and determination of the tax of such corporations upon the basis of such returns will be found in another chapter.12 WHEN ITEMS SHOULD BE REPORTED. The time as of which any item of gross income or any deduction is to be accounted for must be determined in the light of the fundamental rule that the computation must be made in such manner as clearly reflects the taxpayer's income. If the method of accounting regularly employed by him in keeping his books clearly reflects his income, it is to be followed with respect to the time as of which items of gross income and deductions are to be accounted for.13 All items of gross income must be included in gross income for the taxable year in which they are received by the taxpayer, and deductions taken accordingly, unless in order clearly to reflect income such amounts are to be properly accounted for as of a different period. For instance, in any case in which it is necessary to use an inventory, no accounting in regard to purchases and sales will correctly reflect income except an accrual method. For the taxable year 1918 the true income, computed under the Revenue Act of 1918 and-where the taxpayer keeps books of account-in accordance with the method of accounting regularly

11 Reg. 45, Art. 24.

12 See Chapter 10.

13 Revenue Act of 1918, § 213 (a); Reg. 45, Art. 221.

employed in keeping such books, must in all cases be entered in the return, even though this results in apparent omissions or duplications of particular items of income or expense. In the ordinary case such omissions and duplications are more apparent than real and are likely to counterbalance one another so that the change in the basis of reporting calls for no material adjustment. Where, however, the method previously employed by the taxpayer in determining his income subject to the tax, is materially different from the method regularly used by the taxpayer in keeping his accounts, or where for any reason the basis of reporting income subject to tax is changed the taxpayer should attach to his return a separate statement setting forth for the taxable year and for the preceding year the classes of items differently treated under the two systems, specifying in particular all amounts duplicated or entirely omitted as the result of such change. Where, for example, a taxpayer who, prior to 1918, has reported on the so-called receipts basis, is compelled under the above rule to report on the so-called accrual basis, he should include in the separate statement the following information: First (a) expenses paid before the end of the taxable year 1917 but not accrued at that date; (b) income accrued at the end of the taxable year 1917 but not received at that date; (c) expenses accrued at the end of the taxable year 1917 but not paid at that date; (d) income received before the end of the taxable year 1917 but not accrued at that date; and Second, similar items as of the end of the taxable year 1916. If in the opinion of the Commissioner such information indicates that the returns for any previous years did not reflect the true income, amended returns for such years will be required.14

BANK DISCOUNTS. Banks which in the past have treated discount as income before it was actually earned and through the taxable year 1918 have placed discount account upon an accrual basis will be required to submit the information called for in (2) of the preceding paragraph and submit on amended return for the taxable year 1917 and will be permitted to submit (or the Commissioner may require) amended returns for all prior years during which the taxpayer was subject to tax. Additional taxes for prior years found to be due upon such re-examination will be

14 Reg. 45, Article 23 as amended by T. D. 2873.

paid upon the basis of the amended returns in the ordinary way. Where it appears that prior taxes have been paid in excess of the amount properly due such excess will to the extent possible be credited against future income and profits taxes.15

CHANGING BASIS FOR COMPUTATION OF NET INCOME. If a taxpayer should change the method of accounting employed in keeping his books for the taxable year 1919 or thereafter, he must before computing his income upon such new basis for purposes of taxation secure the consent of the Commissioner. Application for permission to change the basis of the return must be made at least thirty days in advance of the date of filing return and must be accompanied by statement specifying the class of items differently treated under the two systems and specifying all amounts which would be duplicated or entirely omitted as a result of the proposed change.16

Accounting Period: Fiscal Year. The return of a taxpayer is made and his income computed for his taxable year as a time unit, which means his fiscal year, or the calendar year if he has not established a fiscal year.17 The term fiscal year means an accounting period of twelve months ending on the last day of any month other than December.18 No fiscal year will, however, be recognized unless before its close it was definitely established as an accounting period by the taxpayer and the books of such taxpayer were kept in accordance therewith.19 A taxpayer having an existing accounting period which is a fiscal year within the meaning of the statute not only needs no permission to make his return on the basis of such a taxable year, but is required to do so, regardless of the former basis of rendering returns. A person having no such fiscal year must make return on the basis of the calendar year. Except in the cases of a return for the taxable year 1918 and of a first return for income tax, a taxpayer makes

15 T. D. 2873.

16 Revenue Act of 1918, § 212. Reg. 45, Art. 23, as amended by T. D. 2873. 17 Reg. 45, Art. 25. The taxable year 1919 is the calendar year 1919 or any fiscal year ending during the calendar year 1919.

18 Revenue Act of 1918, § 200. No return received for a period ending on any date other than the last day of some month will be accepted, unless it is a "final return" and made to the day the corporation ceased business. (Mimeograph letter to collectors, No. 1148.)

19 Reg. 45, Art. 25.

his return on the basis (fiscal or calendar year) upon which he made his return for the taxable year immediately preceding unless, with the approval of the Commissioner, he has changed the basis of computing his net income.20

FIRST RETURNS. The Revenue Act of 1918 provides that "if a taxpayer making his first return for income tax keeps his accounts on the basis of a fiscal year he shall make a separate return for the period between the beginning of the calendar year in which such fiscal year ends and the end of such fiscal year.”’21 The first return under the present statute of a taxpayer who theretofore made returns on a basis different from his accounting period will necessarily overlap his next previous return.

CHANGE IN ACCOUNTING PERIOD. If a taxpayer changes his accounting period, and not merely his taxable year to conform with his existing accounting period, he must as soon as possible give to the collector for transmission to the Commissioner written notice of such change and of his reasons therefor. The Commissioner will not approve a change of the basis of computing net income unless such notice is given at a time which is both (a) at least thirty days before the due date of the taxpayer's return on the basis of his existing taxable year and (b) at least thirty days before the due date of his return on the basis of the proposed taxable year. If the change in the basis of computing the net income of the taxpayer is approved by the Commissioner, the taxpayer will thereafter make his returns upon the basis of the new accounting period in accordance with the requirements of the statute discussed elsewhere.22

FISCAL YEAR OF CORPORATION OR INDIVIDUAL ENDING IN 1919. The method provided for computing the tax for a fiscal year beginning in 1918 and ending in 1919 is as follows: (a) the tax attributable to the calendar year 1918 is found by computing the income of the taxpayer and the tax thereon in accordance with the statute as if the fiscal year was the calendar year 1918, and determining the proportion of such tax which the portion of such fiscal year falling within the calendar year is of the full

20 Reg. 45, Art. 25.

21 Revenue Act of 1918, §§ 226 and 232; Reg. 45, Art. 25. The method of adjusting the tax in such case is discussed in Reg. 45, Arts. 1621-4. § 205 of the Statute is applicable; § 226 has no application.

22 Reg. 45, Art. 26. See Chapter 34.