A 481a adjustment is necessary when there is a change in method of accounting.
A change in an entity’s accounting method is a change in accounting methods to justify income or deductions or a change in the treatment of a specific item, like depreciation. An entity has typically not adopted a specific accounting method unless the method has been used in two or more consecutively filed tax returns. If a taxpayer adopts an appropriate accounting method in the first year of operation, it is also considered to have adopted a method of accounting. Corrections errors are not considered changes in an accounting method.
Whenever a taxpayer starts a change in an accounting method, there is a possibility for replication or omission of income or deductions relating to transactions occurring in the year before the year of change. A change in accounting method requires either an IRC 481(a) adjustment or a change using the cut-off method.
A change in method of accounting generally requires an adjustment under IRC 481(a) to prevent duplication or error in income or deductions when the taxpayer computes its taxable income under a method of accounting different from the method used to compute taxable income for the preceding year. When there is a change in method of accounting to which a 481(a) adjustment is applied, income for the taxable years preceding the year of change must be determined under the new method of accounting. The new method of accounting now determines the income for not only the year of change but all subsequent taxable years as if the new method had always been used.
Certain alternations in the method of accounting changes could be made without an IRC 481(a) adjustment. They would be made using the cut-off method. Under the cut-off method, only the items occurring on or after the beginning of the year of change are changed under the new method of accounting. Any items arising before the year of change would continue to be accounted for under the taxpayer’s former method of accounting. The cut-off method does not duplicate or omit any amounts from income, so an IRC 481(a) adjustment is unnecessary.