Whether you are a start-up enterprise or have been conducting business for generations, determining the “best” accounting method to track your profits and losses can be a daunting task. Various financial reports have different uses. But the one type of report that all businesses require is tax return reporting. Recently, Congress passed new tax law which gives many businesses more flexibility in choosing what accounting method to use for their tax returns. Let’s break this down in in a way that’s easy to understand.
Commercial enterprises communicate business health through three main ways:
1. Financial Reporting: mainly uses generally accepted accounting principles (GAAP) to report results to bankers, creditors, investors, management, and other users of the financial information.
2. Management reporting: basically uses company metrics to provide business owners and executives with the internally-generated information needed to make sound decisions and run the business.
3. Tax reporting: provides federal, state, and local tax authorities with financial results based on a cash or accrual method of accounting (construction and other contractors may have additional requirements related to percentage of completion versus completed contract methods.)
Tax reporting is important because federal and state taxes represent cash outflows from the business. Many businesses have found cash reporting to be most advantageous and so the government has limited its use only for businesses that carry inventory, certain corporations and large businesses with over $10 million in gross receipts. However, starting with the 2018 tax year, most businesses with $25 million or less of gross receipts (on average over the prior three tax years) are eligible to use the cash method.
Is the cash basis method of tax reporting best for your business? A few key considerations follow, which outline advantages and drawbacks.
- Advantage: Simpler to use – similar to a check book
- Advantage: Matches taxes owed with revenue that has been received
- Advantage: Defer income from selling on credit (businesses with large account receivable balances benefit)
- Disadvantage: Recognize income from cash deposits and up-front payments prior to delivery of goods or services
Why do some businesses prefer/find more advantages to using the accrual basis method of accounting? There are some good reasons:
- Accrual basis financial reports are easily understood by bankers, creditors, investors, and executives.
- Better matching of revenue generated with expenses incurred and a clearer picture of net income.
- More flexibility with advance payments such as customer deposits.
- The downside though is the complex rules and less flexibility with income and expense recognition.
The good news is that if your business is eligible for the cash basis, the new tax law permits the business to file for an automatic accounting method change with the IRS. A business would need to calculate an accounting method adjustment to determine the cumulative difference in income from the old method to the current method. If the adjustment is favorable (a deduction) then the business can include the deduction in the year of change, which may reduce taxes substantially. If the cumulative adjustment is unfavorable then the adjustment can be included in income over a four-year period. Examining the cash collection cycle from sale to payment is a useful step in this analysis.
* Example: your calendar-year accrual method business has the following year-end balance sheet:
* A change to the cash method yields a favorable adjustment of $80 ($100-20). Furthermore, the current year change in AR and AP nets another $10 favorable deduction ($20-10) for a total of $90 deduction in 2018 by changing to the cash basis method.
Business leaders should analyze the benefits and costs of their accounting method to determine if a change enhances their cash flows. Whichever method you choose as a business owner and financial leader the key is to be comfortable understanding its impact on the business and your strategic goals. Regular planning meetings with your staff and advisors are a great way to ensure your business is maximizing its opportunities.
This entry brought to you by Darren Finn. Darren is a Director in the firm’s Tax Division. He focuses on developing innovative solutions that generate cash savings, tax savings and increased efficiencies for our clients. To speak with Darren regarding any of your tax questions, contact us today!