There are two methods of maintaining accounting records to track income and expenses for businesses. The accrual method records income when earned and expenses when incurred, as opposed to the cash method, which records income when payment is received and expenses when payment is made. The use of either method will affect how a business can use certain transactions to affect their tax situation at the end of year.
Generally, a business at inception may elect, for tax purposes, to use either accrual or cash method and, for every subsequent year, must continue using the same method unless consent by the IRS is obtained. U.S. tax law does include exceptions for certain entities that must use the accrual method for their accounting, including all tax shelters and all corporations, excluding S-corporations, that have average annual gross receipts greater than $26 million. Most recently the Tax Cuts and Jobs Act of 2017 expanded the number of businesses that may use the cash method. To assess whether an entity meets such requirements, a gross revenue test must be performed by averaging the last three years’ worth of gross receipts.
Another notable exception to the accrual method requirement is any qualified personal service corporation involved in services regarding the health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting fields. Previously, businesses with inventory as a general source of income were required to use the accrual method to account for their inventory but now any business that meets the gross receipt test is exempt from the accrual method requirement.
The advantages of the cash method include the ability to defer income not yet recognized from accounts receivable by delaying collection. By deferring income to next year, the company doesn’t eliminate the associated taxes but may defer them to increase short-term cash flow and use the funds for other business purposes. Furthermore, a smaller and less costly accounting department is needed to maintain the less complex cash method. The advantages of the accrual method include the ability to write of bad debt that is determined to be uncollectible. This can, in effect, reduce the income subject to tax. Another advantage of the accrual method is a more accurate economic picture of a company’s performance.
If you have any questions about the tax implications related to each accounting method discussed, please reach out to our office to schedule a meeting with our team here at ADKF. An experienced professional with extensive experience in the financial planning process can help guide you through this important business decision. In the event of a change of accounting method, ADKF can also assist in securing IRS consent through submission of Form 3115 Application for Change in Accounting Method.