Small businesses often use an overall method of accounting identified as the cash-basis due to its simplicity. As businesses grow, they usually convert to the overall method described as accrual-basis for federal tax reporting purposes which also conforms with U.S. Generally Accepted Accounting Principles (GAAP) requirements for financial reporting.
Starting this tax year, the Tax Cuts and Jobs Act (TCJA) increased the annual gross revenue threshold which limits the use of the cash-basis for tax reporting; if a business generates less than the threshold, it is allowed to use the simpler cash-basis for federal tax reporting purposes. Here's how these accounting methods compare and how the TCJA could affect your financial and tax reporting decisions.
Under the cash-basis, revenue is recognized as payments from customers are received and expenses are recognized as bills are paid. So, cash-basis entities often report large fluctuations in profits from period to period for the reasons described below or if they're engaged in projects that span two or more reporting years. This can make it hard to benchmark a company's performance from year to year - or against other entities that use the accrual method.
Cash-basis entities can postpone revenue recognition by delaying when customers are invoiced and inflate expenses by accelerating payments to vendors at year end. While this strategy can temporarily defer the company's tax liability, the flipside is that it can make a company appear less profitable to lenders and investors.
The more complex accrual-basis conforms to the matching principle mandated under GAAP. That is, revenue (and expenses) are "matched" to the periods in which they're earned (or incurred). This principle eliminates or substantially reduces the profit fluctuations which can occur under the cash-basis.
Accrual-basis entities report several asset and liability accounts that are generally absent on a cash-basis balance sheet. Examples include prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses and deferred taxes.
Under the TCJA, for tax years beginning after 2017, businesses with average annual gross receipts of $25 million or less for the previous three tax years are eligible for the cash-basis for federal income tax reporting purposes. Under prior law, the gross-receipts threshold for the cash method was only $5 million.
In addition, for tax years beginning after 2017, the TCJA modifies Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax reporting purposes no later than when it's recognized for financial reporting purposes. So, if you use the accrual method for financial reporting purposes, you must also use it for federal income tax purposes.
These changes could prompt more companies to opt for the simpler, tax-deferred cash method for both financial reporting and tax purposes. But it's not right for everyone.
Look Before You Leap
As your small business grows, you might be tempted to switch to the accrual method of accounting to reduce the variability in your business's financial reporting from year to year - to attract more sophisticated lenders or investors who prefer GAAP financials. But doing so could accelerate your tax obligations. On the other hand, if you're newly eligible for the cash method for tax purposes, you may want to switch to that method for the simplicity and tax deferral it offers.
If you're in either situation, contact us to discuss the pros and cons of these two options to ensure you're using the optimal method based on your circumstances.