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The Tax Cuts and Jobs Act (TCJA) has introduced changes in business qualifications for using the cash-basis or accrual method of accounting.
Usually, a small business will use the cash-basis method of accounting and then convert to the accrual-basis reporting as they grow. The switch in methods is usually to conform with U.S. Generally Accepted Accounting Principles (GAAP) and for federal tax purposes. With TCJA changes, this may no longer be the best route for every business.
When using the cash method, revenue is recognized as customers pay invoices and as the business pays bills. This often leads to fluctuations in profits from one period to another, especially when they are engaged in long-term projects. These fluctuations make it difficult to benchmark a company’s performance from year to year, and to compare against other entities that use the accrual method instead.
Cash-basis entities often postpone revenue recognition and accelerate expense payments at the end of the year. This comes with the advantage of being able to defer the company’s tax liability temporarily. However, it can make a company appear less profitable to investors and lenders.
The accrual-basis accounting method conforms to the matching principle under GAAP. That is, revenue (and expenses) are “matched” to the periods in which they are earned or incurred.
Accrual-basis companies report many asset and liability accounts that don’t usually appear on a cash-basis balance sheet. These are accounts such as prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses, and deferred taxes.
TCJA changes for tax years after 2017
The TCJA has changed tax policy so now businesses with annual gross receipts of $25 million or less for the previous three tax years are eligible for the cash method of accounting for federal income tax purposes. Previously the gross-receipts threshold for the cash method was $5 million.
The TCJA also modified section 451 of the Internal Revenue Code so businesses must recognize revenue for tax purposes no later than when it is recognized for financial reporting purposes. This means using the accrual method for financial reporting purposes requires using it for federal income tax purposes as well.
These TCJA changes may result in more companies using the simpler cash method for both financial reporting and tax purposes.
Weighing your options
For a small business, it is tempting to switch to the accrual method of accounting with growth to reduce variability in financial reporting year to year. This might attract lenders and investors who prefer the accrual method of accounting. However, switching methods could accelerate your tax obligations.
If you are a business who just became eligible for the cash method for tax purposes, switching might be wise for simplicity and tax deferral, though every circumstance is different.
Either way, we are happy to discuss your options with you. Each method comes with pros and cons, and we can help ensure you are using the best method for your business needs. Contact us at 818-334-8623 or click here, and we will contact you.