Starting in 2018, many more businesses can file their taxes using the cash basis of accounting. If you have previously filed your taxes using the accrual method, should you consider switching? Let’s take a bird’s eye look at so you can know if you should call your CPA to discuss the idea.
Do you qualify?
If your average annual gross receipts for the prior three years are $25 million or less, you most likely qualify.
Will the change save me money?
If your total accounts receivable is greater than your accounts payable and accrued expenses, converting will save you money.
Let’s look at an example. Assume the following facts for Acme Manufacturing using the accrual method with a 12/31 year-end:
Accounts receivable at 12/31: $1,000,000
Accounts payable and accrued expense at 12/31: $500,000
The goal of accrual accounting is to match revenues earned to the expenses required to create that income. That is a great idea if you want to know if you are really making money or would like to benchmark your results against your peers (always a great idea).
Accrual accounting records revenue when it is earned (not received) and expenses when incurred (not paid). Cash basis accounting records revenue when it is received and expenses when they are paid.
Using the cash basis, revenues and expenses won’t match when your receivables and payables grow or shrink at different rates. This can result in distortions in your income and margins. That is why most larger businesses use accrual accounting.
In Acme’s case (using the accrual method) the accounts receivables and accounts payable are already considered revenue and expenses in the calculation of income even though neither has been paid.
If Acme switched to the cash method, income would be reduced by $1,000,000 and expenses would be decreased by $500,000 – resulting in a $500,000 reduction in taxable income.
That is real money and the deferral is permanent unless you switch back to the cash basis or the difference between your accounts receivable and accounts payable decreases. The deferral can grow as your business grows and the difference between accounts receivable and accounts payable grows.
Disclaimer: Of course, there are some technical aspects to this that are beyond the scope of this article. If you think this idea might save you money, talk to your tax professional! This article is not meant as tax or legal advice.
As always, you can reach me at 229.244.1559 if I can help in any way.
Curt Fowler is President of Fowler & Company and Director at Fowler, Holley, Rambo & Stalvey. He is dedicated to helping leaders build great organizations and better lives for themselves and the people they lead.
Curt is a syndicated business writer, keynote speaker and business advisor. He has an MBA in Strategy and Entrepreneurship from the Kellogg School, is a CPA, and a pretty good guy as defined by his wife and four children.