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Small Business Accounting Method Changes Under TCJA

09/05/2018

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Thanks to the Tax Cuts and Jobs Act (TCJA), small businesses can now receive accounting-related relief by using the simpler and more-flexible cash method. The IRS issued guidance (IR-2018-160) last month on new tax law changes that allow small business taxpayers with average annual gross receipts of $25 million or less in the prior three-year period to use the cash method of accounting. The cash method is allowed even if the purchase, production or sale of merchandise is an income-producing factor for these taxpayers. These are a welcome change for small businesses.

In addition, the TCJA modified Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it’s recognized for financial reporting purposes. Therefore, 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. However, it’s not right for everyone.

Among the lesser known provisions of the TCJA are several accounting method changes for tax years beginning after 2017. Key changes include:

  • the rules businesses must follow when recognizing income on their financial statements
  • a more lenient gross receipts test for businesses seeking to use the cash method of reporting
  • eased requirements for inventory maintenance
  • and more.

Which accounting method is right for your business?

Small businesses often use the cash-basis method of accounting. As a business grows, It's typical for the company to convert to accrual-basis reporting for federal tax purposes and to conform with U.S. Generally Accepted Accounting Principles (GAAP).

Beginning in 2018, the TCJA increased the threshold for businesses that qualify for the simpler cash method for federal tax purposes. Here’s how these accounting methods compare and how the TCJA could affect your financial and tax reporting decisions.

Cash-basis accounting method

Companies that use the cash-basis method of accounting recognize revenue as customers pay invoices and expenses as they pay bills. Cash-basis entities often report large fluctuations in profits from period to period, especially if they’re engaged in long-term projects. 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 also tend to postpone revenue recognition and accelerate expense payments at year-end. This strategy can temporarily defer the company’s tax liability, but the flipside is that it can make a company appear less profitable to lenders and investors.

Accrual-basis accounting method

The more complex accrual-basis accounting method conforms to the matching principle under GAAP. That is, revenue (and expenses) are “matched” to the periods in which they’re earned (or incurred).

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.

In most cases, a small business wishing to change its method of accounting must apply for and secure the prior consent of IRS. Careful consideration should be given to switching. Contact us if you have questions about your business. 

LBMC tax tips are provided as an informational and educational service for clients and friends of the firm. The communication is high-level and should not be considered as legal or tax advice to take any specific action. Individuals should consult with their personal tax or legal advisors before making any tax or legal-related decisions. In addition, the information and data presented are based on sources believed to be reliable, but we do not guarantee their accuracy or completeness. The information is current as of the date indicated and is subject to change without notice.