Nicholas P. DiNatale, CPA -
Certified Public Accounting & Business Advisory

Business Resources - FAQ

Cash Basis or Accrual Basis?

Generally, there are two main bases on which to report income: cash and accrual. To provide a quick brush up for everyone who’s Accounting 101 book is a little dusty: in a nutshell, the cash basis reports income and expenses as cash is received and paid, while the accrual basis reports income and expenses as the right to receive the income or obligation to pay the expense first arises, and involves accounts such as accounts receivable and payable. It is popular for service companies to use the accrual basis for financial statement purposes and the cash basis for tax purposes for the ability to take advantage of profit planning and the marketability of a higher accrual basis net income, while the cash basis generally will enable the entity to pay taxes only on money it has received and utilize more aggressive tax strategies. A service business paying taxes on the accrual basis may risk being burdened with reporting income where cash has not yet been received if the accounts receivable balance is large.

The decision of which basis you should report your taxes may not be a decision at all. In many situations, the IRS mandates the use of the accrual basis. To simplify matters, in June the IRS New England district office released a Practitioner NewsFlash highlighting the circumstances when the accrual method was required.

Generally, the following entities must use the accrual method of accounting as their overall method for tax purposes: a) C corporations; b) partnerships that have a C corporation as a partner; c) trusts that are subject to the tax on unrelated trade or business income (but only for such income); and d) tax shelters (Code § 448 (a) and 448(d)(6)).

An entity is specifically allowed to use the cash method if: a) the entity is not a tax shelter; and b) is engaged in a farming or tree-raising business, c) is a qualified personal service corporation, or d) is an entity that has met the $5 million or less gross receipts test for all prior tax years beginning after 1995 (average annual gross receipts for the previous three tax years do not exceed $5 million).

Also, if the "production, purchase, or sale of merchandise is an income producing factor," you must report your taxes on the accrual basis. The determining factor is the income producing process, and not the existence of an inventory balance. In fact, "If [an organization] takes title to goods, even though the merchandise is shipped directly from the manufacturer to the customer" that organization must use the accrual basis for tax reporting. Merchandise is an "income-producing factor if the merchandise cost as a percentage of gross receipts is 15% or more." These statements open many companies who may take temporary title to a product or asset item to the harmful effects of a potential audit change for their reporting technique.

There is some relief for companies finding themselves in this predicament. Form 3115, Application for Change in Accounting Method allows taxpayers to spread the effect of a change in their accounting method over a 4 - year period. Consult your tax advisor if you find your organization in this situation.

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