A new accounting method universe

By Richard J. Beason, CPA

Since the beginning of mankind, we have sought the natural laws of the universe. Newton, Galileo, Einstein and Hawkins are some of the great names who developed theories of how our universe operates. Likewise, CPAs have tirelessly worked to develop complete theories to accurately measure income and net worth. Both physicists and CPAs made great strides with the invention of calculators and computers that enabled mass analysis of data. CPAs rapidly determined that the cash basis of accounting did not accurately present income or net worth, and accounting standards moved to a more realistic definition of income under the accrual method. Now we are fine-tuning the laws of income and net worth measurement with new rules for income recognition, lease versus capital expenditure reporting and determination of timing and derivatives.

While the theory of relativity reflects how time changes with the speed of an object, most people do not need these calculations to get to work on time. CPAs came to this conclusion recently with the decision to accept small Generally Accepted Accounting Principles (GAAP) for certain business entities. Congress too has accepted that the costs of information and accuracy may exceed the benefit of such. For many years, income tax law attempted to follow the accounting theories, but in recent decades, Congress realized that the practical need of collecting taxes and influencing the economy did not always coincide with Generally Accepted Accounting Standards (GAAS). The U.S. Internal Revenue Code (IRC) began deviating from natural laws to practical laws that met the needs of government cash flow. However, these adaptations, like GAAS, placed a large amount of time, energy and costs on businesses to comply. With the Tax Cuts and Jobs Act, Congress attempted to reduce complexity in tax calculations for small businesses by allowing them to calculate taxable income on the cash basis of accounting for businesses with average gross receipts of less than $25 million per year.

The Tax Cuts and Jobs Act reflects this practicality as follows:

“The provision expands the universe of taxpayers that may use the cash method of accounting. Under the provision, the cash method of accounting may be used by taxpayers, other than tax shelters, that satisfy the average gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The average gross receipts test allows taxpayers with annual average gross receipts that do not exceed $25 million for the three-prior-taxable-year periods (the “$25 million gross receipts test”) to use the cash method. The $25 million amount is indexed for inflation for taxable years beginning after 2018.”1

Accordingly, businesses (other than tax shelters) meeting the gross receipts test may use the cash basis of accounting with regard to income recognition and expense deductions and without regard to inventory requirements of hybrid methods or uniform capitalization rules. This reflects a substantial change in accounting for many businesses. Other than for tax shelters, all businesses meeting the average gross receipts test of $25 million or less can now elect to use the cash basis of accounting. That means C corporations, corporate farms, partnerships with C corporation partners, qualified personal service corporations and businesses that acquire and sell real and personal property may now use the cash basis of accounting without the rule that any accounting method has to clearly reflect income if they meet the average gross receipts test.

In the past, companies acquiring and selling personal property have generally been required to use the accrual basis of accounting to account for sales and inventory. There was an exception in the law for companies with $1 million or less in average gross receipts; but, there was also a rule that required the method to clearly reflect income even for the excepted entities, which generally meant accrual basis and an inventory would still be required. The new provision removes the clearly reflect income rule and the inventory requirement for those meeting the average gross receipts test of $25 million. The new limiting rule is items previously reported as inventorial items will now be reported the same as non-incidental materials and supplies under Treasury Regulation Section 1.162-3(a)(1), or conform to the taxpayer’s financial accounting treatment of inventories. The conforming to the financial accounting method may limit the election to remove inventory measurement due to possible loss of security control of assets and financial reporting both internal and external. However, one might assume inventory control for security and protection is outside the definition of “financial accounting treatment.”

Upon the change in accounting method, businesses meeting the average gross receipts test are not subject to IRC Sec. 263A uniform capitalization rules. Businesses previously exempted from uniform capitalization for reasons other than a gross receipts test remain exempt.

The change also allows the reporting of sales on the cash basis for those meeting the $25 million requirement even though the business produces, purchases or sells real or personal property. This too can make life easier for those businesses that sell products on terms. In effect, this provision allows sales to be reported as cash is received rather than at the time of contract for personal property sales. For those selling on credit, this could be a boost to cash flow from deferral of income taxes.

For businesses with average receipts exceeding $25 million, the Act retains the exceptions from the required use of the accrual method of accounting for qualified personal service corporations and other taxpayers other than C corporations. Qualified personal service corporations, partnerships, S corporations and other pass-through entities continue to be allowed to use the cash basis of accounting even if they have average gross receipts exceeding $25 million as long as such method clearly reflects income. Obviously, clearly reflecting income means a seller of personal or real property and grossing more than an average of $25 million will continue to have to account for inventory and sales on the accrual method or hybrid method and continue to follow the rules of uniform capitalization.

Under the new provisions, small real estate contractors meeting the average gross receipts test of $25 million in the year entering into a contract may use the long-term contract method of accounting rather than the percentage-of-completion method if the contract is expected, at the time of entering into the contract, to complete within two years of commencement of the contract.

The new provisions apply to years beginning after Dec. 31, 2017. For small contractors, the provision applies to contracts entered into after Dec. 31, 2017. The Act specifically states that the changes provided therein are subject to a change in accounting method for purposes of IRC Section 481 requiring businesses already in operation to request a change in accounting method using form 3115.

For small businesses, these provisions may save substantial tax dollars. Companies selling personal property on account may now report the income as received rather than the accrual basis. The cost savings from not having inventory accounting could also be substantial. However, it remains to be seen how these changes will be accepted by the state and local governments. Business licenses, inventory property taxes, and state income taxes may be affected by these changes or may require income, inventories and sales to be reported under the old provisions which could be costly and a bookkeeping nightmare. Many states, including Virginia, are currently reviewing the Act to determine their treatment of its many provisions.

The business must also consider its financial accounting method when selecting to use these new provisions, as the expensing of sellable stock in trade may be based on the company’s financial accounting method. Such a change may have important repercussions to bankers and investors as earnings may be timed or otherwise manipulated under the cash method and not clearly reflect income and expenses without inventory accounting. As stated earlier, inventory control and protection may also suffer if the accounting method does not measure the inventory. Additional methods of control would have to be established to protect the assets for insurance, theft and finance off the general ledger.

As noted in the first paragraph, practicality has become more of a concern to Congress than accounting theory. Cash basis accounting offers tax savings and simplicity, but it also may distort business financial reporting upon which the company and third parties rely for financing and business decisions.

1. Joint Explanatory Statement of the Committee of Conference, Business Tax Reform, Section B, Part 2. Small business accounting method reform and simplification (sec. 3202 of the House bill, secs. 13102 through 13105 of the Senate amendment, and secs. 263A, 448, 460, and 471 of the Code).

Richard J. Beason, CPA, CITP, PFS, CGMA is a graduate of Virginia Tech and has been a member of the VSCPA for 41 years. He has offices in Roanoke and Hilton Head , S.C., specializing in taxation and financial planning.