As Benjamin Franklin famously wrote in 1789, “Nothing can be said to be certain, except death and taxes.” No matter the size, all businesses must report their annual financial results to the IRS. For a significant number of companies, the choice is made to file tax returns on a cash basis; if you make or spend the cash during the year, it goes on the return. That choice may seem even more appealing now that the Tax Cuts and Jobs Act raised the threshold for entities to file on a cash basis up to $25 million in revenue. Many companies elect to also report financial records internally on this same tax-adjusted cash basis. Why not simply record cash going in/out the door and provide that same info to a CPA for tax preparation? As you will see, for both internal and external reasons, there are some very important drawbacks to this approach over an accrual method of internal accounting.
Cash versus Accrual 101
The cash basis is very simple – that is the biggest benefit. However, it can provide very misleading results. For example, let’s say your company pays employees every two weeks. This means that two months out of the year will include three payrolls. On a cash basis, this looks like a month with lower profitability. Should you reserve cash for this situation in a month? Absolutely, but should you judge the month’s financial performance by it? Not necessarily. This is why the accrual method exists – in short, it attempts to match revenues and expenses in the period they are related to. There are many other examples like this such as an insurance policy that gets paid in December for the entire following year. That policy is providing coverage for 12 months, so regardless of when it was paid for, the expense should be reflected over the months it covers. In the case of instances like these, the accrual basis smooths out some of the noise caused by timing to allow a decision maker to peer deeper and see how their company is truly performing, and most importantly, take action as a result.
Saving on Taxes at the Expense of Deeper Pockets
Too often, businesses will make big purchases late in the year solely to take advantage of the tax benefits in lowering their overall liability. These purchases may well make sense for the business, but potential tax benefit shouldn’t be the only barometer. When that same business tries to go to a bank or equity partner to raise capital, the reception may be cold at best. Using an accrual basis, the timing of the purchase is not the driver, and even if a piece of equipment is purchased, the cost of that equipment is spread over its useful life, strengthening the balance sheet and taking a much smaller reduction to the P&L, again more accurately reflecting the monthly operational flow of the business. Banks want to see assets, liquidity, profitability, consistency. A business owner should never pay more tax than required, but it is a balancing act that must be navigated. Low tax liability can be terrific, but not at the expense of an expanded line of credit the company needs to grow.
I Want to Sell
Many business owners’ long-term plans involve the eventual sale of the business. For businesses of any size, accountant reviewed or even audited financial statements are a key piece of due diligence sought after by a buyer, because they are an independent verification of the quality of numbers. Reviews and audits must conform to Generally Accepted Accounting Principles (GAAP) which center around accrual based accounting. It is far easier to maintain accrual based records and seek a review/audit, than to try to convert from cash to accrual when a buyer is already poking around. In addition, that independent report on numbers could lead to greater trust and a higher valuation as a result.
A good CPA will be very comfortable adjusting accrual basis books for tax return filing. And certainly, regular consultation with a CPA on tax planning is a must. However, for internal management and external stakeholders, the clearest picture of business performance over time will most likely be in the form of accrual basis financials.