Accounting method rule changes favor small contractors.

An accounting method is a set of rules used to determine when and how income and expenses are reported. Recently, there have been developments that will help some contractors with their tax liability. However, before getting into this, it helps to clarify two methods: cash accounting and accrual accounting. What are they and how do they affect business?

Accounting is the language of business and every business owner should speak it. It is the way to keep score and the way to find out how strong and healthy a business is financially. The success of a business depends to some extent on one's understanding of financial terms and that understanding must include the ability to make financial business decisions from financial reports.

There are two forms of accounting used by small businesses: cash and accrual. The basic difference between the two methods is the timing of income and expense recording. The best method for a company depends on a variety of factors that include the nature of a business, its legal business structure and whether or not it extends credit.

Cash accounting

Most small businesses start using the cash accounting method. Cash accounting is just checkbook accounting and it is very easy to use. It's generally obvious when you receive money from a customer or other payer, or when you pay an expense with cash, credit card or a check. When money comes in or goes out, it's recorded and recognized for tax purposes. You list cash receipts as your customers pay and you deposit the money in the bank--your sales income.

When you write a check that pays a bill or an expense, you deduct the amount of the check from your bank balance--your current cash balance. Under the cash method, income is recognized for tax purposes when it is actually or constructively received. "Constructive receipt" occurs when money is made available to you without restriction, is posted to your account or is received by your agent.

For example, if a customer paid you with a check on Dec. 30, 2000, you have constructively received the money and must count it as income in 2000 even if you didn't cash the check or deposit it into your bank account until sometime in January 2001.

Cash accounting is simple and easy to set up, operate and understand. You can do it in your checkbook. However, if you add a spreadsheet of expense categories, it is possible to get valuable information on where your money comes from and where it is going.

Many small business owners like cash accounting because by deferring some income or expenses, they can shift profits from the current fiscal period to the next fiscal period. Although this makes little difference in the long run in terms of financial performance, it can reduce tax liability by deferring income into the future. The long-term change in financial results is small because revenue and expense change only work at the end of the current fiscal year.

The cash accounting method may serve your needs as you start your business. However, to have accurate accounting information that can be used to make important business decisions, the accrual accounting method is more accurate. Making decisions on accurate and current financial data is basic to running a successful business.

A number of recent developments will make it easier for some contractors to use the cash accounting method. For starters, the IRS reported last spring that firms grossing an average of $1 million or less in the past three years that were on the accrual accounting method could switch over to the cash accounting method--but there was a catch. The switch was permitted only for businesses that kept books on the cash accounting method. If a firm didn't keep its books on the cash accounting method (and the books were on the accrual method), it couldn't take advantage of the IRS decision. Since keeping books on the accrual accounting method gives more reliable information on how a business is performing, it makes a lot of sense to keep a company's books that way.

Recently, the IRS changed its position by dropping the book-conformity requirement. The IRS now says it will permit use of the cash method even if a firm's books and records are on accrual method as long as the firm grossed $1 million or less in average revenue over the past three years. Thus, consult an accountant or tax adviser to determine whether taxes would be lower using the cash method of accounting. If the cash accounting provides better results, switch to the cash method of accounting for the 2000 tax year. A contractor who has already filed a 2000 return using the accrual accounting method needn't despair: He or she can file an amended return using the cash accounting method.

Accrual accounting

Under the accrual method of accounting, a company reports income in the year earned, not when it receives payment, and deducts expenses in the year incurred, not when they are actually paid. The purpose of the accrual method of accounting is to match income and expenses in the correct year. The tax code refers to this as recording income and expenses when they are "fixed"--when all the necessary events have occurred to receive the income or expense the liability. It is not necessary for cash to change hands.

Here's how accrual accounting works. Say, for example, you complete a job on Dec. 15, but you haven't been paid for it. You recognize all expenses in relation to that contract when they were incurred, regardless of whether you've been paid yet or not. Both the income and expenses are recorded for the current tax year, even if payment is received and bills are paid the following February.

A company must use accrual accounting under the following circumstances: If the business has inventory or is a C corporation and not an S corporation; or if the business is incorporated as a regular (C) corporation, but gross annual sales do not exceed $5 million for the three tax years ending with the prior tax year, it can use the cash accounting method.

There are operational differences between the two methods.

Accelerated expenses: To accelerate expenses, accrual-basis companies only need to record (not necessarily pay) every purchase and expense invoice by year-end. Cash-basis companies must pay them off before the end of December.

Employee bonuses: Cash method businesses can only deduct employee bonuses in the year they're paid. Accrual method businesses, on the other hand, can record the bonus in December, and pay the bonus over the next two and one-half months.

Changing methods: A company changing its accounting methods may have to get permission from the IRS. To make the change, it must file IRS Form 3115, Application for Change in Accounting Method. This form must to be filed within 180 days before the end of the year for which the business wants to make the change.

For small contractors, the cash method of accounting is the most practical method because it recognizes income and expenses when the cash is actually paid to the company or by the company. The accrual method requires recognition of income before the cash is received; that is, income is recognized (earned) when the right to the money arises even though it may never ultimately be received.

Under the accrual method, a company is required, in effect, to pay taxes with money it doesn't have, which can be quite a burden for small contractors. The IRS has long favored the accrual method over the cash method, with little thought of small businesses that often find the accrual method a financial burden. Although the Internal Revenue Code places limitations on the use of the cash method of accounting, a specific exception is provided for businesses with average annual gross receipts of $5 million or less for three previous taxable years. The IRS has largely ignored the $5 million exception for small contractors and sought to enforce the accrual method on small contractors by requiring contractors to inventory on-site supplies.

The IRS says these supplies are an income-producing factor. Once a contractor maintains an inventory of supplies, the contractor must switch to the accrual method and even pay substantial underpayment penalties. However, the following developments may send a loud and clear message to the IRS.

A new regulation will permit more contractors to use the installment-sale rules to report gains when selling their assets (usually when a business is sold). Under a '99 law, a business that's on the accrual accounting method can't use the installment sales method to delay tax on its gains. Now, a small business (that meets the $1-million-or-less rule) can adopt the cash accounting method and also sell its assets on the installment sale method. This is mainly of benefit to the small business that sells its business and arranges for the buyer to pay the sale price over a period of time. If a contractor uses the installment sale method and the buyer of the machinery and equipment agrees to pay for it over say, five years, then the payments can be reported as they're received, over a five-year period.

In addition, a recent court decision on tax clarified when contractors are required to use the accrual accounting method. The case in point involved a cash-method S corporation that installed floors. The firm ordered materials as they were needed for pending jobs. It didn't keep a large supply of materials on hand. When the IRS audited this firm, the IRS put the firm on the accrual accounting method. The IRS said the contractor sold merchandise to customers so it wasn't a service business and had to be on the accrual accounting method. The tax court disagreed. It said that the contractor primarily provided services. The court said the contractor wasn't in the business of selling flooring materials and did not maintain any unnecessary inventory. In the court's view, the IRS abused its discretion by not permitting the use of the cash accounting method.

Armed with the ability to speak the language of accounting and knowing what method works best for your business will help make you a more effective business owner.