Choosing the appropriate accounting method, cash vs. accrual, is one of the first decisions business owners should make. Contractors may use one or both methods for internal accounting and handling contracts.
Cash vs Accrual Method
Cash method
The cash method accounts for revenue only when money is received and for expenses only when the money is paid out. This method does not recognize accounts receivable or accounts payable.
Accrual method
The accrual method accounts for revenue when it is earned and expenses when they are incurred. Revenue is recorded even if the cash has not yet been received.
Contractors may use one or both tax accounting methods:
- One overall method for reporting general company income and expenses
- One or both methods for long-term contracts
The choice of accounting method depends on the type of contract you have, the contracts’ completion status at the end of the tax year, and average annual gross receipts.
New Opportunities for Contractors to Use the Cash Method
Before the Tax Cuts and Jobs Act (TCJA), only small contractors could qualify for the cash method of accounting. Large contractors were automatically disqualified. Small contractors were defined as:
- C-corporations with a 3-year average of annual gross receipts less than $5 million
- Partnerships with a 3-year average of annual gross receipts less than $5 million in which one of the partners is a C-corporation
- Partnerships without C-corporation partners and S-Corporations with a 3-year average of annual gross receipts less than $10 million
The TCJA changes that took effect in 2018 increased the gross receipts ceiling for cash basis accounting to $25 million. It also redefined a small business as “a corporation or partnership with less than $25 million in gross receipts for the prior three-year period”. The increase in the gross receipts threshold from $10 million to $25 million creates an opportunity for more contractors to take advantage of the cash method.
Benefits of the Cash Method for Contractors
Below are a few advantages of using the cash method brought on by tax reform:
- Easier administration and simplified accounting
- Tax savings through deferred income recognition
- Accurate portrayal of cash on hand
- 481a adjustment to adjust from accrual to cash could potentially offset current year taxable income
Which accounting method is allowable and most appropriate for tax purposes is not a question that can be easily answered in all cases. If you would like to learn more about your options when choosing the cash or accrual accounting method, please contact an Anders advisor.
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