For those who are are not familiar with the financial term referred to as “accounting methods”, is an accounting tool used to determine when income and expenses are recognized for tax purposes. And with New Years and the 2020 year-end approaching, now or in January is an ideal time to review your tax accounting methods and make sure they’re helping you achieve your business’s goals. To recap a bit, what is an accounting method exactly?  Whatever type of business you hold, whether it is a partnership, C-corp, S-corp or a sole proprietorship, you are required to declare a method of accounting used for your business when reporting corporate taxable income.  As a general rule, taxable income should be computed under the same method that was regularly used to keep its respective books.  On your schedule C, under the Line F section, you are asked if your method is accrual, cash or other.  

• • Cash basis accounting recognizes revenue and expenses when cash changes hands. If a customer bought a product or service from you in July, your July reports would show the transaction. It’s an easy-to-understand method, but it’s limited. 
  • The accrual method of accounting recognizes revenue and expenses when incurred. If you sent an invoice in July and your customer paid you in August, you’d recognize the income in July. Accrual accounting is more complex to understand, but it provides a better long-term view of your business. The only real downside of accrual accounting is that it makes tracking your cash more challenging.
  • Modified cash-basis accounting, also known as the hybrid method, is a mixture between cash-basis and accrual accounting.Because modified cash basis uses elements from the other two accounting methods, it uses accounts from both the cash-basis and accrual methods. Modified cash basis lets you record both short-term items (e.g., utility bills) as well as long-term items (e.g., property).With modified cash-basis accounting, you only record expenses and income when you receive or pay money.

At this time period many medium to large sized companies are beginning to review their current year tax position as well as future years’ projections. And depending on what type of industry you are such as construction, manufacturing or distribution this may be particularly useful. If you are planning for potential tax rate increases or unexpected losses (such as this Covid-19 year), it can be useful to take another look at your tax accounting methods with your CPA and double check to see if all methods and elections are helping you achieve your business’s goals.  

Many large companies use accounting methods to figure out when income and expenses are recognized for tax purposes.  This CPA firm Plante Moran published a webinar back in August that discussed this topic. And the author Kate Oliver stated “accounting methods are a valuable — but often overlooked — tool for managing tax cash flow, which is even more valuable during times of economic uncertainty.” A taxpayer’s choice in which accounting methods are used in determining taxable income can be a very powerful tax planning tool. Any strategy should consider the many competing factors, including current cash flow, longer-term tax implications, international tax implications, and the potential for future changes in tax policy.  Depreciation planning is also an attractive option, and recent tax changes have created opportunities to accelerate deductions. Payroll taxes and prepaid expenses can be deducted at different times to allow for maximum cash flow. The current economic turmoil presents a great reason to revisit tax accounting methods and consider new opportunities. The company Plante Moran article point out a few examples of how accounting methods provide businesses the opportunity to strategically recognize revenue and expenses by: 

• Providing overall cash-tax planning – a yearly review of tax accounting methods can sometimes provide insights into opportunities such as accelerating tax deductions, reducing the current tax burden and freeing up cash for business needs. It is helpful to keep in mind that while some tax method opportunities could provide a benefit that will reverse over several years, such as something called “accelerated tax depreciation”, some methods like the cash method and inventory cost methods will result in perpetual tax deferral that would generally not reverse while the business continues operation.  
• Planning for potential tax rate increases. Depending on what happens in a few weeks in the 2 run off Senate elections in Georgia, changes in the federal administration could result in tax rate changes going forward. The Plante Moran article suggests that “if tax rates do increase, taxpayers generating taxable income could see significant permanent tax rate savings by accelerating income into low tax rate years and deferring deductions to higher tax rate years. Taxpayers identifying unfavorable changes are generally required to spread the unfavorable adjustment over four tax years, but there may be opportunities to accelerate these adjustments to take advantage of the present historically low tax rates.   
• Deferring income – there are specific strategies for advance payments, gift cards, and disputed receivables.
• Inventory tax planning – some companies may be able to reduce capitalized costs, discover strategies for cash and trade discounts, and explore different costing (LIFO, FIFO, and RIM) and valuation methodologies.
• Fixed assets – there may be opportunities to accelerate depreciation or amortization, identify assets disposed that are still being depreciated, and leverage the new tangible property regulations to reclassify capital expenditures as deductible repairs.
• Accelerating deductions. Opportunities often exist for prepaid expenses, bad debts, self-insured medical costs, software development costs, property taxes, rebates, and compensation-related accruals.
• Using the overall cash method of accounting. Service-oriented businesses may be able to use this method.

Optimizing tax method planning opportunities and considerations

Here is a list of accounting method opportunities, both for increasing and decreasing taxable income, depending on the tax planning strategy of the taxpayer.   Keep in mind that accounting methods should be implemented consistently, and once enacted, in general cannot be changed again for up to five years.  

If you want to change your accounting method, you would do so by filing Form 3115 with an annual filed tax return. Other types of planning methods provide for an election made with the tax return. Although, in some instances, method changes may require IRS review and approval, which must be filed by tax year-end.  

So before you move forward with changing from cash basis to accrual basis or vice versa, you must get the official OK from the IRS. According to an article in the Patriot Software site, Failure to request a change in your accounting method can result in penalties imposed by the IRS. To avoid penalties, make sure you reach out to the IRS to find out whether or not you must file Form 3115.

That is why it’s usually a good idea to review your company’s accounting methods before the year closes to make sure that all necessary requirements for using the methods are made on time.  

Conclusion 

If your business is looking for ways to increase its cash flow or finds itself turning profitable and on the verge of paying income tax, looking at your tax accounting methods can highlight opportunities to accelerate deductions or defer income recognition. The result: reduced current-year tax expense and more cash for your business. Companies that can benefit from a review of their accounting methods include those that have grown or become taxable in recent years as well as those that have acquired other businesses. If you have a questions feel free to reach out to Huckabee CPA for a free consultation.  Huckabee CPA can possibly help your company identify and implement accounting method opportunities to meet your business needs. Other areas that could be examined include: 

• Evaluating the accounting methods and their indirect impacts on other tax strategies
• Assistance with guiding the complex procedural rules in implementing a tax accounting method change
• Filing accounting method changes with the IRS and representing your business in the approval process