A change in accounting method from cash to accrual: new revenue procedures use incentives to encourage voluntary compliance.

• Author: Wahrmann, Sally A.

New Revenue Procedures Use Incentives to Encourage Voluntary Compliance

One of the oldest axioms in the business world is "obtain the highest possible financial income while reporting the lowest legal taxable income." It cannot be denied that a strong financial statement builds equity, promotes expansion and eases credit requirements. On the other hand, high income generally means higher taxes. Nobody likes to pay taxes. Thus, it has been the goal of entrepreneurs, and their advisers, to devise methods that would accomplish this objective.

Reporting financial income on the accrual basis, while filing tax returns on the cash basis, is a popular technique. This tactic permits the entity to recognize financial income and expenses according to the matching principle promulgated by generally accepted accounting principles (GAAP). Meanwhile, the recognition of taxable income can be deferred until actually received (often years). A successful enterprise can often defer or reduce its tax liability from the maximum 34% to the minimum 15% rate.

Congress has recognized this disparity in reporting taxable income, and initiated legislation to require, coerce and encourage cash-basis taxpayers to convert to the accrual method. The Tax Reform Act of 1986 (TRA) directly addressed this issue by adding Sec. 448, "Limitation on Use of Cash Method of Accounting," to the Code.(1)

This article will contrast tax law with accounting principles; clarify the appropriate accounting method; identify those circumstances requiring the accrual method; examine the advantages and disadvantages of elective versus required change and the planning strategies available; and analyze compliance requirements and the incentives for change offered under three new revenue procedures.

Tax Code vs. GAAP

The Code and regulations do not define the terms "accounting" or "accounting method." Yet, the law is very specific in stipulating when and how items of income are to be reported. Therefore, an entity's "tax accounting" method would imply the procedures, processes and practices that are followed in determining taxable income. The term "accounting method" includes not only the overall method of accounting used by the taxpayer, but also the accounting treatment of any item.(2) Consequently, it is important to understand that a change in accounting method also includes any change in a material item used in an overall plan. Materiality of an item is defined in the regulations as any item that involves the proper time for inclusion in income or the taking of a deduction.(3)

Frequently, tax law does not agree with GAAP (used for financial statements) because social, economic and government funding requirements have been built into the Code.

The Financial Accounting Standards Board (FASB) has identified several objectives of financial reporting. The general objective is to provide useful information for present and potential investors, creditors and other external users in making rational investment, credit and similar decisions.(4) Since GAAP and "tax accounting" have different objectives, taxpayers have been able to justify maintaining different methods of accounting. In Patchen,(5) the court concluded that reconciliation schedules between the general books of account and a cash method tax return were to be included as part of the "books." Therefore, compliance with Sec. 446 had been met.

Planning opportunity: A taxpayer may keep its records of account on the accrual method and still file its tax return on the cash method. Schedules maintained by the taxpayer reconciling income to the tax return are required.(6) This may be used by new small corporations that are not otherwise required to use the accrual method. Later, an "expeditious procedure" permitted for an accounting change of cash to accrual can facilitate a possible six-year spread of the adjustment to income.

Appropriate Method Under GAAP

GAAP recognizes the concept of matching under the accrual method. The intention is to determine revenue first and then match appropriate costs against revenue. If a financial statement is prepared on another basis of accounting, a statement must be made that the presentation is not in conformity with GAAP. Many small businesses have chosen this method. By preparing their financial statements on an income tax basis, many of the complexities, such as calculating deferred taxes, are avoided. Thus, the cash method of accounting can be used when preparing a compilation or review financial statement.

Permissible Methods Under the Code

Both the cash receipts and disbursements method (cash) and the accrual method are permissible under the law. A taxable entity must follow the general rule that "taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books."(7) Although the law specifically permits the use of both cash and accrual methods, Sec. 448 places limitations on the use of the cash method. C corporations and partnerships including C corporations as partners and tax shelters are not permitted to use the cash method.(8) Thus, new businesses of these types are required to use the accrual method of accounting when filing their first tax return. However, there are three exceptions to this rule.

* Exceptions to the use of the accrual method

For C corporations and partnerships including C corporations, if the entity qualifies under one of three exceptions, the cash method is permitted. 1. A farming business, as defined in Sec. 263A: If the taxpayer is engaged in a separate business that requires the use of the accrual method, this will not preclude the taxpayer from using the cash method for the farming business.(9) 2. A "qualified personal service corporation": According to Sec. 448(d)(2), this exception applies only if two tests are met.

* The function test requires that at least 95% of the corporation's activity involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting.(10)

* The ownership test requires that at least 95% of the corporation's stock be held directly, or indirectly, by active or retired employees who perform, or performed, services as qualified under the function test. The estate of an employee would also qualify.(11)

A personal service corporation that fails to meet either of these tests must change to the accrual method. 3. A small business: This exception requires the application of a gross receipts test of $5 million using an average of three tax years.(12) A change to the accrual method is required in the year following a failure under this test.

Example 1: XYZ Corp. had gross receipts as follows: 1989 3,000,000 1990 5,000,000 1991 10,000,000 Total 3-year receipts $18,000,000 Since this is an average of $6,000,000 ($18,000,000/3), the corporation would be required to use the accrual method of accounting in 1992.

* Inventory factor - accrual method required

The accrual method is required for taxpayers that use inventory in computing income results.(13) If the IRS can establish that inventories are a material income-producing factor, taxpayers have no argument to support use of the cash method.

Two exceptions may exist when dealing with inventory.

* Incidental materials and supplies used in a service business have been deemed permissible with the use of the cash method.(14)

* Small inventories that "did not effect any substantial distortion of income"(15) have also been permitted with the use of the cash method.

The question arises, "Why would a taxpayer change from the cash to accrual method?" Answers to this vary a great deal and depend on different situations. The following circumstances may cause a taxpayer to change methods.

* Acquisition of inventory has occurred for the first time.

* Annual gross receipts exceed $5 million and are...