Recent legislative proposals have accountants stepping up to make clear which accounting method they prefer -- and it's cash, by a long shot.
A number of groups testified or submitted statements on the cash method at recent hearings before the House Committee on Small Business Subcommittee on Economic Growth, Tax and Capital Access. The American Institute of CPAs, the American Bar Association, the National Conference of CPA Practitioners, and the National Association of Enrolled Agents were just some of the groups represented in urging the expansion of the cash method as a way to simplify the tax complexity facing small-business owners.
Chairman Tom Rice, a former tax attorney and CPA, noted that the cash method offers a simple, straightforward solution for entrepreneurs to record business income and expenses. "In cash accounting, a business records income and expenses at the time the funds are received or paid, just like with a personal checkbook," he said. "And it makes it fairly easy to track cash flow - the life blood of many entrepreneurs. Perhaps because of this simplicity, it is the preferred method of accounting for small businesses. The other, more complicated method - accrual accounting - requires a business to record income at the time a sale is made or an agreement to provide a service is reached, regardless of when the payment is actually received. By the same token, expenses are recorded when they are obligated to be paid, regardless of when funds are actually disbursed."
"In determining which accounting method to use, small-business owners must comply with the Internal Revenue Code," Rice observed. "Specifically, all businesses are required to use the accrual accounting method, although exceptions exist."
"Ultimately, whichever method is used can have very real effects on how a small-business operates," Rice said. "Given this, it would be in the interest of us here in Washington to ensure our nation's job creators have the flexibility to use the accounting method that best suits their operations and gives them the best chance to succeed."
The AICPA supported expanding the availability of the cash method of accounting in testimony submitted for the hearing. "We wholly support the expansion of the number of taxpayers that may use the cash method of accounting," the institute wrote in its statement. "The cash method of accounting is simpler in application, has fewer compliance costs, and does not require taxpayers to pay tax before receiving the income being taxed."
The AICPA also expressed its opposition to any legislative efforts to limit the use of the cash method for small and service businesses, including those businesses whose income is taxed directly on their owners' individual returns, such as S corporations and partnerships. "We have confidence that forcing more businesses to use the accrual method of accounting for tax purposes would increase their administrative burden, discourage business growth in the U.S. economy, and unnecessarily impose financial hardship to cash-strapped businesses," the institute stated.
Likewise, the American Bar Association submitted a statement noting the advantages of the simple cash method of accounting and expressing serious concerns over legislation that would force many firms to switch to accrual accounting and pay taxes on phantom income they might never receive.
A draft tax reform proposal released by House Ways and Means Committee Chairman Dave Camp, and a similar draft bill prepared by former Senate Finance Committee Chairman Max Baucus, would require all personal services businesses with annual gross receipts over $10 million to use the accrual method of accounting, rather than the traditional cash receipts and disbursement method.
"As a result, many law firms, accounting firms, medical firms, and other personal service providers would be forced to pay taxes on income long before it is actually received," the ABA wrote. "The existing cash method of accounting produces a sound and fair result because it properly recognizes that the cash a business actually receives in return for the services it provides -- not the business' accounts receivable -- is the proper reflection of its true income and its ability to pay taxes on that income."
Roger Harris, president and chief operating officer of Padgett Business Services, testified at a previous hearing on the Camp proposal before the House Small Business Committee. "Camp's basic proposal was an expansion of the cash accounting method for businesses under $10 million in gross receipts, and the means to pay for it was the removal of cash accounting for all businesses over $10 million, with some carve-outs," he explained. "What that means is that businesses with over $10 million would be forced to switch to the accrual method."
The witnesses at the most recent hearing focused on the challenges to those businesses that now would be forced to give up the cash accounting method and switch to the accrual method, Harris indicated. "The theory all along for the accountant or lawyer is that until you get the money in the bank, it's not income, and until you pay the bill it's not an expense," he said.
"Both the Finance Committee and the Camp reform proposal have cash accounting pieces to them," Harris noted. "And both have a $10 million threshold. The difference between the cash method and accrual method is timing. Net income in both the cash and accrual methods is the same over a 30-year period -- what the accounting method does is decide when an item shows up as income."
Stephen Mankowski, national secretary and national tax policy chair of the National Conference of CPA Practitioners, noted that if small businesses were required to convert their accounting method to the accrual basis, the overall impact might simply be a one-time hit, with the annual effect not as significant as one might expect. "The one-time hit, however, could be very significant, depending on the business," he warned. "Newer entities or entities with minimal accounts receivable or accounts payable would likely have a small tax increase and possibly even a tax decrease. Entities with a larger receivable base, however, would not be so fortunate. To properly convert, they would need to report all open receivables as current income and all unpaid bills as current expenses."
"The impact of this added income could propel the owners into higher tax brackets, which in turn could lead to the phase-outs of itemized deductions and personal exemptions, phase-outs of other deductions and credits including tuition and student loans when the increased income is reported on their individual income tax returns," he added. "In addition, taxpayers may find themselves subject to the Net Investment Income surtax that became effective last year."
The hearings were in response to both the Camp proposal, and Baucus's discussion draft, according to Mankowski. "Both proposals would force some businesses that would normally have been exempt, such as farmers, to have to convert to the accrual method."
"For many small businesses, this would be very cumbersome and expensive," Mankowski said. "The plan provides a graduated four-year phase-in, which would be an accounting nightmare. On our end, it's tough enough to get financial information from small-business owners as it is. Most of them don't have the wherewithal to adequately track their accounts receivable."
Don Williamson, professor of taxation at American University's Kogod School of Business and executive director of the Kogod Tax Center, described the burden placed upon small businesses when they are required to be on the accrual method of accounting. "Even where the law permits a small business to use the simpler cash method of accounting, the general requirement to maintain inventory records creates burdens that may influence by only a few months the timing of a small business' taxable income," he said. "Therefore, we urge Congress to not only expand the number of businesses eligible to use the cash method of accounting but to also enact a â˜simplified' cash method of accounting for small businesses that would further reduce unnecessary recordkeeping and compliance burdens."
Even senators like it
In a sign that the recent hearings are influencing minds on Capitol Hill, 46 Senators have signed a letter to Senate Finance Committee Chairman Ron Wyden, D-Ore., and ranking member Orrin Hatch, R-Utah, urging the preservation of the cash method of accounting for tax purposes.
"As the Finance Committee develops its comprehensive tax reform package, we ask that you consider the negative impact that this proposal would have on the professional services sector as well as farming and ranching businesses," the senators wrote. "We believe that such a change has not been fully vetted and many of the concerns raised by these businesses have not been addressed."
"Requiring more businesses to use the accrual method of accounting would create unnecessary complexity in the tax law and substantially increase compliance costs. ... In addition to the substantial cost of changing accounting systems, these businesses would also be burdened by having to pay tax on income before it is actually received."
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