Many professional services businesses choose to use the cash basis method of accounting over the more complex accrual method. As part of its past tax reform efforts, Congress has unsuccessfully proposed legislation that would limit the use of cash accounting. A recent Senate panel has renewed this controversial debate. And several professional organizations are once again up in arms.
Cash vs. accrual
Cash basis accounting allows businesses to record revenue and expenses when they’re received and paid, respectively. For federal tax purposes, the simpler cash method is available to small businesses with annual gross receipts of less than $5 million and to professional services firms of all sizes. Examples include accounting, architecture, engineering and law firms, as well as dentistry and medical practices.
With accrual accounting, businesses record revenue when it’s earned and expenses when they’re incurred. This method is seen as more appropriate for large and complex businesses.
You can quickly tell if a business uses the accrual method by looking for accounts receivable, prepaid assets, payables and accrued expenses on its balance sheet. These accounts generally occur only when a business uses accrual accounting.
Under the accrual method, revenues are recorded when the work has been completed and the company sends out its invoice. Under the cash method, revenues are reported when the customer pays. So the accrual method generally results in earlier revenue recognition — and faster tax collection for the government — than the cash method.
Renewed interest in mandatory accrual accounting
In late 2013, Sen. Max Baucus, then chairman of the Senate Finance Committee, and Rep. Dave Camp, then chairman of the House Ways and Means Committee, proposed raising the gross receipts threshold from $5 million to $10 million, which would have eased the burden on the smallest businesses. But their proposal also would have forced professional services firms above that threshold to switch to accrual accounting. The Camp and Baucus initiative withered after drawing a wide backlash in Congress.
Now the Senate Finance Committee is considering reviving a similar proposal as a way to boost tax revenues. The committee has asked for public input on mandatory accrual accounting as part of a broader upcoming tax reform effort. In a May statement, Finance Committee Chairman Orrin Hatch and Ranking Member Ron Wyden said they were giving the tax working groups more time to issue recommendations and may issue a proposal as early as this summer.
In letters to the Senate panel, the American Bar Association, the American Council of Engineering Companies, the American Institute of Architects, the American Institute of Certified Public Accountants, and other professional firms and organizations reasserted their opposition to a switch to mandatory accrual accounting for services businesses. They say the switch would impose new tax liabilities and compliance costs on the firms.
The proposal wouldn’t require services firms to use accrual accounting for book purposes. But if a firm instead used cash accounting for book purposes, it could result in book-to-tax differences, thereby adding complexity to financial reporting. For practicality, most services firms would likely use accrual accounting for both book and tax purposes. And record-keeping generally would be more complicated and subjective under the accrual accounting method.
Mandating the accrual method would “significantly complicate tax compliance for a far greater number of small business taxpayers, including many solo practitioner lawyers, law firms, and other personal service businesses,” wrote the ABA in an April 2015 letter. The ABA urged the committee to leave the mandatory accrual accounting proposal out of any new tax reform bills.
The AICPA echoed these sentiments and wrote to Congress, “We believe 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 on cash-strapped businesses.”
Wait and see
The recent public comment letters are a sign that opponents are preparing for a possible repeat of the debate later this year. Their arguments are essentially identical to positions the groups took during fights over accrual accounting proposals in past years. Only time will tell whether these arguments will successfully keep accrual accounting requirements at bay for services firms in the future.