Choosing Cash or Accrual Accounting Can Be Confusing

Guajaro discusses the pros and cons of the cash and accrual methods of accounting.,

By Leslie Guajardo

Because construction contractors often deal with uneven cash flows and workloads, knowing whether to use a cash or accrual accounting method is often confusing. It’s particularly so for contractors who have grown quite a bit since they adopted their initial method. Whether a contractor has grown or shrunk, it’s important that the proper method be implemented because there are special tax rules that control whatever process a contractor chooses.

Leslie V. Guajardo, CPA, CCIFP, is a partner at Padgett, Stratemann & Co. LLP in San Antonio. She can be reached at Leslie.Guajardo@padgett-cpa.com.

To remain on safe ground, contractors should reassess their accounting method at the end of each year to make sure their existing method accurately reflects their financial condition and is keeping them in full compliance with tax laws.

Traditionally contractors have selected their accounting method based on the types of contracts they have, annual gross receipts and the status of contracts at the end of the tax year.

Based on these criteria, contractors then choose to use either a cash or accrual accounting system. Some use a hybrid plan, one that relies on the accrual method for overall accounting and the cash method for projects started and completed in one calendar year.

If a contractor isn’t sure which method to use, they should consult with industry accountants.

In the meantime, let’s look at the basic differences between the two accounting methods, beginning with the cash method.

As its name implies, the cash method is used by contractors who report cash receipts as income when they are received and deduct expenses when they are paid. By the way, if a contractor receives a check toward the end of this year but does not deposit it until the beginning of next year, it still is counted as income for the year in which it was received.

Depending on the length of contracts and the flow of cash, the cash method of accounting is the simplest process. A contractor cannot use it, however, if the company is a corporation or a partner with a C corporation, or has annual gross receipts of $5 million or more. Also, a contractor may not be able to use the method if the company spends more than 10% to 15% of its gross income on materials. There are a few exceptions under Revenue Procedure 2001-10, which permits most small businesses of $1 million or less to use the cash method.

Because of limitations placed on the cash method, many construction companies must use the accrual method. There are a lot of different accrual systems that can be used, each with its own set of rules. What each attempts to do, however, is match income from a contract with the attendant expenses.

With the accrual method, a contractor records income when the sale occurs — whether it be the delivery of a product or the rendering of a service — regardless of when the contractor gets paid. The contractor records an expense upon receipt of goods or services, even though they may not pay until later. The accrual method provides a more accurate picture of a contractor’s financial situation than the cash method. This is because income is recorded when it is truly earned, and expenses are recorded when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so the contractor gets a better picture of net profits for each period.

Common accrual methods used in the construction industry are the “completedcontract method” and the “percentage of completion method.”

Under the completed contract method, all income and expenses from the contract are reported in the year the project is completed and accepted by the customer.

Under the percentage of completion method, income is reported in proportion to the percentage of costs incurred to date when compared to total estimated costs for the contract. In preparing a tax return, accountants may use the Exempt Percentage of Completion Method, or EPCM, which affects only how income is computed and reported on the return. When this is used, all general and administrative expenses and job costs are deducted using the accrual method.

When it comes to the pros and cons of cash versus accrual, the cash method is easier to maintain. Contractors don’t have to record income until the cash is received and don’t record expenses until funds are paid

With the accrual method, a contractor typically records more transactions. For example, if a contractor makes a sale on account (or, on credit), they would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays the bill, the contractor will record the receipt on account as another transaction.

With the cash method, the only transaction that is recorded is when the customer pays the bill. If a contractor is using computer software to do the accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.

For purposes of convenience, a contractor probably should use the same method for internal reporting that is used for tax purposes.

However, the IRS permits a contractor to use a different method for tax purposes. Some businesses can use the cash method. If a contractor maintains inventory, however, the contractor will have to use the accrual method, at least for sales and purchases of inventory for resale.

In general it is recommended that contractors use the accrual method — if it is an option. That is because accrual provides a clearer picture of a contractor’s financial status.

Contractors need to keep a record of accounts receiveable and accounts payable anyway, so the information is already on hand to do the books on an accrual basis. If a computer program is being used, there isn’t much extra effort involved in using the accrual method.