It’s everyone’s least favorite time of year. That’s right, tax season. For those of us who no longer work in public accounting, this time of year is now a welcome reprieve; although for us, it also marks the start of incurred cost season. If you’re not sure what an Incurred Cost Submission is or have questions about that topic, visit our website for a variety of resources.
Cash vs. Accrual Accounting
For government contractors, March 15 marks the due date for your business tax filings unless you’ve prepared an extension. For many government contractors, this time of year is when many questions come up regarding cash vs. accrual basis of accounting. For small businesses, their tax returns are often prepared on a cash basis, but their books of account are maintained on an accrual basis. Cash basis, in laymen’s terms, means that revenue is recognized when the cash is received, and expenses are recognized when the expenses are actually paid. Accrual basis means that you recognize revenue as the revenue is earned in accordance with generally accepted accounting principles (GAAP), often in advance of the actual receipt of cash. Likewise, under accrual basis, expenses are recognized when they become liabilities of the company or when the benefit is received.
Choosing Your Approach to Accounting
There are pros and cons to both approaches. Under cash basis, your books reflect your real cash balance at the time of financial reporting, and generally, for business owners who are not accountants, this method is easier to follow and understand. The primary drawback to cash basis (and benefit to accrual) is that your revenues and expenses don’t always match up, which can generate wild swings in profitability due to timing differences. Because accrual basis employs the matching principle where revenues and expenses are matched to the period in which they were earned/benefit received, your financial statements present a more realistic picture of the actual health of the company. This is the reason why accrual basis is required under GAAP for external reporting typically to your banks, financial statement audit, and why it is a requirement under FAR for certain types of contracts.
Why Use Both Accounting Types?
Why would I maintain my books for government contract reporting on the accrual basis and then have to change it for tax reporting? That seems like a lot of work.
First, It’s a requirement for flexibly-priced contracts (T&M & Cost-type) and highly encouraged for any other FAR Part 15 contracts. FAR 16.301-3(a)(3), which covers limitations on contracting officers for the award of cost-type contracts, requires that the contractor’s accounting system be adequate. As a matter of responsibility, this determination must be made prior to contract award and is done through the SF-1408 PreAward Survey of Contractor Accounting System.
Further, DFARS 252.242-7006(c)(18), which is the current benchmark for contractor accounting system adequacy employed by the DCAA, requires accounting practices in accordance with GAAP. Finally, FAR 31.201-2(a)(3), which applies to all FAR Part 15 contracts awarded to commercial organizations, states that a cost is only allowable when claimed on the basis of GAAP. In summary, if you’re estimating/proposing costs or billing costs under FAR Part 15 contracts the government requires your books to be maintained on an accrual basis in accordance with GAAP.
Second, if you’re going to keep your books on an accrual basis all year, why suddenly change it when it comes time for tax reporting? There are some distinct benefits for all businesses to report for tax purposes on a cash basis. Namely, you’re only paying tax on the revenue (cash) you’ve actually received, so in a way, it defers tax liabilities into future periods. From a cash flow perspective, it isn’t much fun to pay taxes in advance of receiving the cash in your bank account and can place an unneeded strain on the business. Tax accountants should be familiar with both methods, and it is an extremely common practice to perform a “cash-flip” which converts your books maintained on a GAAP accrual basis to a cash basis. This is a basic accounting procedure that any reputable CPA firm or tax preparer should be familiar with as a routine process in the preparation of business tax returns.
We Can Help
For additional information regarding accounting types, reach out to the experts at Redstone Government Consulting. We offer training and resources to assist your accounting team in choosing he right method for your company’s needs. Visit our resources page for a slate of blogs and whitepapers filled with information you can use to strengthen your knowledge of government regulations, compliance, and accounting requirements unique to the industry.