For accounting and tax reporting purposes, there are two widely accepted bases for accounting for a business - the Cash basis of accounting and the Accrual basis of accounting. In a recent litigation matter for which Financial Evidence Group's A. Christine (Chris) Davis served as the accounting expert and forensic accountant, the distinction between Cash basis and Accrual basis of accounting was at the heart of the experts’ opinions. Discussed below is a refresher on Cash v. Accrual basis of accounting along with a real-life example of how a privately-held company’s Equity account was materially and negatively impacted by its switch from Cash to Accrual accounting (but only temporarily as deferred revenue would convert to revenue over time).
A. The Cash Basis of Accounting and the Accrual Basis of Accounting
1. The Cash basis of accounting is a method that recognizes revenues and expenses based on the timing of when cash is received and paid, respectively, without regard to whether all associated services have been performed. The AICPA explains that, under the Cash basis of accounting:
· Revenues are recognized [i.e., reflected in the financial statements] only when cash is received rather than when earned, and
· Expenses are recognized only when cash is paid rather than when the obligation is incurred. [1]
2. For example, if a Company was paid by a customer $10,000 in January 2019 in exchange for monthly services to be rendered ratably by the Company over the next 24 months (a 2-year contract), under the Cash basis of accounting, the Company recognizes the $10,000 payment as revenue during the 2019 fiscal year reporting period. The $10,000 is earned income at the time the amount is received.
3. The Cash basis of accounting is simpler than the Accrual basis of accounting and commonly used by small businesses. In our case study, let’s assume that, from the Company’s inception in 2014 through June 30, 2020 (Q2 2020), it operated its business and appropriately accounted for its operations under the Cash basis of accounting.
4. The Accrual basis of accounting is the opposite of the Cash basis. Accrual accounting is a method that recognizes revenue when the amount is earned, and the expense, incurred, without regard to whether the related cash has been exchanged. Under the Accrual basis of accounting, whether revenue is deemed “earned” is determined by specific rules that apply under the relevant accounting framework, such as GAAP.
5. Using the same illustrative transaction in paragraph 3 above, under Accrual accounting, the Company recognizes earned income of $5,000 in fiscal year 2019, and the remaining $5,000 in fiscal year 2020, because the Company would have provided (i.e., earned, 50% of services it was obligated to provide in 2019 (the first 12 months out of 24 months). The revenue recognized in 2020 is classified as Deferred Revenue in 2019 (a liability).
B. Internal Revenue Service (“IRS”) Instructions Are Consistent with the AICPA Guidance
6. IRS Publication 538, Accounting Periods and Methods (revised January 2019), provides guidance to businesses pertaining to the appropriate determination of the accounting period and accounting method to use for tax reporting purposes.
7. With respect to accounting methods, the IRS is consistent with the AICPA’s guidance and discussion above:
The most commonly used accounting methods are the cash method and the accrual method. Under the cash method, you generally report income in the tax year you receive it, and deduct expenses in the tax year in which you pay the expenses. Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received. You deduct expenses in the tax year you incur them, regardless of when payment is made.[2] [Emphasis added.]
8. Publication 538 also explains the concept of “constructive receipt” under the Cash method or basis of accounting. Constructive receipt is consistent with the AICPA’s guidance referenced above which states revenue is earned when cash is received:
Income. Under the cash method, you include in your gross income all items of income you actually or constructively receive during the tax year. …
Constructive receipt. Income is constructively received when an amount is credited to your account or made available to you without restriction. You do not need to have possession of it. If you authorize someone to be your agent and receive income for you, you are considered to have received it when your agent receives it. Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations.[3]
9. Finally, Publication 538 explains the “gross receipts test” pertaining to partnerships and corporations: businesses using the Cash basis of accounting are required to convert to Accrual accounting upon reaching a revenue milestone—when the Company’s average annual gross receipts for the three preceding tax years exceed $25 million, it must convert to Accrual accounting.[4]
10. Using data from our case study, shown below are the Company’s gross receipts for the tax years 2014 through 2020, and the corresponding average gross receipts for the three preceding tax years beginning with 2017. As the table shows, the Company was not required for tax purposes to convert to the Accrual method until the tax year 2020, when the average gross receipts for the three preceding tax years exceeded $25 million.
11. Similar to the discussion above regarding the Accrual basis of accounting, IRS Publication 538 defines the “Accrual Method” as follows:
Accrual Method
Under an accrual method of accounting, you generally report income in the year it is earned and deduct or capitalize expenses in the year incurred. The purpose of an accrual method of accounting is to match income and expenses in the correct year. [5]
C. During Fiscal Year 2020, the Company Was Advised to Convert and Did Convert from the Cash Basis of Accounting to the Accrual Basis of Accounting Effective January 1, 2019
12. Because of the Company’s significant revenue increase in 2019, it was required to convert to Accrual accounting for tax year 2020 based the IRS’ gross revenue test. During the third quarter of tax year 2020, the Company’s accountants advised the Company to convert its accounting for the business from Cash basis to Accrual basis.
13. In or around Fall of 2020, and heeding the professional advice of its CPAs, the Company converted its 2020 financial statements to Accrual accounting. In addition, at the CPA’s recommendation, the Company retroactively applied Accrual accounting treatment to the results of operations for the entire fiscal year 2019.
14. The impact of the conversion to Accrual accounting pertained to recognizing or establishing, for the first time, the deferral of revenues relating to customer payments received but for which future services were owed. In the Fall of 2020, to retroactively convert 2019 to Accrual accounting, the Company recognized for the first time the Deferred Revenue account as of December 31, 2019 with a $36.9 million balance (a liability). The Company’s Equity account was decreased for the same amount. As the Company’s 2019 Equity account prior to Accrual accounting conversion was a positive $2.8 million, the post-accrual Company Equity account became revalued to negative $35.1 million.[6] This was the first time the Company’s Equity became negative, and this fact was not known until the Fall of 2020 in connection with the conversion to Accrual accounting.[7]
D. Insights/Conclusion
15. It is important to note that the magnitude of the newly-established Deferred Revenue account and the related negative impact to Equity was not a result of an accounting error, a misapplication of accounting principles, or fraud—it was a result of something very positive: the accelerated growth the Company had experienced in the last few years leading up to 2019. As shown in the table below, Gross Receipts (cash receipts) increased from $16.4 million in 2017 to $64.9 million in 2019. Had the 2019 Gross Receipts been materially lower, the adjusting journal entry recognizing Deferred Revenue would reflect a much lower amount.
16. With respect to Deferred Revenue and the related (negative) impact on Equity, it is equally important to note that Deferred Revenue is reduced and reclassified to Revenue as services are provided by the Company. As Deferred Revenue is reclassified to Revenue, the Equity account is correspondingly increased (towards the positive). In reviewing the underlying data supporting the accrual journal entry in the Fall of 2020, Chris observed that the majority of the Company’s Deferred Revenue was reclassified to Revenue within the short-term; this is good news, as it also means the Equity improved accordingly.
17. The table below shows that the Company had been reducing Deferred Revenues (that were created upon switching to Accrual accounting) at a relatively fast pace by providing services as promised. As shown in the table, of the Deferred Revenues at 12/31/2018 in the amount of $16.5 million, 89% of that amount was earned by the end of 2019. Similarly, of the Deferred Revenues of $35.1 million at 12/31/2019, 68% had been earned as of June 30, 2020 (within 6 months). This means that the Company’s Equity was also improving at the same rate - the material and negative equity created by the Company’s switch to Accrual accounting as required by IRS guidelines will reverse into positive equity within the next few years. There’s no question that the Company, or any company, would gladly accept the accounting recognition of negative Equity on a temporary basis in exchange for the significant revenue growth and positive cash flow it had experienced.
[1] See AICPA Practice Aid, Accounting and Financial Reporting Guidelines for Cash- and Tax-Basis Financial Statements, page 6 [2] See IRS Publication 538, Accounting Periods and Methods, page 2. [3] See IRS Publication 538, Accounting Periods and Methods, page 8. [4] See IRS Publication 538, Accounting Periods and Methods, page 9 (Gross receipts test). [5] See IRS Publication 538, Accounting Periods and Methods, page 10. [6] The 2019 Partnership tax return shows that the Company’s equity as of December 31, 2019 was negative $35,133,182 (Form 1065, Schedule L, Line 21(d)). The $35.1 million in equity reflects approximately $1.0 million in other adjustments in addition to the $36.9 million of deferred revenues. [7] It is important to note the recognition of deferred revenues arising from a conversion to Accrual-basis accounting is not unique to the Company. Any business accounted for on the Cash basis of accounting will necessarily establish a Deferred Revenue account upon conversion to Accrual-basis accounting if the business provides services under a multi-period contract and receives payment in advance of providing services.