Converting from Accrual to Cash for Construction FirmsJuly 29, 2019 July 20, 2019 /
Your success as a construction firm ultimately depends upon your ability to manage cash.
In the construction business, it is quite common for there to be significant delays between invoices being issued and receipt of payment. You have to know what you have on hand and when, as well as when you can expect more cash to come in.
The two main types of accounting methods used by construction firms are cash or accrual accounting. For some firms, it may make sense to switch from accrual to cash, but of course, we suggest you get tailored advice from a qualified CPA first!
Here’s how they work and some recent changes impacting construction firms:
Accrual vs. cash accounting
To start with the basics, let’s define how each accounting method works:
- Accrual accounting — This records your revenues and expenses during the period in which they were earned, regardless of whether any cash has been exchanged yet. So for example, if you complete a project during the month of July, the revenue from that project will be recorded in July even if payment is expected in August. The same thing goes for your expenses: you could be paying an invoice next month, but have it recorded this month.
- Cash basis accounting — This method means that you only record revenue and expenses as the cash flows in or out. So, given the same example of a project completed during July but paid for in August, the revenue would be recorded in August.
Prior to Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (2017) introduced some changes which we will go into later, but prior to that, most construction firms would have been required to use the accrual basis for their accounting.
Before the changes, any construction companies structured as C corporations (or as partnerships with a C corporation partner) were prohibited from using the cash method if their average gross receipts for the previous three tax years exceeded $5 million.
Additionally, if your construction firm made substantial inventory purchases as compared to your gross receipts, accounting for inventory was required (with “substantial” generally meaning at least 10 – 15% of gross receipts). The accrual method for accounting was required unless your gross receipts were $10 million or less.
Due to these stipulations, many construction firms had to use the accrual basis and are still using it by default. However, it may be possible to make a change….
How the Tax Cuts and Jobs Act has changed things
The Tax Cuts and Jobs Act has become synonymous with the corporate tax cuts it introduced, but there is a lot more to it, including a new ability for many construction firms to use cash basis accounting.
In a nutshell, previous thresholds for gross receipts have been raised, with both now set at $25 million. This means that any construction firm with $25 million or less in gross receipts can now use the cash method. This is regardless of their entity type or their inventory holdings. Nothing changes for companies that use a different entity, don’t hold inventory or were making less than the receipt thresholds previously.
This leaves a new decision for many construction firms: do you stick with accrual basis or switch to cash accounting?Construction firms may be eligible to switch from accrual to cash accounting now Click To Tweet
Pros and cons: Moving from accrual to cash
Both the accrual and cash methods have their pros and cons and it’s worth knowing about these first. Let’s take a closer look:
Accrual basis pros and cons
One of the biggest advantages of the accrual basis is that it shows a more accurate financial picture of the business, allowing you to plan ahead better. As revenues and expenses are shown early, any expected cash can be factored into the decisions that you make.
Many people advocate for accrual basis because they feel that it gives better control over financial information. If you typically deal with 30, 60 or 90 day periods between invoicing and payment, it’s important to be able to track and manage that.
Importantly for construction businesses, you have the choice between percentage-of-completion method or completed-contract method for your accounting. The former option allows you to bill periodically, depending on the percentage of the job completed, while the latter means you recognize revenue and expenses only once the job is completed.
Onto the cons of the accrual basis, the most prominent disadvantage is that you can end up paying taxes on income you haven’t yet received. For example, you complete a project and invoice for it in December, but don’t expect payment until February. Your receipts will be counted for December and therefore be taxable for that year.
In another situation, say you begin a project in December and bill a substantial amount early on, knowing that you’ll need cash for materials to complete the project. Generally, over the course of the project your expenses will balance out that apparent chunk of income, but if you haven’t made a lot of purchases in December, it will look like you have a much higher profit. You can end up having to pay more taxes in the short-term as they become due.
One thing to be careful of with the accrual basis is that you still need to understand the cash position of your company. Accrual can make you look flush on paper; however, if you don’t yet have the cash, you can struggle to meet your obligations. A cash flow statement is an important tool to manage this issue.
Cash basis pros and cons
Cash accounting is the simplest method, easy for most people to understand and therefore used by a lot of small businesses who meet the eligibility requirements. Construction firms can often easily manage their own books, in conjunction with a CPA who specializes in construction.
Cash accounting can give you more ability to defer income or expenses until the following year. So that invoice sent in December but not paid until February will be counted in taxes the following year. You can also ask clients to defer payment until January for an earlier invoice, therefore deferring the tax payment.
Another advantage of cash basis accounting is that you’ll clearly see the cash position of your company at any time.
A disadvantage of cash accounting is basically the flipside of accrual accounting: when you have long delays between invoicing and payment, your financial statements aren’t so useful for accurate forecasting. Sometimes, to combat this disadvantage, construction firms might use the cash method for tax purposes, but accrual for their own planning.
Time to switch?
If you’re considering moving from accrual to cash accounting, it’s worth taking a good look at the pros and cons specifically for your firm. For example, you might consider whether your accrued income tends to be higher than accrued expenses. If so, switching to the cash method may allow you to defer your tax payments.
On the other hand, the opposite is true if accrued income tends to be less than accrued expenses. In this case, switching to the cash method may accelerate income for tax purposes.
Other tax implications to consider
Here are a couple of other tax implications you should consider before making any switch:
- Your tax bracket and how that may change in the future. If you expect your tax bracket to either remain the same or decline, using the cash method along with completed-contract can provide a tax advantage. However, if you believe you may shift into a higher tax bracket, accrual can be the better option.
- Alternative Minimum Tax (AMT). If you’re considering a switch from percentage-on-completion to completed-contract method, bear in mind that you’re required to calculate income based on percentage of completion for purposes of the alternative minimum tax (AMT), too.Under the Tax Cuts and Jobs Act, the corporate AMT is repealed and the AMT exemption amount for individuals is substantially increased, so many construction firms will no longer be affected. On the other hand, if you are any business structure besides a C corporation, it would be diligent to do the math before making any changes.
Under the Tax Cuts and Jobs Act, there may be an opportunity for your construction firm to switch your method of accounting from accrual to cash.
Doing so can be advantageous under certain circumstances, but it’s important to go ahead only after you’ve got all the information on any implications involved. In some cases, it will not be advantageous.
Seek advice from a qualified CPA who understands the nuances of the construction trade. This will ensure you don’t end up with any unpleasant surprises.