Interestingly enough, Caleb just covered accrual vs cash here on Going Concern the other day. Not interestingly enough, as a subsection of the Georgia state government, the Georgia DOT’s only option is government accounting and that sure as hell ain’t accrual. Apparently Georgia governor Sonny Perdue is hip to this accounting trick that just can’t be tapped and is questioning whether or not the DOT has the legal authority to use accrual for multi-year state funding commitments.
The short answer, without being an authority on matters of accounting legality, is HELL no. They better stick to fund accounting like every other government agency but that comes with its own set of flaws. See also: 49 of 50 states facing massive budget deficits.
If you aren’t familiar with government accounting, let me make it very simple: in regular accounting, balance sheets balance. Companies shoot for assets to outweigh liabilities and if they don’t for an extended period of time, shareholders bail and the company goes under.
In government accounting, there is no real concept of “balance” and it’s all about expenditures and estimates of spending that have little connection with actual money coming in. Most government agencies would be crippled if they were forced to institute GAAP, even with the magic of government accounting we have already witnessed from the smallest municipality to entire sovereign nations.
Anyway, in 2008, an audit of DOT practices concluded that accrual accounting was a violation of Georgia’s constitution (and the sanctity of government accounting fortheloveofsweetbabyJesus) but DOT officials claim that sweating their questionable accounting methods prevents the state from funding important road projects.
Again, magic on paper, garbage in practical application. Accounting methods are not meant to turn insolvency into funding, they are merely options and their use should not be abused for users. Seriously.
Georgia voters will be trusted with resolving the issue. Better start reading some Advanced Accounting textbooks, Georgia voters, you’ll need them to pick the right door on this little game show.
Voters to weigh on DOT accounting system [Atlanta Business Chronicle]
The cash versus accrual decision is one that all businesses have to make but small businesses have to make and depending on an entrepreneur’s familiarity with the issue, this could be a very simple decision or a “HELP!” moment.
, a quick refresher:
Cash – You get cash; you record the transaction. You pay cash, you record the transaction. Simple.
Accrual – This is what your copy of Kieso, Weygandt, & Warfield harped on in college. Accounts receivable, accounts payable, deferrals, revenue is recorded when earned; expenses are recorded when incurred, the matching principle, you know the drill.
Before we get to the pros, let’s consider a simple example. If you and some friends want to pool your money together and buy a piece of commercial property, it doesn’t make a lot of sense to go the accrual route. Your tenants pay rent, you record revenue. You pay for supplies to make improvements, you record the expense. In general, don’t make something complicated that is inherently easy.
However, depending on the entity structure of your business, you may be disqualified from using the cash method. Generally, C Corporations, partnership with one C Corp partner, and tax shelters are not allowed to use the cash method. So if any of these apply, hello accrual.
Enough with the elementary crap though, amiright? Thought so. To get some additional insight, we called on a couple of partners who have no problem sharing their opinions: Scott Heintzelman of McKonly & Asbury in Camp Hill, PA and our own Joe Kristan of Roth & Company, P.C. in Des Moines, IA.
Since Scott is effectively the visitors, he’ll get first at bat. He told us that he encourages clients to adopt accrual right away for three reasons:
1) Fewer surprises. I just met with a prospect and the number 1 frustration they had about [their] prior accountant was that CPA encouraged [c]ash but things fell wrong that next year and they got killed with a tax liability.
2) It helps to prevents “games” being played with year end cash receipts and cash disbursements.
3) It helps the company to think like a “grown up” business. Too often a small business thinks and acts small (cash basis is thinking little) when I encourage them to think bigger.
So, according to Scott, if you’re thinking about getting into business you should think BIG, thus, accrual is the way to go.
Is it that simple? Well, maybe but Joe has some other considerations including – what else – taxes, “For tax, cash is normally preferred because of the ability to control taxable income at year-end. Farmers are notorious for stocking up on feed at year-end to manage taxable income, but being able to manage income by paying off A/P at year end is useful for anybody.”
Of course, the more complex your business gets, the cash method is less available:
Where it becomes a disadvantage is in mixed structures or large entities. If you have related entities doing business with one another, accrual is nice because you eliminate a lot of Sec. 267 related party problems. You don’t have to worry about paying a related party for A/P by year-end to get the deduction because they have to accrue the income.
For a simple structure without a lot of related entities, you will want to do your tax returns on a cash basis. As the structure gets more complicated, accrual method becomes more attractive, and likely mandatory under Sec. 448 or in medium to large entities with inventories.
But for anyone that has to produce GAAP financial statements Joe concedes, “I have no idea why anybody would be cash basis. You can’t be GAAP on a cash basis, and lenders don’t like that.”
The lesson? Like everything in this world, it depends. Do you have a complex entity structure with several related parties engaging in business? Accrual might be better. If you want to be the next Google (or even a fraction of Google), then you might as well be on accrual. If your bank requires GAAP financials to get a loan, you’ll be on accrual.
But on the other hand, if you’ve got no use for GAAP and a simple business not looking to get crazy, the cash method may be the way to go. If you’re still nervous about checking one box or the other, don’t worry, nothing is written in stone. Just consult your business or tax advisor and they’ll help you figure this out. Anyone got more advice? Feel free to chime in.