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Cash vs. accrual: Weigh risks of each method
In late 2001, the U.S. Treasury Department seemingly gave many small business taxpayers, including veterinarians, one less headache in the form of a cash-based accounting method.
In late 2001, the U.S. Treasury Department seemingly gave many smallbusiness taxpayers, including veterinarians, one less headache in the formof a cash-based accounting method.
But read the fine print first, cautions Marsha Heinke, DVM, CPA withOEM, Inc.
The revenue notice says service-related businesses with $10 million orless in annual average gross receipts can elect cash basis of accountinginstead of the more complex accrual and inventory method. Previously, theIRS allowed businesses with gross receipts of $1 million or less to usethe cash method.
While Sen. Kit Bond (R-Mo.), proponent of the cash method, calls thechange "a home run for small business" Heinke, who advises U.S.veterinary clients on accounting issues, wants veterinarians to beware beforeswitching methods.
More than meets eye
"The revenue notice provides guidance through (various) code sections(446, 471, 441, 442, 263) to build a case for how a business might be eligiblefor cash basis accounting," she says.
Of note, two code sections involve business inventories.
The code sections denote any business's supplies and inventories thatare more than an incidental portion or contributory to revenue generationneed to be counted, Heinke says.
The cash receipts method requires declaration into revenues only amountsreceived from clients whether earned or not, she says. "(For) expenses,what you've paid can be deducted."
Many companies will try to defer income recognition as long as possibleand accelerate deductions quickly, thereby creating a mismatch in cash methodology.
Code section 446 is pivotal to the accounting methodologies.
"It basically says whatever method you choose must clearly reflectyour operations," Heinke says.
With pure cash basis, it becomes a "yeah, but" situation, shesays. You can take the cash basis option, but when you realize all the exceptions,it may not be worth it.
Inventories and supplies
Inventories and supplies raise a red flag for animal hospitals.
The cash basis option says you may not deduct for tax purposes amountspaid for supplies or inventories until the latter of when those items aresold to clients, consumed while providing services or when the bill is paidfor the items.
"You have to create an accounting system that allows you to keepthose (items) off the tax return until you can take them as a deduction,"she says.
For service-based veterinarians, such as board-certified ophthalmologistswho use minimal supplies, they might make an argument for cash receipts,she notes.
"Equine and large animal practices or small animal practices thathave been very lenient in allowing clients to charge on account are theexception to the rule."
The advice from Heinke for other practitioners is to ask an accountant:Have we capitalized inventories and supplies appropriately? Are receivablesunder control to make a change from modified cash to accrual less painful?
"The important thing for practitioners to understand is if theyare not in compliance now and the IRS audits them, they can force the changeall in one year," she says. "That creates a huge potential taxliability plus possible penalties and interest. If you voluntarily ask thecommissioner for a change in accounting method, you can elect to take atax hit over four years, and effectively mitigate some potential lossesfor the practice."
Heinke recommends practitioners devise a plan to go to accrual, lookat ramifications and plan accordingly. Seek an accountant or specialistin the veterinary profession and tax law to analyze your situation for alternativeadvice.
The new rules are effective beginning with the 2001 tax year.