Tech Industry Cash Flow: Cash vs Accrual Methods
Cash is king for many tech companies, but this is especially true for startups. Deferral of income taxes frees up cash and makes it available for reinvestment. Maintaining a healthy reserve can be the difference between surviving and thriving, so why pay the government early? You need your accounting approach to meet your needs for liquidity.
Tech Industry Cash Flow: Cash vs. Accrual Method
Generally, tech companies must use accrual or cash method of accounting as their overall method of accounting.
Let's say a company's accounts receivable is greater than accounts payable (accrued expenses). The cash method grants them the ability to defer paying income taxes on the difference. It takes cash flow into consideration, allowing a company to pay tax on income when received, instead of when earned.
You'd report income in the year actually (constructively) received and deduct (capitalize) expenses in the year paid. Generally, you can do this if inventory is not an income-producing factor, or if its role is small compared to the services provided.
Under the accrual method, a company would report income in the year earned and deduct expenses in the year incurred. Unless you meet an exception, this method is required when you maintain inventory for production, purchase, or sale.
Companies can also elect to maintain their books using the accrual method of accounting, and use the cash method for tax purposes. The accrual method is often required by banks, as it can help companies verify their financial position.
Determining Factors for Utilizing the Cash Method
Many tech companies qualify for the cash method because of their business’s unique characteristics. Factors that determine whether to use cash or accrual-based accounting include:
- What a company produces or provides as a service,
- How they’re organized (entity type and organizational structure), and
- Gross revenues a company has received
What about exceptions? Here are some to avoid having to use the accrual method:
- Rev. Proc. 2001-10 – $1 million exception
- Non-tax-sheltered businesses with average annual gross receipts of $1 million or less over the past three years usually qualify for the cash method. You could treat inventory as materials and supplies under Reg. 1.162-3.
- Rev. Proc. 2002-28 – $10 million exception
- Companies that are not involved in mining, manufacturing, wholesale, retail, or the information industry and have average annual gross receipts over the past three years of $10 million or less may qualify to use the cash method. Section 448 generally prohibits the use of the cash method by a C corporation. Also, tax shelters cannot use this Rev. Proc. You could treat inventory as materials and supplies under Reg. 1.162-3.
- C Corporations
- C corporations with average annual gross receipts over the past three years of up to $5 million can sometimes use the cash method of accounting. If inventory is an income-producing factor, they'll have to use the accrual method of accounting instead. This requirement does not apply to C corporations with average gross receipts over the past three years of less than $1 million, or to qualified personal service corporations.
Review Your Method Annually
Remember, the longer a company can defer paying income taxes, the more cash they will have on hand to inject into the business. Many tech companies are eligible for the cash method of accounting and should review their situation each year to ensure that they are using the best method.