Cash or Accrual: Which Will It Be? When You Add Things up, One Method Has More Inherent Benefits

In recent years, there has been much buzz about what method of accounting best suits medical practices. This article explains the differences in these methods and points out the inherent benefit of the cash method of accounting for such practices.
Under the cash method of accounting, gross income includes cash or property actually or constructively received during the tax year. Deductions are usually taken in the year cash or property is actually paid or transferred. It doesn’t matter when the income was earned or when the expense was incurred. A few exceptions include the deduction for expenses paid by note, charge card, and pension or profit sharing accrued and paid prior to filing the tax return.
Under the accrual method, income is reported in the tax year in which the right to income becomes fixed, and the amount of the income can be determined with reasonable accuracy. Deductions are claimed in the period in which all events have occurred that determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy.
The accrual method is mandatory for most businesses where inventories are accounted for. Additionally, C corporations with gross receipts over $5 million must use the accrual method of accounting unless they are a qualified ‘personal-service corporation’ (PSC). A PSC is, generally, any corporation “substantially all the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting,” and which is owned by employees providing these services.
In November 2013, Senate Finance Committee Chairman Max Baucus released a discussion draft containing a number of tax proposals, including the reformation of certain tax-accounting rules. According to a summary of the proposals, businesses “must navigate a maze of tax-accounting rules to determine their taxable income,” and “similarly situated businesses are often subject to substantially different tax-accounting rules.”
The goals of the tax-accounting proposals in the discussion draft are to simplify tax-accounting rules so as to lessen compliance and enforcement costs, and improve tax neutrality by “eliminating the use of certain accounting methods that allow taxpayers in some industries to significantly defer or otherwise distort income measurement.”
To that end, the proposals in the discussion would require businesses that do not satisfy the below-$10 million gross-receipts threshold, including those engaged in farming and personal-service businesses, to adopt the accrual method of accounting.
The American Bar Assoc. came out strongly opposed to this proposal. Keep in mind that law firms also benefit from the ability to use the cash method of accounting. However, methods of accounting changes have been mentioned in 2015 and could surface again. What would it mean for your practice?
As with many provisions in the tax law, accrual-method accounting can be a two-edged sword. Income must be reported the earlier of when the service is provided or when payment is received. If the practice receives an advance with unrestricted use of the cash, income must be recognized although accounting principles would indicate it should be recorded as a prepaid liability.
On the reverse side of the accrual method from income recognition is timing of deductions for expenses. Expenses can be deducted when they can be calculated with reasonable accuracy and services are performed. However, accrued expenses or accounts payable must be paid within specific time limits after year-end to obtain a deduction in the year they relate. For example, accrued salaries must be paid within 2 ½ months after year-end to get a deduction. Many other expenses must be paid within 8 ½ months. Special rules apply to related party expenses.
So, there is no specific time in which accounts receivable must be collected and must always be recognized but expenses are limited. Accounts receivable must be accrued in full up to the amount expected to be paid when services are rendered. The ability to write the receivable down due to uncertainty of collection is determined on an all-or-nothing basis as to each receivable.
However, the IRS ruled that an accrual-basis taxpayer may exclude “contractual allowances” from total receivables in determining gross income if there exists, at the time the services are performed, a legally enforceable contract that provides that the payor incurs a liability for such services in an amount that is less than the standard billed charge for the same services. Additionally, the IRS concluded that an accrual-basis taxpayer may use estimates to determine the amount of “contractual allowances” to the extent the use of estimates results in gross income being determined with “reasonable accuracy.”
This ruling also addressed contractual allowances related to managed-care arrangements. The ruling states that, if, at the time of billing, the practice had in its possession the identity of the patient, any insurance coverage on the patient, the nature of the medical services provided to the patient, the standard charges then associated with the medical services provided to the patient, and the terms of any managed-care contract then in effect between the medical facility and the third-party payor and the historical payment experience, if any, with such third-party payor with respect to a particular managed-care plan.
The practice’s medical facilities used computer programs to compute contractual allowances at the time of billing for governmental receivables and a certain percentage of managed- care revenue. The medical facilities used these computer programs in determining the expected payment due from a third-party payor for medical services provided to a particular patient by applying the reimbursement terms of the relevant managed-care plan. This process is referred to as ‘modeling.’ Managed-care contractual allowances determined through modeling are reported in the patient accounts receivable at the time of billing. The practice’s methodology for computing contractual allowances for accounts that are not modeled involve the use of estimates.
In the ruling, it was stated that, to use estimates, the taxpayer must show that its methods of estimating are reasonable and properly reflect actual experience. In the event the practice fails to do this, the IRS may deny the practice’s methods of estimating the amount of contractual allowances unless the taxpayer adopts a more reasonable method of estimating that is based on actual experience.
In summary, while the ability to record accounts receivable net of contractual allowances is positive, it still does not mitigate that income may be accrued and the cash not available to make payroll payments within 2 ½ months after year-end denying the offsetting deduction. Accrued expenses other than payroll and pension or profit sharing are usually minimal. Given that the deduction for accrued pension and profit sharing is one of the exceptions and allowed for cash-basis taxpayers, let’s hope further legislation is not introduced.
Of course, this conclusion is based on generalizations, and you should consult your practice’s CPA for an exact analysis.

Kristina Drzal Houghton, CPA, MST is a partner with the Holyoke-based accounting firm Meyers Brothers Kalicka, and director of the firm’s Taxation Division; khoughton@mbkcpa.com