Case Study: Understanding Cash vs. Accrual Can Create Opportunities for Tax Savings and Process Efficiency

Case Studies | Andrea Fantozzi | Jul 27, 2021

Many companies assume the tax professional processing their returns will convert their financials to tax basis. This can be a costly assumption in terms of both tax savings on a yearly basis and ongoing financial reporting efficiency. The Italian Service Group of Prager Metis recently assisted a US subsidiary of an Italy-based organization with the conversion of their books from cash to accrual   basis. The name of this client is being withheld for privacy purposes.

The Challenge

The client, a distributor, engaged Prager Metis to prepare its annual US corporate tax returns and educate the client about US tax compliance. Prager Metis is also assisting with the management of tax depreciation of the client’s fixed assets.

During the proposal process, Prager Metis and its Italian service group observed that the client kept its financial reporting on an accrual basis but elected the cash basis for tax purposes, which was highly inefficient and likely causing the client to miss out on opportunities for tax savings.

Prager Metis learned that the client had previously engaged a local office of a national accounting firm to prepare its tax returns. The client informed Prager Metis that it had relied on the national firm’s accountants to prepare the conversion from accrual basis to cash basis, but the client did not fully understand the process and simply turned over the financials to the accounting firm.

The Solution

Making the proper election on federal tax returns is a serious matter with potentially significant financial consequences. First, the Prager Metis Italian Service Group informed the client that converting its tax basis of accounting from cash to the accrual method was an additional service to the tax return compliance, not an included service as assumed, for the previous accounting firm.

Second, Prager Metis explained how converting to accrual could result in greater financial reporting efficiency and tax savings.

With cash basis accounting, sales and expenses are documented when money changes hands. Professional services companies typically use this method of accounting. With accrual basis accounting, however, reveues and expenses are recorded as soon as transactions take place

Accrual basis accounting makes more sense for manufacturers and distributors. This decision often hinges in large part on accrued expenses that are generally advantageous for tax purposes.

Because this distributor client’s accrued expenses appeared to be increasing and the client would not have a significant amount of deferred income or receivables, Prager Metis recommended converting from cash to accrual, which would likely result in tax savings as well as process efficiencies.

The Results

The benefits of the Prager Metis strategy are clear when applied to the client’s prior year tax returns. The client added back approximately $900,000 of payables to its taxable income and deducted accounts receivable of approximately $600,000.

On an accrual basis, the client would have had approximately $300,000 less taxable income, likely resulting in more than $60,000 in tax savings.

The client is already maintaining its books and records on an accrual basis, which allows for greater gains in process efficiency. Previously, each account would have to be researched separately to determine how to reverse its accruals. This is a resource-intensive process.

With the Prager Metis solution, all account data is connected, enabling the client to easily convert its financials from accruals back to cash with the click of a button.

Contact Prager Metis for Tax Planning and Preparation

Understanding the difference between cash and accrual accounting and how to convert from one to the other can result in substantial tax savings and efficiency gains for manufacturers and distributors. Contact Prager Metis and its Italian Service Group ( Andrea Fantozzi, Partner and Italian Desk Leader email afantozzi@pragermetis.com and Marc Vojnich, tax  manager email mvojnich@pragermetis.com) for tax planning to achieve the greatest tax benefit.

2021-08-20T11:24:46-04:00