• Home
  • /
  • Blog
  • /
  • Does a change in accounting method impact cashflow?
Loading the audio player...

Wyatt asks:

I have a series of business tax returns (2020-2023) that I’m reviewing. The company switched from cash basis to accrual basis between 2020 and 2021. On the 2021 tax return, the company included on Line 5 of Page 1 (S-Corp) an $8.9MM IRC 448 Adjustment. This has not appeared on the expense side anywhere that I can find, nor has it recurred in any year before or after 2021. Could you help me determine if I should include/exclude this item in the company’s cash flow?

Robert Says:

A change in accounting method can create a double-counting of revenue or expenses, or cause you to miss something significant altogether. Thus, these adjustments are critical to understand.

That said, as so so often the case, the decision to include the adjustment or not is complicated. It depends on what year you are in.

Why are they changing their accounting method?

The fact is that it is a hassle to change an accounting method. Remember, the tax return is not designed to be helpful information to the business so the accounting method used on financial statements is more important for management purposes than the accounting method used on a tax return.

On the tax return, we typically make the choice that will minimize or defer taxes. For many small- to mid-size businesses, that is cash basis. As the business grows, accounts receivable may grow as well. The longer you can wait to report that income and pay taxes on it, the better.

What is an IRC 448 adjustment?

IRC stands for Internal Revenue Code. IRC 448 happens to be the reason this borrower is changing the accounting method. Their revenue reached the level that requires the accrual basis method.  Cash basis is not allowed, generally,  once gross receipts are in excess of $27 Million in 2022. 

What about the IRC 481 adjustment?

There is a great blog post on the IRC 481 adjustment which is the needed adjustment not to drop income out of the picture or report it twice.

In that post, you will walk through how the change in accounting method can actually cause you to double-count or lose income altogether. In your example, I believe that one-time amount is picking up revenue that was earned in 2020 (and therefore properly left out of the cash-basis return) and received in 2021 (and therefore properly left out of the accrual basis return).

My general rule:

If you are analyzing 2 or 3 years and the pre-change year is in the mix, leave the adjustment in. It is picking up what you would have included if the earlier year was the same method as the other years.

According to the IRS: “The IRC 481(a) adjustment period is one taxable year for a net negative adjustment and, in general, is four taxable years for a net positive adjustment for an accounting method change.” So if you are still looking for cash flow, find out if the adjustment needs to include all 4 years.

Once the oldest year is after the change, do not include the adjustment anymore. You may have the last of the 4 years in your numbers, but no longer need the adjustment.

More on Cash vs Accrual method

In the Financial Statement Analysis course in Lenders Online Training, we focus on the fundamentals and practical application of the financial statements your small- to mid-size business borrowers provide. And yes, we have a module that walks you through cash vs accrual, what difference it makes, and even how to convert it yourself.

Got a Question? Send it to us at experts@lendersonlinetraining.com and have your question answered by one of our Credit Analyst Experts.

More Resources for Credit Analysts

Here is the link to our demo so you can see for yourself what learning with Lender’s Online Training is like.

We have also “written the books” on Tax Return Analysis. Check out our Lender Training Manuals.

Subscribe to "Ask the Experts"

Are you a credit analyst seeking clarity on complex tax returns and financial statements?

Subscribe to our "Ask the Experts" blog and have your most pressing credit analysis questions answered by industry professionals. 

You may also like