Your Taxes: Cash or accrual basis?

Good accounting is fine, but less tax is better for most people (even temporarily).

Money cash Shekels currency 521 (photo credit: Reuters)
Money cash Shekels currency 521
(photo credit: Reuters)
Accountants the world over are brought up to prepare financial statements on the accrual basis rather than the cash basis. Under the cash basis, income is recognized when the customers pay you and expenses are recognized when you pay them.
The cash basis is simple but open to manipulation . For example, you can get your annual taxable profit down by encouraging clients to pay the following year, or by your suppliers before they supply anything.
Under the accrual concept, you generally recognize income and expenses when the transaction arises, not when payment is made; also you recognize profit in a year only after deducting all relevant expenses, paid or not, from income. So the accrual basis is intended to quantify profit year by year more reliably than the cash basis so that business owners have a clearer picture of how they are doing.
The differences between the two bases are usually short-lived; profit pushed into a later year is subject to tax in the later year.
Other accounting concepts also exist. Israel has adopted international financial reporting standards (IFRS), and the Israel CPA Institute has issued many accounting standards of its own that also follow international norms.
In communist countries before the Berlin Wall fell, accounting rules were poorly applied, making it harder for state enterprises to know how they were doing.
Can you have it both ways?
Good accounting is fine, but less tax is better for most people (even temporarily).
It seems some taxpayers have taken to issuing financial statements on an accrual basis but converting the outcome to cash-basis results on the tax computation that is attached to their tax returns. This is done mainly by reversing balance-sheet receivables, payables and provisions at the start and end of each year. Therefore, the books are not consistent with the tax returns. In other words, taxpayers are trying to have their cake and eat it.
What the ITA thinks
The Israel Tax Authority (ITA) issued an important circular on “The Basis for Tax Reporting – Cash or Accrual” (Statement of Practice 8/2012 of July 25, 2012). This takes aim at the book/tax inconsistency.
The circular points out that the Income Tax Ordinance (ITO) contains no express provisions regarding the basis for reporting income of a taxpayer apart from certain exceptional instances. For example, prepaid rental income is taxable upon receipt (ITO Section 8B), and foreign-exchange differences are recognized on an accrual basis (ITO Section 8C).
The circular refers to the case of the Hashomerim Group vs The Large Enterprises Assessing Officer (Civil Appeal 494/87). In that case, the Supreme Court ruled that in the absence of binding rules regarding the reporting method for income and expenses, the matter is decided under accounting principles generally accepted by accountants, and the timing stems from the accounting method adopted. In this case, the court allowed cash-basis accounting.
Therefore, the circular concludes, if financial statements are prepared on an accrual basis according to generally accepted accounting principles, the taxpayer can’t switch to a cash basis on the tax return unless a specific rule in the tax law applies to a particular item of income.
This applies to the 2012 tax year onward. For earlier tax years, a cash basis will continue to be tolerated according to a temporary announcement of March 9, 2005, in the case of service businesses and has no business inventory.
The ITA is skating on thin ice by insisting on book/tax consistency; there are no clear rules in this regard.
But so are taxpayers who choose to disregard the circular, because there is little doubt that accrual accounting is the usual accounting approach for businesses. It would be hard to justify cash-basis reporting to the ITA if financial statements on the accrual are issued basis to other third parties such as the bank manager and external investors.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
Leon Harris is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.