(Editor’s Note.  Though we generally focus on cost, pricing and contract issues, we decided to address some basic financial reporting and now tax issues commonly faced by government contractors since many of our readers are financial specialists.  This article is intended to touch on some common tax issues and should be considered a substitute for qualified tax advice.  It is based on an article by Graig Langstraat, a professor of accountancy and taxation at the University of Memphis in the Mathew Bender “Accounting for Government Contracts” text.)

The accounting method selected for tax purposes usually has a significant impact.  The general rule is that taxable income should be computed using the same method used for keeping contractors’ books.  The purpose of this requirement is to enable the Internal Revenue auditors to examine the contractor’s books and records directly to find support for the numbers on the tax return.  Different methods may be used if the contractor’s books and records are kept consistently with the tax method used in which case the books need to be adjusted to prepare financial statements.

Under the cash method, items of gross income are recognized only upon actual or constructive receipt while deductions for expenses are taken only when actual payment is made.  The cash method has the advantage of allowing contractors to control income and deductions by timing receipts and payment. Under the accrual method, income and deductions are recognized in accordance with an “all events” test.  When all the events necessary to fix the right to income or establish the existence of a liability have occurred and the amounts can be determined with reasonable accuracy income or expenses are recognized.  

Unfortunately, many government contractors cannot use the cash method because (1)  books and records need to follow the accrual not cash method to be consistent with generally accepted accounting principles (2) when contractors have inventory, the accrual method needs to be used (3) the Tax Reform Act of 1986 requires regular corporations (not S corporations), partnerships with regular corporations as partners and tax shelter to use the accrual method.  Exceptions (cash method is allowed) are for qualified personal service corporations (i.e. consulting, law and accounting) and entities having less than $5 million the prior three years.

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