See below for a quick video update on applying for PPP forgiveness, including a short summary of Rev. Ruling 2020-27 and Rev. Proc. 2020-51.
Unexpected Tax Bill
I OWE taxes?!?! How can that be when I had a loss?
It is the midst of THE season. What season might that be? The dreaded tax season…
For those of you who have already optimized your finances, you can stop reading, as you will likely have minimal surprises when your tax return is complete. But those of you who haven’t should read on to figure out what might be causing you to owe money to the government, when you thought you had a LOSS for the year.
Cash vs. Accrual Basis
First, it’s important to know what your basis of accounting is. For a more detailed discussion on the basis of accounting, see the prior post “A Tale of Two Methods.” To briefly simplify, under the cash basis of accounting, you pay tax on income when you receive the money and you deduct the expense when it is paid or charged on a credit card. Under the accrual basis of accounting, you pay tax on income when you perform the service or complete the sale, and you deduct the expense when it’s incurred.
Many small businesses will be able to file under the cash basis of accounting, which is simpler. However, there may be impactful differences among the two methods. It is my experience that not understanding the methods or knowing what method you follow for tax purposes can create a major problem at tax time.
Without getting into too much accounting detail, the timing of when income and expenses are recognized can cause major differences between what is filed on a tax return, and what is kept in your internal accounting system. And, not only does this cause a difference in one year, but the opposite impact may occur the following year.
Small business scenario
The best way to understand this is to look at a simple example: John’s Janitorial Service performed a job for Rebecca on December 30. John booked the Accounts Receivable invoice on 12/30, as he needed to send the invoice to Rebecca so he could get paid. But Rebecca didn’t pay John until January 4.
On the accrual basis of accounting, John would pick that income up (and be taxed) on the current year tax return. However, if he is following the cash basis of accounting, he wouldn’t pick that income up (and be taxed) until the following year.
As you can see, the cash basis could cause a difference in the income shown on his books when compared to what is reported on his tax return for BOTH years. Depending on the change in Accounts Receivable and Accounts Payable, the fluctuations could be extreme and have a large impact.
Many times, businesses are looking at their accrual basis financial statements (which is how they run their business), without factoring in the cash basis financial statements (which is how they pay their taxes). This is the first issue that many have when getting hit with an unexpected tax bill.
Deduction limitations & other issues
The second issue is that there may be limitations on what can be deducted. For example, meals are only deductible at 50% for tax purposes. This means that half of the meal cost doesn’t provide a tax benefit. Starting in 2018, entertainment expenses are not deductible at all for tax purposes — so no tax benefit for that golf membership or tickets to the Mizzou game. Political donations and some portions of dues also are not deductible at all. These expenses are examples of what accountants refer to as “book-tax differences,” meaning that there is a different treatment on the books (100% deductible) as opposed to on the tax return. There are numerous other items that may cause book-tax differences; these are just some of the more common ones.
Finally, errors in coding may also cause issues. Many times, financial statements have “adjustments” done due to incorrect entries that were made. A common example is coding the entire amount of the loan payment to interest expense. In reality, the principal repayment portion is not an expense, only the interest is. There may be other mistakes that are made that could cause major changes to the book financial statements.
One of the goals of Optimized CFO + Controller Services is to help business owners avoid surprises at tax time. By regularly looking at the financials, we can minimize any errors in coding. We can also project out estimated taxable income, factoring in some of these book-tax differences, and differences with the basis of accounting. If you’ve recently been shocked by an unexpected tax due, or unhappy with the amount of adjustments that are made each year on your tax return, I would love to talk.
Margins: The Golden Ticket
Margins, margins, margins. What’s the deal with margins? Why should you, as a business owner or manager, care about them?
Margins are the golden ticket in analyzing product sales. For most businesses that sell physical product, margins provide a meaningful way to evaluate sales and to ensure that they have priced their product to cover overhead costs.
Margins can be used to compare the sales of product and can be consistently evaluated over time, as well as over varying sales volumes. In addition, margins of your company can be compared to industry averages.
But what exactly are margins? How are they calculated?
When I refer to margins, I am mainly referring to your Gross Profit Margin (GP). Gross Profit Margin is calculated as Gross Profit divided by Gross Sales:
Gross Profit is calculated as Gross Sales less Cost of Goods Sold:
So, in other words, the Gross Profit Margin is calculating how much you are making in profit off every $1 in sales.
There are a few things to note to ensure that the margin is calculated appropriately. First, be sure that items that are included in cost of goods sold are truly the costs of the product that you are selling, and not what may actually be overhead costs. Also be sure that you have factored in all true costs.
For companies that are in the business of selling product for retail that they purchased from a supplier, it’s easy. For each item, the gross sale would be the sales price of the item, and the cost of good sold would be the cost to purchase the item.
For companies that are in the business of manufacturing a product, it’s a little more difficult. The gross sale of each item would be the sales price of the item, but the cost of goods sold would need to include all costs that went into making the item. This includes not only product costs, but also labor costs.
Note that the above explanations are fairly basic descriptions. With this post, I am not going to delve into the details of what is the correct cost of the items, which can differ depending on the inventory valuation method that your company is using. For purposes of this article, I am assuming you are starting with clean, clearly defined sales and cost of goods sold calculations.
In theory, the amount of gross profit is what you have left after selling the item to cover your company’s overhead costs.
You may be thinking, “That’s great – I just need to have higher and higher margins.” But watch out! Margins are largely dependent on the industry. If you are in a very competitive industry, simply raising your prices in order to attain a higher margin will not necessarily bode well for gross sales if you have customers jump ship to competitors.
Also note that the concept of margins is best looked at in comparison – either over time or to others in your industry. Given that the margin calculation is basically taking the result down to a per dollar factor, margins are helpful to examine over time, and can be consistent even with varying sales volumes.
Do be careful that you aren’t looking at your margin calculation in a vacuum. For example, it doesn’t make sense to just calculate it once and not compare it – that isn’t telling you anything! It also doesn’t help to compare your margin to other companies that aren’t in your industry. Margins can vary drastically among industries. (Growing up, I was directly exposed to the extremely slim margins that gas station owners face. Quick actions were necessary to make it in that business, with volatile price changes, extreme competition, and tight margins).
Overall, margins can be a very helpful tool to evaluate how your business is doing. In my experience, most industries have fairly consistent margins. An exception would be a business that is in a highly seasonal or cyclical industry or area. If your company is in a stable industry and area, margins that are jumping all over the place can be a sign that something is either wrong with the accounting process for recording inventory and cost of goods sold, or that there could be more fraudulent factors at play, such as theft of product.
Margins, margins, margins – an important tool for analyzing profitability of your sales. I love educating clients on this topic and helping solve issues with margins. Let me know how I can assist.
The Balance Sheet – King of Financial Statements
When considering financial statements, many business owners and managers spend 80% of their time and energy focused on the income statement (or profit and loss statement), and only 20% focusing on the balance sheet. For some business owners, the percentages are closer to 100% and 0%. But this split of time and focus is not the most effective.
The Balance Sheet Reigns
Contrary to popular belief, the balance sheet reigns supreme in the world of financial reports. Why is this?
The balance sheet is a snapshot in time of the assets, liabilities, and equity of a company. Items on the balance sheet can all be verified to external, or at least secondary, source documents. In other words, the balance sheet accounts can all be validated. Doing this “tie out” of the balance sheet ensures that the financial statements are reliable.
Without focusing time and energy on tying out the balance sheet, one cannot have any assurance on the income statement. Yet, a correct tie out of the balance sheet will ensure that the bottom line net income is correct.
Focused Month-End Close
Therefore, the bulk of your company’s month-end close process should be balance sheet focused. Instead of focusing the most resources on the income statement, the majority of time should be spent on tying out the balance sheet. Not only should existing accounts be verified, but a big picture view should be taken to ensure that any and all assets, liabilities, and equity are included and that account balances are reasonable. Only once the balance sheet has been tied out should any focus be placed on the income statement.
What’s your 80/20 split? Are you focusing your attention on the true king of the financial statements (aka the balance sheet)? Let me know if I can help you in tying out the balance sheet and gaining a better understanding of your financials.
Real World vs. Computer Realm
I recently read the book Ready Player One by Ernest Cline. The book drew me in from its concept of escaping the real world with a computer, or virtual realm. In the book there is a virtual realty system where humans can escape from their dreadful existence in a future world that has become poverty-stricken and depressing. The lines between real world and the virtual world blur, especially as the main character races against the clock to win a competition.
We are in the midst of the Fourth Industrial Revolution, also known as the Digital Revolution. One day, the accounting software program that your company uses may be fully entwined with the outside sources. This may easily enable the tie-out of the balance sheet to occur automatically. However, we aren’t quite there yet. Therefore, one must still look at the flow of items in the accounting system, both in the real world and in the computer realm.
In other words, your accounting system should include processes for not only the physical flow of documents and resources, but also the technological flow of inputs and calculations in the accounting software system. The goal is to mirror these as close as possible. Computerized accounting processes must be examined in coordination with real-world flows.
An easy way to look at this is to take the checking account of the business. If the real-world process involves the collection, storage, and deposit of multiple checks, the software input and output should mirror this. Same with outstanding items. If there are checks that have been written and mailed, but not yet cashed by the payee; the software input and output should reflect these outstanding items. The closer we can get to mirroring the real-world inputs and outputs in the accounting software system, the more up-to-date and accurate output we will have.
Let me know if I can help in evaluating your own system to ensure the real world and computer realm flows are in alignment.
A Tale of Two Methods
You have probably heard about the “method” of accounting before (also referred to as the “basis” of accounting). But what does that mean to you? Your method, or basis, of accounting determines how things are recorded (or recognized) and realized on the financial statements. To be honest, in the lifetime of a business, the methods used will equal out. However, in interim years of a business’ life cycle, the method of accounting can have a major impact into the amount of income (or loss) for that specific year.
Understanding the methods of accounting, as well as knowing what method your business follows, can enable better tax planning. This also means less surprises on tax day. (No one wants the shock of owing $17,000 on April 14th, when all along they thought their business had a loss for the year!)
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Cash Method of Accounting
The first method is the cash method of accounting. Under the cash method of accounting, revenues are not recognized as income until the payment is received. This may be weeks or longer after the job has been performed. Expenses are also not recognized until payment is made. Payment may be either a check written, or a credit card charge incurred.
The cash method of accounting is straightforward. There is also room for flexibility, especially on the expense side. If it is more beneficial to incur an expense 20X1, as opposed to 20X2, the check just needs to be written in 20X1. However, if it is more beneficial for an expense to be incurred in 20X2 instead, you may hold off on writing the check until January 1, 20X2.
Under the cash method, timing is everything! If you don’t receive payment from your customer until January 2, that income doesn’t get reported to the government (aka taxed) until the following year. This can be a good thing – who doesn’t like keeping money in their pockets for longer?
Accrual Method of Accounting
The second method is the accrual method of accounting. The accrual method is used for GAAP (Generally Accepted Accounting Principles). Under the accrual method, revenues are recognized as income when the job is done (even if payment is not received at that time). Expenses are recognized when the expenditure is incurred (even if payment is not made at that time).
The accrual method is a more realistic picture of the business’ operations, given that it includes all known and expected revenues and expenses, not just those that have had cash receipts or payments made. However, there is also less flexibility with timing of recognition. You aren’t relying on the mailman to determine when your income is recognized.
Tax Planning – Know Your Method
For many businesses, it is most effective to follow the accrual method of accounting to run their business. It is helpful to know what vendor payments (accounts payable) are coming due, and it is vital to know what customer receipts (accounts receivable) are upcoming.
However, many small businesses may qualify for the cash method for their income tax returns. Starting in 2018, the threshold to require the accrual method for income tax purposes is gross receipts of $25 million. This means more small businesses can opt to use the cash method of accounting for their income tax returns.
This is generally good news due to the flexibility with planning. Many accounting software options, including QuickBooks, allow the dual use of methods. So, financial statements can be run on both the cash and accrual methods at the push of a button. However, it is important to keep in mind that net income can fluctuate quite a bit between the two methods. So even if you showed a loss on the accrual method, you may have taxable income on the cash method, and vice versa.
As you prepare for taxes, be aware of the potential large differences. I have witnessed business owners that were shocked at tax time because of these major swings of which they were unaware. Also be aware that QuickBooks and some other software products may have issues if you have entered any journal entry transactions that impact Accounts Receivable or Accounts Payable.
A Tale of Two Methods, or Is It?
Keep in mind that over the business’s entire life cycle, these timing differences in recognition will be eliminated between the cash and accrual methods. For example, if you delay recognition of a customer payment on the cash method, due to not receiving it until January, you will pick up that income on next year’s return. In the grand scheme of things, the business would recognize the same total amount of income (just over different years). The same is true for expenses.
Knowledge is the first step to action. Now that you understand the tale of two methods of accounting, take action. Check out what method you use for your tax return (it should be shown on the tax return). Let me know if I can help at all with understanding your basis of accounting. You will then be in a good position to take action with your year-end planning.