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Bookkeeping & Accounting Issues
A business that is either just starting out or undergoing a
significant growth stage must deal with four main issues in regard
to recordkeeping: the use of the most appropriate "tax year;"
whether to use a cash vs accrual method of accounting; maintaining a
good recordkeeping/bookkeeping system; and, having a working
knowledge of the major IRS reporting requirements for various
payments.
The right decisions in these matters help increase the chance of
business survival and of maximizing business profits. In addition,
it can make matters much easier in dealing with such groups as the
IRS, your state tax authority, an insurance carrier, outside
investors, and accountants. This can save you time, aggravation, and
money.
The Use Of The Most Appropriate Business Tax Year
A business may be required to choose between two different tax year
periods: a Calendar Year or a Fiscal Year. A calendar year is one
which ends on December 31. A normal fiscal year consists of 12
consecutive months ending in a month other than December. The
business must establish which of these two options it will use for
its operational life.
Why would a fiscal year be chosen? Many businesses use a fiscal year
to match the business cycle–take advantage of the highs or lows.
Others do it for convenience of recordkeeping. Getting information
ready for doing taxes or financial reports can be time consuming, so
a fiscal year that ends during a lull period gives the owners a more
efficient time frame to do the recordkeeping activities. Businesses
where inventory(and inventory-taking) is a big factor frequently
elect fiscal years.
Similarly, businesses where the cash flow may differ from a calendar
year period may decide on a fiscal year so money will be available
to pay any required income taxes. In brief, a fiscal year may be
more beneficial than a calendar year for a business where the
preferred operating or income cycles end other than December 31.
From an income tax reporting standpoint, there are some business
types that are either limited in the choice, or must make a special
application to get permission to use a specific choice. This is due
to the so-called "default" issues related to certain types of
entities in which they are restricted in their selection.
In this regard, businesses that are either sole proprietorships,
partnerships, or special subchapter S corporations must generally
use a calendar year for income tax filing purposes. Regular C-type
corporations can usually elect either calendar or fiscal without any
restrictions, unless they fall under the classification of a
"personal service corporation." In that case, a calendar year would
also become the required default choice. A personal service
corporation is one in which the principal activity consists of
personal services done by owner/employees.
There are ways in which a business may still be able to qualify for
a fiscal year selection instead of a required calendar year. The IRS
may grant special permission to use other than the required tax year
if the business can prove it has a definite "Business purpose" for
another tax period.
For instance, a business that is highly "seasonal" in nature where
the main activities have monthly "peaks and valleys" that do not end
on December 31 would be a good candidate. A tax preparation business
where April is the dominant month is a good example; certain farming
related businesses also fall into this category.
Other determining areas might be such things as the use of a fiscal
year due to employee hiring patterns, consumer buying
patterns(swimming pools, boats, etc.), regulatory purposes, or model
year changes, to name a few. Reasons that CANNOT be used to get out
of using a required tax year revolve around a business purpose that
causes a significant shift in income or deductions such that it
reduces potential tax liability.
Another way for certain business types to use a tax year different
from a required tax year is to make a Section 444 Election. This is
done by filing IRS Form 8716, "Election To Have A Tax Year Other
Than A Required Tax Year." This may work for partnerships, personal
service corporations, and subchapter S corporations where the
"business purpose" test doesn't apply. This involves meeting various
deferral period requirements and possibly making a payment if there
are any calculated tax benefits from this deferral into a fiscal
year.
Change In Tax Year: If you decide to try to change an existing tax
year, an IRS Form 1128, "Application To Adopt, Change, Or Retain A
Tax Year" must be filed. This is due before the 15th day of the
second calendar month following the close of the prior tax year.
Cash Vs Accrual Accounting Methods
Under IRS definition, an accounting method is a set of rules used to
determine when and how income and expenses are reported. Normally
for IRS purposes, the accounting method–cash vs accrual–is chosen
before you file the first business income tax return. It must then
be used on a consistent basis for the life of the business, unless
changes in the business occur that statutorily necessitate a change
in the accounting method. If you wish to change methods for
particular reasons of your own, you must get written permission from
the IRS.
Normally, you calculate your income and expenses by using three
major methods: 1) Cash Method; 2) Accrual Method; or, 3) Hybrid
Method in which select elements of cash and accrual are combined.
Cash Method
This is used by most sole proprietorships, and many businesses where
inventory is not a major factor. In this method, income is reported
when actually(or constructively) received, and expenses are deducted
when paid or legally charged(like with a credit card).
Constructive receipt means the money is made available to you
without restriction. It doesn't always mean you have to have it in
your possession. If it is credited to you, or given to your agent,
it is still considered constructively received by you.
Expenses that you pay for are generally deducted in that particular
year, unless you have substantially prepaid expenses that actually
were for another year. As an example, if you prepay a three year
service contract you cannot deduct the full three years of expense
in one year. You would have to allocate the cost instead.
Note that there are restrictions on which type of business can and
cannot use the cash method. Generally, this method can be used by
sole proprietors, corporations with less than $5 million dollars in
gross receipts (current 2000 year rules), most general partnerships
(unless a C Corporation is one of the partners), and farm businesses
with less than $25 million dollars in gross receipts.
Tax planning opportunities exist with the cash method if you can
time your constructive receipt of the income in such a way as to
push it into another tax year. When you bill the client, when you
actually receive the money and bank it, and when the job and its
guarantees reach completion can each define when you have to report
the income.
As to taking expense deductions, buying and placing into use such
things as business equipment and supplies can be equally timed.
Advertising, marketing, and employee bonuses can also be timed to
best suit you for tax planning purposes.
Accrual Method
Using an accrual method, income is reported in the year it is
earned, not necessarily received, and expenses are deducted in the
year they are incurred, not necessarily when paid. From the gross
receipts perspective, an accrual method generally means you report
the income when the client is billed and/or has received your
service or product. So if you finish a job and bill the client this
December 2000, but don't get paid until January 2001, the income is
reported in 2000 under the accrual method. Note that there are
certain exceptions to this if the business transactions involve
"related persons, entities, and controlled groups" but this is
relatively rare for the scope of this discourse.
Unlike the cash method of accounting, accrual methodology can also
involve making adjustments to reported income for bad debt
allowances. If you report income when billed, but do not end up
collecting all that is due you, you then may be able to write off
the non-collectible portion as a business bad debt.
In regard to business expenses, you deduct or capitalize these when
you become liable for them. This liability issue involves meeting
the "events and economic performance" rules. Before taking the
deduction, all necessary events that create the liability must have
happened, and the economic performance of the action must have
occurred. Thus, if the expense is for materials, property, or
services you incur in the production of income for your trade or
business, economic performance occurs as you provide your service or
product.
Tax planning avenues that may be open to accrual type operations
involve the attempt to defer income into a future year, and
accelerate expense deductions into the current year. In this way,
the net income from the business may be lowered for the current year
at the expense of the next year. This may be possible by arranging
it so the job you are doing is not fully completed before the close
of the year, in which case the receipts collected don't necessarily
have to be posted as taxable income at that point. You get the cash,
but defer paying taxes on it until a later date.
Similarly on the expense side, you would attempt to accelerate
expenses into the current year so the bill you receive can be
written off even though you haven't paid for it yet. This type of
tax deferring can be beneficial in two ways. First, from a "use of
funds" perspective it may make sense since you will have an extra
year's use of the tax money you have delayed. Second, if your
business experiences relatively large swings in taxable income from
year to year, this is a way of "levelling off" the taxable income,
thus possibly lowering the marginal tax bracket and actually saving
taxes overall.
So if you are billed for office equipment placed into use in
December 2000, but don't pay for it until January 2001, the
deduction is taken in 2000 under an accrual method.
While the use of an accrual method may be elective for most, a
business that maintains inventory as a significant part of the
production of income(stores, manufacturers, wholesalers) must use
some form of accrual based accounting for the purchases and sales of
the particular products in question. The full cash method is
generally not allowed in this case.
Hybrid Method
This combination of cash and accrual may be allowable if you can
clearly show income and expenses in a consistent methodology. If you
have two distinctly different businesses, you may use a cash method
for one, and an accrual method for the other. If inventory is a
significant part of your business, you could use accrual for
purchases of inventory and sales of these items, but you may use
cash methods for all other income and expense items.
However, there are limitations. If you elect the cash method for
income, you must generally use the cash method for expenses.
Conversely, if you elect accrual for expenses, you must use accrual
for income.
Within this hybrid method there may be different elections as to how
income will be reported. As an example, a completed contracts method
may be elected for income. This may apply to a construction-type
business where the projects take more than one year to complete.
Minimum Bookkeeping System Requirements
Maintaining a good, acceptable bookkeeping/recordkeeping system
should not be solely to satisfy the government. There's no question
that the more successful businesses also have more efficient
bookkeeping systems in place. This is because a good bookkeeping
system can give a business the timely information it needs to
increase profit-making opportunities.
A good bookkeeping system can help the business answer many
important questions such as:
How much business is being done?
How much cash is on hand?
How much is tied up in receivables, and how old are these
receivables?
Should credit continue to be extended?
Should collection action be taken?
What are the expenses by categories?
What are the important business ratios that should be analyzed?
Are sales, expenses, capital, and profits showing improvement over
previous periods?
Where is the break-even point?
How does this business compare with others of its size and industry?
What is the projected income tax bill going to be, and how can this
be minimized?
Is payroll at its optimum level, and is there enough cash coming in
to meet payroll?
A good bookkeeping system allows the business owner and accountant
to create and review important business ratios, profit and loss
statements, balance sheets, customized management reports,
reconciled bank statements, and required tax return information.
Requirements Of A Good System
For most businesses, especially privately-owned ones, an adequate
recordkeeping system should be relatively simple to use and
understand, accurate, designed to provide timely information,
consistent in its treatment of income and expenses, reliable, and
exportable in its context. The last feature refers to how easy it is
for others besides the one recording the information to be able to
understand, compile, and make adjustments to the information for
their own purposes. Tax accountants, bankers, outside investors,
shareholders, and actual business owners fall into this group.
Single Vs Double Entry: There is sometimes a choice between
these two types. A single-entry system is the easier to keep, and
also the more limiting for information, auditing, and
accuracy-checking purposes. In single entry, an income or expense
item is posted once with no other account offsets. For simple,
one-person sole proprietorships where the owner also pays the bills,
collects the income, does the bookkeeping, and where managerial
reports are secondary, this system is easier to use and understand.
A single-entry system tends to concentrate primarily on the profit
and loss statement and not the balance sheet side, so it is really
only a partial system.
The double entry system involves the use of journals and ledgers to
track profit and loss and balance sheet items. Transactions are
entered into a journal, then summarized in ledger accounts. These
include income and expenses, assets, liability, and capital
accounts. Unlike the single-entry, the double entry system is
designed to be self-balancing. Every entry involves both a debit and
credit in which the ultimate sum of the debits equal the sum of the
credits.
At given periods(usually monthly, quarterly, annually), financial
statements can be prepared which usually center around the Income
Statement and the Balance Sheet. The income statement is similar to
a profit and loss statement in that it reflects the income and
expenses for the period. The Balance Sheet shows the business
financial position at a given point in time in regard to assets,
liabilities, and capital. While more complicated to maintain,
double-entry systems allow for much more flexibility and
standardization. They help to minimize errors, and possible
embezzlement problems. Further, for businesses that may require
audited, compiled, or certified financials (for investors, or
lenders, etc.) double-entry systems are definitely the preferred way
to go.
Features Of An Adequate Bookkeeping System
Whether single entry or double entry is selected, a bookkeeping
system should have as a minimum the following component parts:
1) Income Register: This records and details money received by the
business. It's especially important from a tax audit standpoint to
be able to track the nature of the business deposits and
differentiate between taxable and nontaxable sources. This income
should be in balance with your bank statements, and supported by
sales slips, invoices, register tapes or any documents used in the
sales process which are stored separately.
2) Disbursements Record: This classifies, categorizes, and
summarizes the expenses paid out for the business. Reimbursements
and cash payments are handled the same way as checks. These expenses
are recorded according to the date, check number, amount, and
expense category. Further, all expenses should be backed up with an
invoice or cash receipt which are stored separately.
3) Petty Cash Vouchers: For minor, incidental expenses where writing
a check would be a nuisance(such as for office coffee, stamps,
etc.), the use of a petty cash system is recommended. A check is
written to fund the petty cash box for a designated amount. Money is
taken out to pay for these small items(usually under $5), and the
receipts are recorded on petty cash vouchers. Periodically, another
check is written to replenish the petty cash fund.
4) Travel & Entertainment Reports: For tax purposes, contemporaneous
records must be kept for such expenses as food and entertaining, use
of vehicle, outside travel, and other employee paid business
expenses to be reimbursed. This T & E log breaks down the expenses
per employee, and per category. In addition, back-up receipts where
required for these expenses must be stored in case of audit.
5) Equipment Register: This records all assets/equipment bought or
disposed of by the business. It shows the dates involved, purchase
amounts, check number, supplier's names, and disposition details.
For calculating depreciation, and any tax consequences upon
disposition, this register is highly recommended.
6) Payroll Register: A separate, detailed record is in order for
controlling various aspects of payroll. Records verifying the
accuracy of how payroll is calculated, taxes are credited and
deposited, overtime is calculated, etc., are mandatory.
7) Insurance Log: Business insurance policies are identified and
detailed as to the type of coverage, premium costs, policy numbers,
name of insurer, effective policy dates, and expiration dates(to
avoid unwanted loss of coverage).
8) Accounts Receivable Control Ledger: This helps you keep track of
who owes the businesses, how much is owed, and for how long it has
been owed. It is essential to maximize your cash flow situation, and
to minimize business bad debts. Accounts receivable are usually
tracked according to their "age" using 30 day, 60 day, 90 day, and
180 day cycles.
Please understand that these eight features represent the minimum
for an adequate bookkeeping system. The nature and type of business
dictates what other features or customization should occur. In fact,
many business types customize their systems; restaurants, automotive
businesses, manufacturing, and others have their own particular
nuances that need to be considered in setting up a system.
IRS Reporting Requirements For Payments
Businesses may be required to send notification to the IRS and state
tax authorities for payments made in diverse areas. These are
usually called "information returns" in which the business discloses
to the government the nature of the payment, the amount, and to whom
the payment was made.
Generally, these forms are required to be distributed to the
recipient of the payments as well as to the government. For IRS
purposes, they are usually due on or before February 28 of the year
following the year of payment. There may be penalties charged to any
business that fails to file these information returns. Some of the
most common filings are:
Form 1099 Misc: Payments in excess of $600 per individual for
services rendered (such as
subcontractors, landlords, other nonemployee compensation).
Form 1098: For payments of mortgage interest in excess of $600 to
individuals on loans
owed by the business.
Form 1099 DIV: Payments in excess of $10 per recipient for
dividends, and stock dividends.
Form 1099 INT: For payments in excess of $10 to recipients of
interest income.
Form 8300: Report of cash payments received by a business in excess
of $10,000 per
transaction or related transactions.
Form W-2: Payments to employees for wages, tips, and other
compensation. No dollar
limitation.
There are many other possible information returns that may be
required for different business activities and business types.
However, these are the main ones that tend to impact most average
businesses. When in doubt as to the ones required in your business,
check with the appropriate professional before the year ends.
A Word On Computerized Systems
With today's explosion of the use of data processing systems, more
and more businesses of all sizes are using computerized
recordkeeping systems. There are no government restrictions or
limitations on these systems as long as they meet the same tests and
requirements as manual ones do.
The IRS position is that you must be able to show records that
provide the necessary information to determine correct tax liability
in a way that the auditors can track. The documentation must show
the applications performed, the procedures used in each application,
and the controls at hand. In other words, the computerized system
must provide an adequate audit trail back to the original source of
entry.
Using Outside Accounting Services
Many firms elect to use outside bookkeeping and accounting services
to handle the major aspects of the recordkeeping–especially as it
relates to government tax filings.
This may be the most efficient use of a business owner's time. To
try to be an expert in accounting, and to try to keep up with the
changes that occur in the field can be prohibitive for a business
owner. So the use of a professional to help design, change, and
implement the necessary bookkeeping systems is certainly a viable
option.
Conclusion
Decisions on accounting and bookkeeping isssues are important for
businesses, especially in the early stages. The purpose is twofold:
1) To meet government requirements, AND,
2) To increase the business chance for success by providing timely,
efficient, and informative data with which to make comparative
choices.
While it is usually easier to make these choices at the start of the
business operation, this is not always possible. Businesses change
along the way. In fact, running a business is not a static event;
rather, it is a dynamic. These changes may necessitate corresponding
changes in the accounting method, year, or bookkeeping system being
used.
With few exceptions, it is strongly recommended that a business
owner consider using an outside professional for at least some of
the decision-making process here. The expeditious use of this type
of assistance in the earlier stages of development can go a long way
toward achieving the maximum business success possible.
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