When Repairs Are Not Expenses ….

Bookkeeping that records every payment for property repairs as an expense is just so much fiction. Cash outflow isn’t always found on the business income statement – also known as the profit and loss statement. In fact, it’s the balance sheet that reveals whether money was directed to decreasing debt or increasing assets.

Expenditures for so-called capital goods appear on the balance sheet as fixed assets. These items – such as equipment and buildings – are different from ordinary operating expenses on the income statement.

But “capital goods” can also include repairs to existing fixed assets. The cost for these expenditures is depreciated over time rather than immediately appearing as an expense on the profit and loss statement.

Small-business operators are frequently faced with deciding whether a cost is a repair expense or a depreciable capital expenditure. And this can prove a sizable burden.

Repairs

Improvements to existing fixed assets constitute a new capital expenditure when the cost is sufficiently high for capitalizing and the improvements extend the useful life or functionality of the fixed asset. These are distinguished from repair expenses, which constitute minor alterations. Capital improvements are generally structural – such as a new roof for a building. More cosmetic costs – like painting – are expensed as repairs.

Distinguishing between a repair and a capital improvement is complex. Tax authorities have released some general guidelines to help. A capital improvement is an expenditure for the “betterment,” “adaptation,” or “restoration” (B.A.R.) of the property. Determining whether any of these conditions applies requires comparing the condition of the property when it was purchased – or when the last work on it was performed – to its condition after the new expenditures.

Detailing B.A.R.

“Betterment” ameliorates a deficient condition in property and adds to a property’s capacity, size, or quality. “Adaptation” changes a property to a new use that’s different from the original, and “restoration” returns property to its efficient operating condition. “Restoration” also applies to any major component of a property that contributes to the property’s substantive function, which can make identifying a capital improvement tricky. It means, for example, that replacing the motor necessary for a machine to run properly is a capital expenditure, even though the entire machine is not being replaced. Work performed on smaller assets – such as machinery – is commonly a capital expenditure. A component critical to the usefulness of equipment is very likely a capital improvement when replaced – unless the cost is minimal.

Large properties – like buildings – are more likely to incur repair expenses. Tax rules require dividing a building into multiple property units; the entire building is not a singular property, but rather each system in the building is considered separately. So replacing the air conditioning compressor might be a depreciable capital improvement, since the ventilation system is viewed as a distinct property unit.

Uncovering whether expenditures are repairs or capital improvements isn’t easy. The best way is to consult a tax expert when these costs are incurred so that purchases are correctly recorded.

Financial Advice to Avoid on the Road to Success

Be wise when seeking financial guidance. There’s a massive amount of advice out there, and some of it may lead unwary business owners off track instead of setting them on the road to success. Here’s some advice to avoid:

Raising money without a goal: One suggestion deserving of the dustbin is money-raising with no goal in sight. Money is a means to an end; save your money-raising efforts for specific expenditures.

Spend to make: Likewise, disregard the suggestion that you must spend money to make money. This may be true in the short term, but habitually spending big is likely to land you in trouble in the long run. Operating on a tight, well-designed budget forces you to make efficient choices and innovate rather than throw money at your difficulties.

Multiyear projections: Then there’s the advice on preparing multiyear financial projections. Because small business operations tend to be unpredictable beyond next year, projecting too far into the future wastes time.

Bigger is better: Perhaps the most important advice to ignore is that by charging lower prices than competitors, you can build a large organization and make more money. But a low-price strategy results in low profit margins, and only very high-volume enterprises can function successfully on low margins.

Small businesses are generally successful at serving niche markets rather than tackling larger markets (and more competition). There’s no rule that says you must be big to be highly profitable.

Your best way to avoid bad advice? Trust your accounting pro to steer you in the right direction.

Determining the Value of Large Expenditures

Whether your enterprise will thrive or struggle often hinges on decisions surrounding large expenditures. An owner’s purchase of an asset – such as equipment that will be functional for many years – typically entails a substantial sum of money.

These types of long-term assets are referred to as “capital expenditures.” They are not recorded as expenses on the income statement. Rather, they appear as assets on the balance sheet. Determining whether the cost for a capital expenditure is worthwhile necessitates a capital budgeting analysis to assure efficient allocation of resources.

Does it make sense

Your capital budgeting process begins with a ranking of large purchases in order of priority. This is how you decide when projects will be undertaken and how much capital is needed to accomplish them. Although some capital expenditures are urgently required to maintain operations, discretionary purchases are generally ranked based on their profitability.

Several methods are available for evaluating profitability of capitalized purchases. The most common ones – those followed by sophisticated business managers – are “net present value” and “internal rate of return.” Both processes consider cash flow over the entire length of a project and discount future cash flow to reflect the time value of money.

These methodologies contrast with the simplified payback model, which measures the amount of time required for recouping an investment. This non-discounted approach unrealistically regards future dollars as having the same value as current dollars.

Failure to consider profitability over the long term is another drawback to the payback model. A fast payback ultimately might not generate much profit, while a slow payback could disguise a vastly profitable undertaking over the life of the investment.

Quantifying the benefit

Discounted cash flow models are frequently used to identify the current value of a major purchase. The net present value method estimates all the future cash inflows and outflows. For example, cash inflow is the revenue expected from investing in a new piece of equipment, and cash outflow is the cost to purchase, maintain, and operate the equipment for generating that revenue.

The net cash flow over future periods is then discounted to a present value. Financial calculators and printed present value tables show the amount of value today that’s equivalent to future incoming cash. This is accomplished by assuming a discount rate reflecting the greater quantity of money we would accept in future to bring us the same happiness as would a lower sum today.

A positive net present value indicates the equipment will earn more than the discount rate. But even if the figure is negative, the equipment may still provide profitability (although likely not as much as avoiding the purchase and holding onto the money for the future). You can identify the rate of return for an investment by finding a discount rate that arrives at a net present value equal to zero. This internal rate of return determination is helpful for ranking expenditures in order of importance.

Confusing? Contact your accountant to help you understand how to value your capital expenditures.

Business Credit Cards Help Record Company Purchases Accurately

The system used by a small business owner to record credit card purchases is a measure of whether the entrepreneur is efficiently tracking expenditures or living under a pile of unfiled receipts. A credit card dedicated solely to business use is the definitive solution, and a reason why the more efficient tracker is successful.

You can establish a credit card account for your business with accounting software. Charges are recorded like checks drawn on a bank account; each charge entry automatically creates a liability on the company balance sheet for credit card payable. This credit card liability is therefore owed by the business. Note: be sure to categorize personal expenditures on the card as “owner distributions.”

You can reduce the incidence of errors by assuring that payment of the credit card bill applies to the liability account. Simply writing a check for an expense category called “credit card payments” is incorrect. The expenses are already recorded when each credit card charge is entered. Enter all credit card charges so the sum appears in the balance sheet liability account for credit card payable. Then apply payments sent to the credit card issuer to that liability account.

If you use a credit card for some business purchases but mainly for personal expenses, don’t create a credit card liability account for the business. Instead, have the business reimburse you and record the expense categories being reimbursed as if the company had paid them directly. Then pay the credit card bill with personal funds. And come out from under those piled-up receipts.

Monitor Your KPIs at Least Twice a Year

The midyear financial assessment is a common practice among entrepreneurs who have successfully navigated both the ups and downs of their small business. They know that regularly assessing accounting measures will validate management decisions and uncover areas for improvement.

Fortunately, evaluating your financial data isn’t difficult when you know where to find the numbers that are crucial to your own small business.

The key performance indicators (KPIs) you will need to monitor reflect the nature of your operation: does your success depend on increasing sales, maintaining profit margin, collecting accounts receivable in a timely manner, or turning over inventory promptly?

Knowing the ratios that measure these factors allows you to make informed decisions throughout the year. And by watching these ratio trends, you’ll avoid being blindsided by circumstances that could have been foreseen – and prevented.

Reviewing revenue

The rate of sales growth is especially vital in a young enterprise. Greater sales volume is needed to ensure your resources are fully utilized. Measuring the sales increase in a recent period – such as sales in a calendar quarter compared with those in the previous quarter – is the first step.

Then compare that rate of increase against the rate measured in earlier periods. Eventually, revenue will flatline, as all your resources are being utilized to their full capacity. Until then, you’ll want to maintain your growth rate or find out why it has slowed. Later, the addition of more resources – such as staff – may be required to accommodate continued growth. As sales increase, profits should keep pace. Ideally, your profits should rise at a rate that is the same as or higher than that of your revenue.

Identifying inventory

Inventory turnover of items acquired for resale is an often overlooked but important measure. From the balance sheet, identify the cost of inventory currently on hand, and divide that figure by the cost of inventory sold in a recent period, which is found on the income statement. This is the inventory turnover.

For a clearer picture, multiply inventory turnover by the number of days in that period. This yields the number of days’ worth of inventory you have on hand based on recent sales. In this calculation, you will be looking for low numbers as an indication that your cash management process is unfolding as it should; you should have only sufficient money tied up in inventory as is required to meet upcoming sales.

Referencing receivables

The process of invoicing your customers after a sale doesn’t generate cash flow; the payment must be received. Meanwhile, the business has bills to pay. By measuring the accounts receivable turnover, you can determine whether the collections process is functioning in a timely way. Do this by dividing the current accounts receivable on the balance sheet by sales from a recent period from the income statement.

Then multiply receivables turnover by the number of days in the period to find the average number of days customers take to pay your invoices. When this number is consistent or diminishing over time, it’s a sign your cash flow management system is effective.

Details Matter in Tax Accounting for an Asset Sale

There are so many variables surrounding the sale of a business asset that it can be confusing.

Money received from the sale is only one element in the transaction; it’s not simply added to income as if you were selling a small item that was categorized as an expense when originally acquired. The cost of a fixed asset, such as equipment or a vehicle, is expensed over time as depreciation.

Understanding how this difference appears in financial statements helps you identify the underlying details for your tax accountant when the asset is sold.

The original cost for a fixed asset and the part of that cost already expensed as depreciation over time form an interlocking network with the sale proceeds. The difference between the asset’s cost and its accumulated depreciation is carried on the balance sheet as a net book value. A sale price that’s greater or less than book value is recorded as either a gain or a loss.

Book value is what the business is giving up in the sale. The asset’s original cost and accumulated depreciation are moved from the balance sheet to the income statement as a cost of sale.

The selling price is recorded on the income statement as sale proceeds. Both the cost and proceeds typically appear in the same account as gain or loss; however, your tax accountant needs both figures for accurate reporting.

Finally, repaying the asset’s loan doesn’t impact the gain or loss; it affects the amount of the sale price received as debt reduction rather than as cash.

Monitor Your KPIs at Least Twice a Year

The midyear financial assessment is a common practice among entrepreneurs who have successfully navigated both the ups and downs of their small business. They know that regularly assessing accounting measures will validate management decisions and uncover areas for improvement.

Fortunately, evaluating your financial data isn’t difficult when you know where to find the numbers that are crucial to your own small business.

The key performance indicators (KPIs) you will need to monitor reflect the nature of your operation: does your success depend on increasing sales, maintaining profit margin, collecting accounts receivable in a timely manner, or turning over inventory promptly?

Knowing the ratios that measure these factors allows you to make informed decisions throughout the year. And by watching these ratio trends, you’ll avoid being blindsided by circumstances that could have been foreseen – and prevented.

Reviewing revenue

The rate of sales growth is especially vital in a young enterprise. Greater sales volume is needed to ensure your resources are fully utilized. Measuring the sales increase in a recent period – such as sales in a calendar quarter compared with those in the previous quarter – is the first step.

Then compare that rate of increase against the rate measured in earlier periods. Eventually, revenue will flatline, as all your resources are being utilized to their full capacity. Until then, you’ll want to maintain your growth rate or find out why it has slowed. Later, the addition of more resources – such as staff – may be required to accommodate continued growth. As sales increase, profits should keep pace. Ideally, your profits should rise at a rate that is the same as or higher than that of your revenue.

Identifying inventory

Inventory turnover of items acquired for resale is an often overlooked but important measure. From the balance sheet, identify the cost of inventory currently on hand, and divide that figure by the cost of inventory sold in a recent period, which is found on the income statement. This is the inventory turnover.

For a clearer picture, multiply inventory turnover by the number of days in that period. This yields the number of days’ worth of inventory you have on hand based on recent sales. In this calculation, you will be looking for low numbers as an indication that your cash management process is unfolding as it should; you should have only sufficient money tied up in inventory as is required to meet upcoming sales.

Referencing receivables

The process of invoicing your customers after a sale doesn’t generate cash flow; the payment must be received. Meanwhile, the business has bills to pay. By measuring the accounts receivable turnover, you can determine whether the collections process is functioning in a timely way. Do this by dividing the current accounts receivable on the balance sheet by sales from a recent period from the income statement.

Then multiply receivables turnover by the number of days in the period to find the average number of days customers take to pay your invoices. When this number is consistent or diminishing over time, it’s a sign your cash flow management system is effective.

Details Matter in Tax Accounting for an Asset Sale

There are so many variables surrounding the sale of a business asset that it can be confusing.

Money received from the sale is only one element in the transaction; it’s not simply added to income as if you were selling a small item that was categorized as an expense when originally acquired. The cost of a fixed asset, such as equipment or a vehicle, is expensed over time as depreciation.

Understanding how this difference appears in financial statements helps you identify the underlying details for your tax accountant when the asset is sold.

The original cost for a fixed asset and the part of that cost already expensed as depreciation over time form an interlocking network with the sale proceeds. The difference between the asset’s cost and its accumulated depreciation is carried on the balance sheet as a net book value. A sale price that’s greater or less than book value is recorded as either a gain or a loss.

Book value is what the business is giving up in the sale. The asset’s original cost and accumulated depreciation are moved from the balance sheet to the income statement as a cost of sale.

The selling price is recorded on the income statement as sale proceeds. Both the cost and proceeds typically appear in the same account as gain or loss; however, your tax accountant needs both figures for accurate reporting.

Finally, repaying the asset’s loan doesn’t impact the gain or loss; it affects the amount of the sale price received as debt reduction rather than as cash.

How to Best Use Your Value-Added Accountant

Small business owners often view accounting services as only delivering the necessary output for tax reporting. And, yes, financial professionals do fully understand balanced bookkeeping with accurate categorization of transactions, plus the forms for various taxes. However, your accountant isn’t just about your taxes; accountants are also capable of providing analyses that can strengthen small businesses and help them grow.

Consequently, tax season should not be the only reason for meeting with your accountant. Savvy small business owners arrange to meet frequently with the professionals who most understand their financial situation, as they have the tools to help owners build their companies.

New insights

Accounting professionals can use your financial data to give you insight into business trends and help you weigh risks against potential rewards. This kind of financial management service can provide solutions to support sustainability and growth of your small business.

Those savvy individuals who avail themselves of these services recognize that different phases of their business demand different skill sets. Taking a concept from development to a full operation is not the same as overseeing an evolving organization. To thrive in business, you need to understand the financial measures that promote success. And your accountant can help you.

Executives at large enterprises have at their disposal an extensive network of internal financial professionals to help them navigate their operations. As a small business owner, you have access to the same expertise through your accountant. Relying on him or her for financial mentoring will increase your knowledge and improve your decisions.

Understanding industry standards

Your accountant can explain the business facts represented by your numbers. Ask first for a comprehensive general overview of key financial elements for your industry. Find out how your business compares in the basic measures of financial soundness. Inquire about trends in your financial measurements. Keep asking until you understand the actions that deliver good results versus those that contribute to declining performance.

Strategic planning

Your accountant doesn’t live in the past; he or she can see where your business is headed and what’s required to reach specific targets. Consider your accountant a consultant who can identify likely future scenarios, explain new initiatives you could implement to attain improved results, and quantify the costs. He or she will ask you to consider factors you may be overlooking. From these, you can project cash flow to help in plotting an achievable course of action.

Planning for financial security

Your accountant can also help you plan for long-term financial security. Some of the cash your business generates exceeds what’s needed to sustain operations and provide for your own compensation. Saving techniques suggested by your accountant may ultimately enable you to fund a business expansion, save for retirement, or transition to a different business model. Best of all, they may also deliver tax benefits now.

Your trusted accountant provides solid guidance that’s crucial for the inevitable but uncertain changes every business owner faces. Make good use of him or her.

Forecasting Can Direct Your Actions and Impress Lenders

Financial forecasting is one of the greatest challenges confronting a small business owner. But the process is important because it allows you to use the lens of experience to peer into the future.

Nevertheless, financial forecasts are frustrating because they require time to establish expectations that are almost never achieved as planned. What forecasting does do is provide a guide to conditions that could exist for your business; basing your actions on this guide is the reason we forecast, and it’s crucial to your desired results.

Monitoring performance

A financial forecast enables you to monitor performance. And this is key: spotting a gap between forecasted figures and desired outcomes allows you to get ahead of problems before they become enormous disruptions. Acting on this (by making changes in spending, focusing on the most profitable sales opportunities, or developing a new marketing strategy) will put you back on track.

Your company will not always grow at the same rate as in the past. Based on your financial forecast, you may expect to grow at a faster pace – cash flow can change as a result of a growing or changing customer base, and new circumstances can trigger a need for capital.

Experience and practice help. As you learn to connect your projected numbers with factual data, you’ll become better at forecasting. And when your forecasts reflect the facts, you’ll feel more comfortable approaching potential lenders; your financial forecast will provide a believable foundation to support your loan request. Desired result: loan approved!