Attention Cash Basis Bookkeepers: Watch for Accrual Entries

Most small businesses maintain their bookkeeping on a cash basis of accounting, recording revenue and expenses only when money flows in or out. By contrast, accrual accounting records revenue when earned and expenses when incurred. Cash basis is easier and provides a satisfactory financial picture if your business is generally paid promptly by customers and pays its bills immediately upon receipt. Nevertheless, some transactions are necessarily accounted for as accruals even by cash basis operations. These are most often amounts that will be remitted in the future for taxes.

For example, payroll taxes are expensed by a business on payroll dates, but remitted on future days. Payroll taxes that are deducted from employee pay are part of the company’s expense for wages, although the withheld amounts are not paid simultaneously with net paychecks. The employer part of payroll taxes is another expense category that’s also recorded on payday.

Because payroll taxes are remitted at a later date, recording the expense on payday is offset by an accrued liability on the balance sheet. If the taxes accrued for remittance in the future are not recorded on the balance sheet, the expense will not appear on the income statement. Profit is therefore overstated due to the missing expense.

When an accrued amount of payroll taxes is eventually remitted, it has no impact on the income statement because the expense has already been recorded. The remittance applies to the accrual on the balance sheet.

To assure accuracy of expenses, it is essential to constantly examine the accrued tax liabilities on your balance sheet. This close watch will help you avoid financial surprises.

Preparing a Business Budget for the New Year

Every business owner has goals, and achieving them requires a bit of planning. Because goals are linked to money, a proper plan includes devoting a little time to budgeting.

Fortunately, you don’t need an elaborately detailed budget like that of a multinational corporate behemoth. Simply having an outline connecting spending and revenue is sufficient. Setting aside a planned amount of cash for spending later assures you have sufficient funds for future plans to succeed. A budget tells you what is and is not a financially sound decision.

Making the Business Budget

You can create a budget using the old-fashioned tools of pencil and paper, but this is only a good starting point. After sketching out a general income and spending pattern for next year, placing the numbers in electronic format will help when filling in the remaining details.

Spreadsheet applications on your computer will work nicely. Perhaps your bookkeeping software gives you an option to place budget figures into it. This will benefit you later when comparing your budget to actual results.

Start the budget process by estimating an amount of monthly revenue based on available resources. Your income is limited by how much time you work, the equipment you possess, and the prices you charge.

Moreover, you may need to adjust income based on your cash resources. That’s because higher income may lead to paying more expenses prior to collecting from your customers. The money you have for expenses puts a cap on how many customers you can serve.

Using the Business Budget

The budget shows a timeline for building cash over time. A controlled growth rate and a tight rein on spending allow your cash to gradually increase. This capital reserve is then available to fund further growth with new customers.

The timing for a rising cash flow depends greatly on when customers pay you. A lot of businesses are paid a month or more after work is completed.

That means your budget will show you deploying your available resources and paying your bills one month, but collecting the revenue over the next month or two.

Over those next couple of months, you will spend more time and money on additional work. Your budget should indicate, however, that you have a little more cash than when you started. That’s because the revenue received exceeds your costs. This is the profit you aim to accumulate and then spend for tackling more customers.

To ensure that you achieve profit accumulation, monitoring your actual business performance is crucial. The budget predicts increasing business cash flow, but turning that expectation into reality necessitates comparing actual to budget.

Obtain your statement of revenue and expenses after the first few months projected in your budget. You want the report that has revenue you already collected and expenses you already paid. Put these numbers in the same spreadsheet as your budgeted revenue and expense categories for the same months.

Is your revenue coming in as you expected? Is your spending on track with the budget?

Most likely, you will uncover areas where you have excelled and others where you’re falling short. Making the necessary adjustments will propel you to meet your annual goals.

Donations and Deductions: What You Need to Know

Taking a tax deduction for items donated to charities is a common practice for millions of individuals. But what about tax deductions for donating business property? This process is a bit more complex.

A personal income tax return is where most business owners deduct the charitable contributions of their companies. Only a regular C corporation deducts donations on the income tax return of the business. Sole proprietors, partners in partnerships, shareholders in S corporations, and everyone with a limited liability company (LLC) treat charitable contributions by the business as if they had been made personally.

How much?

The amount of tax deduction that an individual takes for donating personal property is typically the fair market value of the donated item. Fair market value is simply what an ordinary buyer would pay for the item and what an ordinary seller would agree to accept for selling the item. In other words, the tax deduction is whatever amount of money the charity receiving the donated item can get from selling it.

A general exception, however, is that the individual cannot deduct more than what was originally paid for the item. This amount is known as the basis of the property. For example, donation of business inventory results in a tax deduction for the cost rather than the fair market value of the items. Likewise, the tax deduction for donations of art, literature, or music is limited to the cost of creating it.

Conversely, an asset specifically held for appreciation in value may, in most cases, be treated as if it were sold and the proceeds donated. The deduction in these instances is the fair market value, not the basis. This is true, for example, of investments in qualified shares of stock.

What about accounting?

Thinking about the bookkeeping for a business, it’s easy to see the complexity of deducting fair market value for a donated item. Unlike inventory, the basis for most items is $0, because the business already deducted the cost at the time of purchase. Therefore, the charitable deduction is limited to $0. Office supplies and most small equipment fit this description.

Long-lived fixed assets are generally not expensed when purchased. Their cost is depreciated over time. If the original cost has not yet been fully depreciated, these items have a basis above $0. Basis for these items is the part of original cost not yet depreciated.

The basis for fixed assets is found on the company’s balance sheet, which is the financial statement showing assets balanced against liabilities and equity. When a charitable donation is recorded, the asset’s basis is removed, the expense lowers profit, and equity decreases.

However, the bookkeeping technique is different if the deduction is not limited to the asset basis.

For example, what if the fair market value of the donated item is lower than its basis? In these instances, the business deducts the part of the basis that is not deducted as a charitable donation as a loss on asset disposal.

In rare cases, if the fair market value is more than basis, the business may choose to report a gain on disposal of the asset.

Do you need to record a charitable donation from your business? To ensure proper navigation of these bookkeeping measures, consult with your tax adviser for assistance with business asset donations.

Worth the Expense? Measuring the Impact of New Initiatives

An entrepreneur makes changes in the business not merely to improve satisfaction or add excitement, but also to increase profitability. Determining if these creative actions are adding to the bottom line begins with identifying which categories on the business income statement are impacted by initiatives.

Typically, a change entails some additional spending in the near term that’s aimed at delivering benefits later. For instance, crafting a new sales strategy or marketing campaign will increase certain selling expenses. How can you tell if the expenses were worthwhile? Monitor the changes by comparing marketing costs after implementing the new strategy with the costs in these same categories under your old sales process (be sure to compare with the same time period last year). Later, examine revenue to see if you achieved the expected rise that should follow a successful program.

Other potential changes are new products, added services, a different menu, or a big sale. All of these enhancements are aimed at improving output, supplying an increasing number of customers, and improving sales. These goals are commonly preceded by higher expenses, such as acquiring product samples, adding a new employee, paying for new printing or promotional materials, buying extra advertising, and making changes to your website. To measure their impact, compare the increase in relevant expense to the increase in revenue. This ratio reveals how well your new actions have succeeded.

Some innovations are intended to increase profit without raising revenue. They simply aim to reduce expenses. For example, a new physical layout for your business may inspire easier workflow. If such innovations are worthwhile, your income statement will show an increasing profit margin due to lower costs. Success!

Solving the Mystery of Financial Statements

Business owners often limit their examination of financial statements to a single report. They rely solely on a statement of incoming revenue and paid expenses, commonly known as the profit and loss report, or P&L.

Making the best decisions for a business, however, depends on recognizing the limits of P&L evaluation. Many vital numbers depend on the type of P&L you obtain as well as other complementary financial information.

Accruing Information

Some businesses operate on a cash basis. Customers pay at the time a sale is made. But many enterprises invoice for services and are paid at a future date. The true output for your business is the amount invoiced. The P&L you want, therefore, is accrual basis, which shows the total invoiced sales. And it will have the accrued but unpaid bills for expenses. Conversely, a cash basis P&L only shows the expenses already paid.

An accrual basis P&L reveals how effectively your time was deployed to realize a profit. The obvious number is the bottom-line profit that represents the amount by which revenue exceeds expenses. A few key ratios will unlock the context of the profit figure.

The most helpful profitability ratios depend on your industry. Some businesses depend mostly on personnel for their output. These businesses should measure profit as a percentage of employee hours. Other enterprises are primarily impacted by the quantity and type of equipment. They should determine the profit as a percentage of capital investment in fixed assets.

Comparing these ratios for various periods conveys the trend in business profitability. You will find out if working more hours or an investment in new equipment is delivering the improved results you expected. Be sure to consider seasonal factors. Contrasting your ratios from recent months to the same period in prior years is usually the best process.

Cashing In

The detail you’re missing, however, when examining the accrual basis P&L, is the cash impact of your operations. The companion of the accrual basis P&L is a cash flow statement. This report adjusts your accrued profit by showing changes that affect business cash. The cash flow statement is crucial to identifying how easily your business can pay its bills in the near term. A growth trajectory is nice to see on the accrual basis P&L, but it can trigger a cash constraint. Your business must pay its bills on time, even if your customers are late in paying your business.

Cash flow will be negative if you recently acquired new customers who are slow in paying your invoices, while you have paid the costs to acquire and serve those customers.

Your business cash flow may also be negative if you recently invested in new equipment. Eventually, these expansion efforts should pay off with rising cash flow. You merely need assurance that your company has enough cash to sustain a period of negative cash flow. Fortunately, cash flow statements tell you the amount of negative cash flow, and indicate when the trend is turning positive.

Use these financial statements to monitor and maintain healthy growth for your business.

If you need assistance, a financial professional can walk you through how to set these up and use them to foster ongoing business success.

Three Expenses to Examine to Eliminate Wasteful Spending

Are you spending more than you have to? Unnecessary expenditures chip away at your profit margin. Keep a close eye on the following three areas to control overhead costs and boost your bottom line.

1. Office Space: Rent is expensive. Selecting the right location and amount of space is very important. For example, although a retail business benefits from a visible site on a main boulevard, the owner doesn’t need a large private office. Some enterprises don’t need any space at all. Many small operations have only personnel who work remotely. Keep in mind, if you don’t meet clientele at your office, an expensive location on a main avenue is unnecessary.

2. Staff: Even if a freelancer costs a bit more per hour than an employee, you may still save money. Employees are paid regularly regardless of how much work has been assigned to them. Freelancers are only compensated when your business needs them. For routine daily matters, employees are the answer. But a company can manage with freelancers to perform special projects for customers or to complete multiple nonrecurring tasks. Moreover, you have to provide employees with supplies, office space, and equipment, as well as administer payroll taxes. Not so with freelancers.

3. Non-Essential Services: Knowing the difference between DIY roles and outsourcing is vital. If you have the time to clean your office, for example, you don’t need a janitorial service. An extended service contract isn’t needed for things you can fix yourself. But don’t jeopardize your future merely to cut short-term costs. You may, for instance, be capable of troubleshooting a problem with your internet router, but tackling unfamiliar territory like preparing financial statements or income tax returns is best left to finance professionals.

How to Separate Business and Personal Finances

The two biggest hassles for most entrepreneurs are accounting for expenses and paying taxes. It’s not a coincidence that these things are inextricably linked. Business expenses lower your taxable profit.

Failure to capture all your business expenses results in overestimating your profit and overpaying income tax. But mixing personal expenditures with your legitimate business costs creates bookkeeping confusion and may trigger scrutiny from the tax authorities.

The fact is, not all business purchases are paid from the company checking account. You likely use a personal credit card and spend some cash. Especially complicated is adding to your bookkeeping a home office or business use of a personal vehicle.

Adhering to specific accounting procedures ensures you take the correct tax deductions for using personal funds or credit cards for business costs, as well as for contributing personal items to the business. Use the following principles to guide your accounting practices.

You Are Not the Business

Think of your business as something separate from yourself. In fact, this is exactly the legal structure if your business is a corporation or partnership, or an LLC treated as one of these entities for tax purposes. When you spend money on your credit card for business, simply turn in the receipts for reimbursement by the company. Of course, the business doesn’t need to actually reimburse you as it would an employee. Since you’re the owner, these personally paid items count as capital contributed to the enterprise.

Personal cash used for business must be accounted for by promptly providing receipts for reimbursement or, rather, capital contributions. Holding these for too long is a mistake because they could be misplaced. Or you might not remember what exactly was purchased, which means the expenses cannot be properly recorded in the correct bookkeeping category.

An even better practice is having a dedicated credit card for business purchases. Remember, just because you have a card for your business doesn’t mean everything you buy is a tax-deductible expense. Personal uses of the dedicated business credit card become capital distributions from the business. These make your company poorer. You don’t want an investment in a business that’s losing wealth.

Things for You and the Business

Special tax rules apply to business use of your personal vehicle or home. Don’t expect reimbursement or capital contribution credit for all your gasoline purchases simply because you drove around for business.

Actually, you may be cheating yourself out of a larger tax deduction by not having the crucial record of business miles driven. Fuel is only one of the expenses considered when using the standard reimbursement rate established each year for business miles driven.

Home offices may or may not be tax-deductible expenses, depending on several circumstances. Track your home expenses separately from business costs. A calculation is made at year-end based on those amounts and the percentage of your home used regularly and exclusively for business.

Lastly, when you make a major business purchase with personal funds, especially if money is borrowed, advice from your tax accountant is vital. The entire cost, along with any loan, must be recorded in your bookkeeping records. Also, the accounting for tax purposes is very precise when you acquire some things that are used both professionally and personally.

Building an Emergency Fund for Your Business

Every business needs a rainy-day fund, but a commitment to action for accomplishing this objective is often elusive. Waiting to see how much money is left for your virtual piggy bank after paying all the bills is not a viable solution. There’s never enough unless you take steps to control spending.

An effective method to build a cash reserve is to make a place in your budget for the emergency fund as if it were another vendor bill. Adding this cost of doing business may seem impossible at first. But close examination of your recent spending categories is certain to reveal some areas for expense reduction.

Look at the trends in your business spending. Are some types of expenses rising? Buying more is common when a business starts generating a little more revenue. Finding your previous spending level and returning to it merely requires inspection of historical expenses. Perhaps your vendors’ prices have increased. This is an opportunity to negotiate volume discounts, find different vendors, or raise your own prices.

Most important of all in creating an emergency fund is putting aside the additional income you make from an extraordinarily profitable month or period of the year. Completing a particularly large project or seasonal phase means you have more cash to retain for future lean periods.

Keeping a separate bank account is usually best to avoid the temptation of extra spending. This same account functions as a place for those ongoing deposits of small fixed amounts every month until the inevitable disaster strikes. When it does, your rainy-day account provides the perfect protection.

No Accounting Degree? No Problem

Small-business owners don’t need an accounting or financial background to use a few key numbers to help their company thrive.

To keep the business on the right path for ongoing success, entrepreneurs should regularly examine central measures in their company’s financial reports. This basic information can transform routine operations into productive actions.

This review begins with an assessment of overall profit trends as well as an examination of the profitability of specific products or projects. To do this, you must first ensure that the data being reviewed is providing useful and accurate information.

Keep in mind that you don’t have to be a numbers person to recognize whether you have solid financial reports. But before you can review what your figures convey, they must be understandable. If your bookkeeping procedures and formats are off track, evaluating them won’t help. If your books need a bit of organization, start with classifications.

Classify for Clarity

Your bookkeeper needs sufficient information to properly categorize all expenditures and revenue. Expense accounts should be grouped in a fashion that makes sense to you. You may want to generate reports by classification for various projects or product lines. This requires clearly identifying the classes for all amounts spent or earned. Some types of businesses may have recurring projects for ongoing clients. If you’re one of these, each client may be a classification.

Having the right classification system and the procedures for providing category information to your bookkeeper allows you to create functional income statements. Examine the report by class to ensure that all sales have been properly classified. Confirm that all expenses are appropriately applied to the correct classes.

Now you can easily identify the profitability of projects, product lines, or specific clients. Better yet, you can generate an income statement that compares the period that recently ended with the same period a month ago or a year ago. This gives you the opportunity to quickly see trends in revenue categories and types of spending.

Balance for Better Business

Accurate bookkeeping relies on double-entry accounting. This is a system where every increase in cash is the result of a balanced increase in either debt or profit (from adding revenue). Every decrease in cash is triggered by either a decrease in debt or less profit (due to an expense). The only exception is that some cash decreases may add a different type of asset other than money, such as equipment or other property.

Regardless of what classification applies to incoming or outgoing cash, your bank account is always impacted. Making sure you’ve captured all bank transactions is simply a matter of reconciling your bookkeeping with your bank statements. Asking your bookkeeper for this reconciliation report ensures that all transactions are recorded and reconciled.

The company balance sheet is therefore an important report to inspect. This is the summary of your assets balanced against your liabilities owed and your business capital. The latter includes your investments plus cumulative profits you have not taken out of the business.

Obviously, your aim is to keep enough cash and incoming receivables to cover upcoming bills owed. And don’t let debt vastly overtake capital.

This ongoing evaluation of financial statements will provide the foundation needed to build a solid business that consistently delivers outstanding products and services.

How to Account for Renovated Business Space

When small businesses lease office or retail space, unusual bookkeeping measures are inevitable. Additions or changes to rented space create unfamiliar accounting situations. Untangling the tax treatment for these scenarios typically triggers a cascade of questions regarding improvements, depreciation, and repairs.

Improvements: The tenant, rather than the landlord, generally pays for customization of rented space. As a tenant, you cannot designate your cost for changes to rented property as an expense. Rather, the amount spent appears on the balance sheet in an asset account called “Leasehold Improvements.” These include structural modifications such as adding walls or plumbing. The costs are depreciated over time.

Depreciation: Each element of improvement should be separately identified along with its cost. Depreciation periods vary depending on whether the improvement is floor covering, part of the building structure, or an appliance attached to the building. In most cases, the depreciation recorded for company bookkeeping is the same as the standardized amount established under tax law. When you move prior to the end of a tax-allowable period, the not-yet-depreciated improvement costs are written off upon abandonment.

Repairs: Minor repairs and maintenance are exceptions to depreciation as leasehold improvements. You may expense the cost to fix a floor tile or paint a room. Routine maintenance that makes the building fit to occupy counts as an expense on the income statement of your business, but a landlord will often pay for these measures. In addition, when the landlord pays for some of the tenant finish-out, that part of the leasehold improvements cost isn’t counted as a depreciable cost for your business.