Before we even start talking about this month’s topic, we have to state for the record that we are not
planning on teaching you how to deceive the Internal Revenue Service, your banker, your insurance agent or any of your company’s owners. What we are going to teach you is the various real, honest-to-goodness accounting methods that you might use in presenting the financial results of your business. So, let’s get to it.
First and foremost, remember that the Enrons, WorldComs and many other “publicly-traded” companies of the world are required to report their financial results based on Generally Accepted Accounting Principles or GAAP
. Generally Accepted Accounting Principles are primarily agreed to by CPAs and are intended to show all the assets and liabilities of your company. GAAP are living, breathing rules that change over time as the way we do business changes. While there are some core concepts and rules at the base of GAAP, there are a whole lot of transactions that don’t fit into the previously issued rules. When that happens, if there are enough such transactions, CPAs try to get general agreement on how the transactions should be handled.
One last thing on GAAP; it’s use is not limited to public companies. Any business that wishes to do so, should issue the financial statements using GAAP. Unfortunately, this is not always practical and, in some instances, can be quite costly. For example, let’s assume your small company has a defined benefit pension plan. Not only will you have to get your accountant to record various accruals, but you will also have to hire an actuary to figure out the numbers that are supposed to go on the financial statements. Are you an oil producer? Don’t forget to get an outside engineer to prepare a report on how many barrels you have left in the ground at year-end.
Because of the cost of applying GAAP in some instances, accounting rule makers give us an option of using an Other Comprehensive Basis of Accounting. Accounting methods like the Cash Basis of Accounting or Income Tax Basis of accounting are very common. Many times business owners manage using one basis of accounting and, when it comes time for the year-end financial statements that go to the bank, use another basis. We suggest that you sit down with your accountant and determine what will help you best manage your business and use this basis for your internal and, if acceptable to a lender, for your external financial statements.
Let’s take a look at some of the more common alternate methods:
- Cash Basis – The cash basis of accounting recognizes income when the money is received and expenses when the money is spent; even fixed assets and inventory. It’s that simple…well there are those expenditures for long-lived assets that really should be shown as assets and depreciated over their useful lives. When you need to record significant expenditures as depreciable assets, you might be moving away from the pure cash basis of accounting and moving toward the Modified Cash Basis. Basically, this is using the cash method of accounting but recognizing that you distort your earnings if you don’t capitalize a significant piece of equipment and write it off over its 10-year life.
- Accrual Basis – Under the accrual basis of accounting, you record income when you make the sale, even if you don’t get paid for 30 days, and you record expenses when you incur them, even if you don’t pay them for 30 days. You are also required to recognize inventories, prepaid expenses, long-term assets that are depreciated over a period of time and many other transactions as creating balance sheet entries (assets and liabilities). With few exceptions, when we talk about accrual basis statements, we are thinking in our heads GAAP.
- Income Tax Basis – Betcha you can’t figure this one out! Ok, you’re right, this is the basis of accounting for transactions that you use on your income tax return. In some respects, it is the most complicated because it sometimes takes us years to figure out the proper treatment of a transaction and with a new tax bill each year, that’s no mean feat. Once we have settled on the treatment of a transaction, the IRS comes in and tells us we aren’t doing what they want. Then we go back to the drawing board.
Well…it’s not really that bad, but there are numerous instances where we have to interpret what Congress meant when it enacted a law. Unfortunately, the IRS does too, and sometimes we disagree.
The income tax basis of accounting can be either accrual or cash, depending on numerous factors. You may report revenue one way for GAAP, but a completely different way for taxes. For instance, say you own a corporation that has $1 million in land in it and you want to get that land out in your name. You get an appraisal that says the land is worth $100,000 and you buy the land from the corporation at the appraised price. For GAAP, we would record a $900,000 loss. Not so with the income tax basis. The income tax basis won’t recognize losses between a corporation and a related party. We could come up with examples that would fill volumes. Just remember that tax law is designed to raise revenue and shape society; it isn’t a logical animal.
So, what’s right for you? That’s a matter of opinion – specifically yours. Here are a few guidelines:
- Pure Cash Basis – If your business is relatively simple, with one major activity and inventory and fixed assets are not a significant, the pure cash basis is probably a good choice. A typical business might be one in the service industry (lawyers, doctors, accountants) or one that may sell product, but it’s basically a matter of getting the product and turning it around to the customer as soon as you get it. A landscaping business would be a good candidate also, as long as the equipment used is low dollar (lawn mowers, small tools).
- Modified Cash Basis – Businesses that are a bit more complex and rely on machinery rather than labor to produce income would probably be good candidates for the modified cash basis of accounting. Simply by their nature, such businesses have to be more sophisticated to make the buy call for major equipment. They might need to carry large inventories of product and using a pure cash basis would distort what they are really earning.
- Accrual Basis – Business that carry inventory and generally pay for it on terms, rely on material capital expenditures, incur material amounts of debt and are relatively sophisticated in their accounting procedures are good candidates for the Accrual Basis of accounting. These businesses have complicated production methods and perhaps numerous activities and a simple cash-in, cash-out approach to accounting would materially distort their financial picture. For example, a manufacturing company, with several product lines would need the accrual basis to properly cost it’s materials and, therefore, properly charge for their products. Such companies need to capture things like vacation accruals and similar costs as they are incurred so they can apply costs to proper products.
- Income Tax Basis – A little earlier, we said this might be the most complicated method of accounting because of the numerous tax laws that take logic and throw it to the wind. While that may be a little unfair, tax accounting can become quite complicated and if you are oriented first to making money and second to keeping it, using tax basis financial statements would give you a good idea of what taxable income might look like. Since the tax basis can be cash or accrual, you have the best of all possible worlds. You can book your transactions on a cash or accrual basis while also bearing in mind the tax treatment of those transactions. Since you’re going to report to the IRS on the tax basis, in many respects, this method of accounting simplifies tax return preparation.
Ultimately, the basis of accounting you use should be conducive to your management style and provide you the information to make business decisions. Sometimes, it’s better to use two sets of financial statements (this is the book cooking part) depending on their purpose. You may keep your internal statements on the tax basis, but prepare GAAP financial statements at year-end for your banker. Many times, especially for capital intensive industries, this will give you external financial statements with higher net worth than what the tax basis would give you.
There are numerous ways in which you could capture and record your financial data to present the best possible picture of your company to whatever user may rely on the data. Let us help you decide what’s best for you. Our experience in accounting and taxation coupled with your knowledge of your industry is a powerful combination that can help you best capitalize on all of your opportunities.
Keep our military personnel around the world in your thoughts and prayers and have a great September!