Tax season is coming and for small business owners, especially new ones, now is the time to hire a good accountant .
While business owners generally can’t wait to offload their day-to-day accounting onto a CPA or bookkeeper, even designating a professional to handle finances doesn’t absolve entrepreneurs from understanding some accounting basics.
“For the most part, a lot of small businesses have a technician who’s very good at a particular skill,” said Bob Pryba, a co-founder of Pryba, Tobin & Company, a 12-person accounting and tax firm located in Latham, N.Y. “We don’t find a lot of accounting strength in entrepreneurs.”
But business owners can develop a financial understanding that will help them manage current operations as well as plan growth. Pryba recommends business owners create a weekly flash report for themselves that contains six to 12 metrics that let them know how the business is doing.
Understanding some key accounting terms will help entrepreneurs better understand those reports and give them the knowledge needed to hire a good accountant.
Here are some accounting terms and concepts that will help entrepreneurs grasp their business’s results:
GAAP versus Tax Basis Accounting
What it is: Over the years, auditors and accounting standards boards have developed generally accepted accounting principles (GAAP). The experts believe that these guiding standards lead to the best and most consistent reflection of how a business performs. GAAP differs in many ways from tax basis accounting, which is driven by the rules codified in governmental tax law. One of the most common differences between two systems lies in how businesses recognize larger, long-term expenditures called capital assets (below).
Why it’s important: Small businesses often don’t have reporting requirements beyond filing a tax return each year. Therefore, they can use tax rules to prepare their books. When a company seeks bank financing or enters into a significant contract with a customer, either of those institutions might require audited financial statements. It’s highly likely those statements will have to conform to GAAP.
What it is: In putting together a tax return, businesses have two options in how they choose to recognize revenues and expenses. Under the cash method, a business recognizes revenue when they receive the check and expenses when they cut the check. Accrual basis accounting requires a business to recognize revenues when earned. For example, an accrual basis construction company would recognize income when it finishes building a house, even if payment is delayed for a month. Likewise, that company would record an expense when it receives a shipment of lumber, regardless of when it pays the bill. The accrual method offers a more accurate picture of how a business is doing at a specific moment.
Why it’s important: Choosing the right accounting method can have a major impact on taxable income. Most small businesses choose the cash method, which allows them to exert some control over income and expense recognition. Most businesses for which inventory is significant must use the accrual method, but exceptions exist for certain small businesses.
Direct versus Indirect Costs
What it is: Direct costs can be tied directly to revenue: expenses incurred to make a product or produce a service. Indirect costs are overhead and supporting costs that would be incurred regardless of whether a product was made. For example, the costs of flour, cheese and tomato sauce are direct costs of making a pizza. The payroll costs for the person working the register are indirect costs.
Why it’s important: A business owner won’t understand profitability or make good decisions until he or she understands exactly how much it costs to make one additional unit. “It’s essential to pricing,” said Pryba, “both in determining your profitability and understanding how you fit into the market.”
LIFO/FIFO Inventory Valuation
What it is: Businesses have some flexibility in how they value the goods they buy to sell or make other products. Most businesses use First In, First Out (FIFO), meaning they expense the cost of the oldest goods first, and that the value of their inventory is based on the most recent prices. Last In, First Out (LIFO) allows the business to expense goods at the most recent purchase price.
Why it’s important: Most businesses use the FIFO method. But if the business includes inventory with volatile price swings, consider consulting an accountant to understand the best method.
Fixed Assets versus Operating Expenses
What it is: Fixed assets are investments in land, buildings, machinery and equipment that benefit a company over an extended period. Operating expenditures typically don’t provide a lengthy use.
Why it’s important: Accounting treatment differs for fixed assets and operating expenditures. Because fixed assets have long lives, both tax and GAAP rules generally require that they be written off over a period of time matching their benefit. Businesses can write off operating expenditures immediately.
Depreciation & Section 179
What it is: Depreciation is the method by which businesses recognize the expense of fixed assets. Section 179 is a special federal rule that allows small businesses to recognize immediately the expense of certain fixed assets provided the business meets certain qualifications.
Why it’s important: Taking advantage of Section 179 can yield favorable tax consequences.
What it is: Businesses can create or purchase intangible assets — such as goodwill, patents, copyrights and trademarks — that have long-term value. As you might expect, there are GAAP and tax rules for how to recognize those expenses.
Why it’s important: If purchasing a business, it's especially important to understand intangible assets. Part of the value one pays for may be the business’s brand or reputation. In this case, it's necessary to allocate some of the purchase price toward that asset and deduct it over what is often a long period of time.