Fundamentals Of Accounting

The Problem with Cash Basis Accounting

There are a good number of businesses that, through the methods they employ in their accounting procedures, are effectively placing their necks within a hair's breadth of the chopping block. And the worst part? Most of them know they're doing it, yet do little or nothing to lower their risk level. What we're talking about here are companies that use cash basis accounting as their primary method of tracking their day to day financial dealings.

This can develop into a serious problem. Cash basis accounting doesn't comply with GAAP principles. If you're surprised to learn that, you might want to continue reading. The fact is, even though there are companies to whom a cash accounting method makes practical sense, the significant gaps in time between recording profit and expense can cause havoc—especially when it comes to prolonged jobs. A company can appear to be earning great profit one year, resulting in far higher tax liabilities. In order to combat this, many companies spend those revenues elsewhere to reduce their tax liability, but inadvertently put themselves in the position of having short cash flow when the time comes to foot the bill to complete a job.

So why do so many businesses still operate using cash basis accounting? In a word, simplicity. Far more straightforward than the method of accrual basis accounting, where income is recorded when it's earned and expenses are recorded when they're incurred, a cash accounting method is just simpler. But simple doesn't always mean better.

The Benefits of Cash Basis Accounting

If it seems like extolling the virtues of cash basis accounting at the same time as discussing its equally profound problems is a bit schizophrenic, welcome to the wonderful world of accounting. Here, one company's liability can be another company's saving grace. And although cash basis accounting fails to meet basic GAAP principles, there are some companies that can benefit.

The problem is, those companies might be few and far between with respect to the commercial landscape. If your company falls into any of the categories below, cash basis accounting might be for you:

  • Does not have the ability to take credit card payments
  • Pays all expenses in cash
  • Requires a simplistic accounting system

If your company doesn't fit the description above, a cash accounting method is something you should steer far and clear of.

The bottom line: accrual basis accounting gives a company the ability to take an accurate financial snapshot at any given time. With a cash accounting method, that picture is not as clear. Its outcome depends on at what point the snapshot is taken, once again proving that the path of least resistance is not always the best path to take.

Ensuring Financial Report Standards through Outsourcing

As a result of the financial scandals of 2001 (anyone remember Enron?), Congress passed legislation that severely impacted publicly held companies. It required them to implement stringent internal auditing controls. Although the Sarbanes-Oxley Act (SOX) only applies to publicly held companies, the ramifications of these financial meltdowns resulted in many private companies ramping up their own accounting standards. In short, most are figuring that it's not a bad idea to cover all bases.

Having an in-house accounting department or controller is essential for the accurate preparation of company financial reports. But any time the words "in house" and "accounting" appear in the same sentence people begin to get a little nervous. And rightly so. The fact is, not everyone is a criminal—but when there are too many hands in the proverbial pie, and all those hands just so happen to work for the same company, the fraud risk always exists.

For this reason, many businesses are opting to outsource their accounting to third party companies that balance books and compile financial statements at a reasonable cost. Not only does this eliminate the potential for fraudulent activity, but also saves the cost of hiring a dedicated controller and caring for all the intricacies that have to be considered with internal audits.

Myths About Accounting: The Question of Audits and Reasonable Assurance

One of the most common misconceptions that exists about auditors and company financial reports is that once audited, the financial statements are guaranteed to be accurate. In reality, there are no such guarantees. There are only "reasonable assurances" that vouch for, but stop short of officially certifying, the accuracy of the statements.

The fact is, it would be economically infeasible for a company—not to mention unrealistic time wise for any auditor—to review every single monetary transaction reported on a business's financial statements. As an alternative, an auditor "spot checks" particular transactions. These are frequently done at random, but are sometimes chosen due to inordinate characteristics like high dollar amounts and other transactions that appear to be out of the ordinary.

For this reason, once company financial reports have been audited, a company is required to sign a letter stating that they accept full responsibility for the accounting standards contained within the report.

In the end, all an auditor's letter can offer is added credibility to the information contained in the company's financial statements. However, when an auditor provides their "unqualified opinion" it doesn't mean that they've vetted the company's internal controls. They're basically stating that, to the best of their knowledge, the financial statements don't appear to be wrong.

Making Hay by Making Pay(roll)

SMBs without adequate business accounting support (and sometimes even those operating under the assumption that their accounting is up to snuff) are constantly in the precarious situation of fumbling when it comes to payroll. Needless to say, a company's ability to process payroll in an accurate and timely manner is of immeasurable importance. Without that, the reputation of the company can seriously degrade from within. Here's an important tip to help ensure you're keeping your employees happily paid, while continuing to maintain established GAAP accounting practices.

Establish Lag Time
It is frequently the bane of the existence for anyone who's ever had to answer inquiries from concerned employees about the accuracy of pay stubs, payout of holiday pay, and inclusion of overtime. But a lag between "time served" and "time paid" can actually be one of the most efficient accounting practices for the elimination—or at very least, reduction—of common entry and reporting errors.

A Caveat: Check Your State
Allowance for lag time varies from state to state, so the establishment of a buffer that will allow you adequate time to "proof" your payroll entries may not be all that's needed to iron out the kinks. Ensuring that you have a qualified business accounting staff in place is the most essential element of keeping your workforce paid and happy.

The Big 3 Errors of Accounting: Commission, Omission and Principle

In the hierarchy of common business accounting errors, there are three distinct designations. Although often times it's impossible to expect absolute perfection, adherence to GAAP accounting principles requires steadfast vigilance in the pursuit of that all-elusive "numerical perfection" goal.

Errors of Commission
This occurs when the a financial transaction is entered incorrectly—whether the result of simple fat-fingering (ten-key errors and the accidental transposing of numbers among the most frequent) or recording information on the wrong account.

Errors of Omission
One of the more difficult errors to detect in business accounting are those that are invisible—as in the case of entries that don't make it onto the books at all. This is where careful scrutiny and double checking of work comes into valuable play.

Errors of Principle
This is where it starts to get really sticky. The more a company sees these on its books, the more obvious it is that a consultation with a professional accounting service might be what the doctor ordered. Errors of principle move beyond honest goofs and stray into the category of big-time foul-ups—like the improper entry of debits as credits or recording capital expenditure as revenue expenditure.

How Cost Accounting Can Help a Business

Cost accounting is the method by which all actual operating costs of a business are gathered and reviewed to determine profitability. In other words, it helps shed light on what's making money and what's not. Standard cost accounting takes a far simpler view of a company's performance and boils it down to dollars spent versus dollars earned. Job costing also comes in handy in day to day business operations, such as:

  • Tracking work progress. Cost accounting makes it possible to perform "real time" adjustments. This infuses a company's operation with a far greater flexibility than the kind that's typically afforded through hindsight financial reviews.
  • Removing the guesswork. Many companies operate under loose budgetary assumptions that are the result of a failure to gauge estimated versus actual operating costs.
  • Scheduling. Standard cost accounting gives a company the needed perspective to measure productivity, allowing them to make the best use of their resources and their workforce.
  • Overall spending. Job costing boils certain tangibles, like vendor costs, down to dollars and cents—and sense. Having the ability to determine which vendors are providing the most efficient product or services makes it possible for a company to tighten its budget without sacrificing quality.

The Limitations of Cost Accounting

In the day-to-day operation of a business, standard cost accounting is viewed as a practical method of gauging financial performance. It offers a solid, mathematical method of being able to take a snapshot of where a company is financially so that decisions can be made to increase efficiency and cut cost. Cost accounting is seen as a foolproof method—but that doesn't mean it's free from limitations and drawbacks.

Limitation #1: Timeliness = Accuracy
One of the most prominent limitations inherent in standard cost accounting is the limitation of time. Cost accounting reports can't be delivered overnight. The longer it takes for the information to be brought together into a cohesive, deliverable format, the information contained therein could be out of date.

The Catch-22
In an ironic twist, one of the most practical methods that a company can employ to ensure this doesn't happen is to run reports more frequently to capture an accurate reading—which costs more money.

Limitation #2: Final Numbers Can Be Deceiving
Job costing can also provide deceiving results. For example, a projected cost that comes in far under budget could be the result of cut corners (using cheap resources, for example) that could result in a substandard product.

Tax Havens vs. Doing Foreign Business Legally

Corporations who either purposefully or unknowingly participate in shenanigans aimed at tax avoidance can find themselves in serious hot water with the Internal Revenue Service. And that's stating it mildly. Although tax accountants and tax accounting firms are not responsible for policing these situations, they are given the resources that allow them to spot some of the most common tax avoidance schemes.

Creating Offshore Tax Havens
This is one of the most common schemes. While offshoring business isn't illegal, collusion with foreign governments or corporations for the purposes of obtaining financial secrecy is. Businesses have been known to be enticed by offers to bring their operations outside of the jurisdiction of the United States in order to take advantage of certain monetarily beneficial tax arrangements. Participation in these arrangements, or involvement in hiding them by tax accounting firms, is considered a criminal offense.

This isn't to say that every company that has operations outside of the U.S. is involved in some sort of tax evasion plot. There are plenty of perfectly legitimate legal circumstances, such as establishing a company in a foreign country in order to be able to do business there legally. A certified tax accountant experienced in SMBs will be versed enough to provide knowledgeable counsel on these types of issues.

Qualifying Company Cars for the Alternative Fuel Motor Vehicle Credit

Experienced tax accountants skilled in the preparation of corporate tax returns are aware that businesses in the practice of providing company cars to certain employees can take advantage of the Alternative Fuel Motor Vehicle Credit. These credits were enacted in 2005 as a part of the Energy Policy Act, and have the potential of bringing considerable tax savings and valuable write-offs to many SMBs. There are four specific categories of vehicles that fall under this umbrella.

  1. Hybrid: This describes vehicles that operate with a combination of gas and electric engine.
  2. Fuel Cell: Vehicles powered by one or more cells that convert chemical energy into electricity.
  3. Alternative Fuel and Heavy Hybrid: New or converted vehicles that run on alternative fuels like natural gas, propane, and hydrogen.
  4. Advanced Lean-Burn Technology: Diesel-powered vehicles with internal combustion engines that use higher amounts of air to combust the fuel.

Tax credit amounts vary depending on the type of vehicle, and the number of vehicles eligible for the credits may be limited. Any certified tax accountant or tax accounting firm can offer their corporate clients detailed information on the specific requirements needed to qualify for these tax incentives.

What Is Accrual Basis Accounting?

In the business world, there are two methods of accounting that, both in practice and theory, separate the sole proprietorships from the SMBs of the world. The two specific methods are:

  • Cash basis accounting: Mainly used by sole proprietors and small businesses, this method only records income when it's received and expenses when they're incurred.
  • Accrual basis accounting: In use by most all medium to large size corporations, the method of accrual accounting records matching transactions simultaneously. Income and related expenses are recorded when they're earned and incurred, respectively. The use of this matching concept complicates the accounting process, but is necessary for companies to be able to accurately forecast their financial performance.

Accrual basis accounting is the only of the above listed techniques for reporting business financial activity that adheres to GAAP accounting standards. GAAP standards are set in place to prevent companies from taking part in "creative" and deceiving practices that paint unrealistic pictures of how a company is performing. These conventions are set in place to protect the interests of both lenders and financial investors.

Although generally accepted accounting principles are in place throughout a majority of large industrial nations, the fact remains that each of these countries have sometimes substantial differences in standards that are "generally accepted."

The Challenges Inherent in Accrual Basis Accounting

Accrual basis accounting is required for all medium to large sized businesses that want to ensure compliance with GAAP accounting standards. But that doesn't mean doing so is a simple task, or that it doesn't have its drawbacks and challenges.

Time and Effort
Accrual basis accounting is, by its nature, more complex and expensive than the far simpler method of cash basis accounting that's usually employed by small businesses and sole proprietors. For this reason, many SMBs find themselves having to outsource their accounting needs to third party companies, or paying the necessary overhead to staff a sizeable accounting staff just to keep up with the constant recording and tracking of financial transactions.

Cash Flow Inaccuracies
The matching concept that underlies accrual basis accounting has a tendency to make it difficult for corporations to get an accurate representation of exactly how much available cash they have. Since the accrual method takes into account funds that are expected but may not be received for some time, management decisions based on existing cash flow can be difficult to make.

Tax Liabilities
Companies that may take a long time to obtain receivables also run the risk of owing taxes on revenues they've claimed, but haven't actually received yet. But despite these drawbacks, it's generally accepted that the accrual method gives companies far more effective tools to measure their profit and overall performance.

Constant Change, and the Question of Cost

Constant change has come to be an accepted fact of life when it comes to compliance with accounting standards -- begrudgingly by some, casually accepting by others. Yet both share one main concern: cost. Put simply, companies are becoming increasingly concerned with the ability of their CPAs to adapt in the face of ever changing requirements. Many have found themselves facing tough decisions about how best to handle the ever evolving landscape of business accounting.

Re-training Concerns
Many small and medium sized businesses employ entire accounting departments educated in GAAP standards that may be required to undergo frequent and substantial re-training to cope with this constant change. Caring for this is the genesis of great concern, as it translates directly into great cost to ensure that in-house accounting procedures are up to date.

A Silver Lining
Yet not all SMBs are in the same boat. Businesses that outsource their accounting needs to third parties are in an excellent position to experience seamless transitions, for obvious reason. Since third-party accounting firms are typically ahead of the curve on changes in financial reporting methods, the move to these types of services could be a shrewd money saving venture.

There's Always Time
Although changes to financial reporting methods has become an accepted way of life as companies move to provide better transparency in their accounting procedures, the reality is that it often takes years for major changes to be enacted -- giving fair warning to those who'll be affected first. Yet the real question remains: train, or outsource? In the end, that decision becomes a matter of cost vs. convenience.

Putting LIFO on Life Support

Once conversion to the international accounting standards set forth by IFRS is complete, U.S. companies will face major changes in inventory accounting procedures. The fact that the last in, first out (LIFO) method is not an allowed practice in IFRS—only the FIFO method is allowable—will have a serious impact on businesses that rely on it as a method of lowering their income tax liability.

The Potential Repercussions

  • Increase in businesses seeing heightened income tax liability.
  • Required low cost or net realizable value inventory.

Tips for a World After LIFO
  • Begin reducing inventory and LIFO reserves to minimize impact of negative effects.
  • LIFO reserves could be counted as taxable income, discovering new and previously unrealized levels of heartache for many U.S. corporations compelled to adhere to international accounting standards.