Accounting 101: Back to Basics
We had the opportunity to once again pick the brain of Todd Zgoda, CPA, and asked him to share some accounting basics for business owners.
The Importance of Keeping Financial Records
Paychex: Many business owners don't place enough importance on maintaining good financial records. Can you share some of the common mistakes they make?
Todd: One of the most frequent mistakes is throwing out receipts. A common misconception I hear is, "I don't need the receipt. I have my credit card statement." By law, the Internal Revenue Service (IRS) mandates that a business owner have a receipt for every deduction they take. Under audit, an IRS agent doesn't have to accept a credit card statement as proof of an expense.
Another common misconception: if a business owner has most of his or her receipts that will be good enough for the auditor. An IRS agent has the authority to disallow any deduction for which the taxpayer cannot prove via receipt.
Paychex: Do you ever run into business owners doing their own version of "shoebox accounting"?
Todd: Believe it or not, I have had the unlucky experience of a client showing up at my office with their records all thrown into a shoebox or plastic bag!
That's a great example of another common mistake—not organizing records. When this happens, a taxpayer may forget to take a deduction for a legitimate expense, may forget to include money received as reportable income, or may duplicate an expense or income item. Plus, the taxpayer may end up with a higher-than-anticipated accounting bill, since their accountant or tax preparer was required to spend additional time organizing their records, making sure that all items were properly categorized and accounted for.
When you keep your financial records in good shape, you can proceed with confidence that your income and expenses are reported accurately. This is, of course, in regards to all activity taking place through the business owner's checking and savings accounts. This should prevent any income or expenses from being reported twice or inadvertently omitted.
There are instances when a business owner pays for a business expense with personal cash or credit card, or deposits a business check into their personal account. In those cases, the business owner should make all attempts to incorporate these transactions into their financial records.
Paychex: Do you recommend a certain type of accounting system to your clients?
Todd: We stress to all of our clients that own a business, the importance of maintaining their records on some type of accounting software system. This is just as important for a sole proprietor as it is for a partnership or corporation. Although a sole proprietor is only required to report their income and expenses on Schedule C of their personal income tax return and are not required to report a balance sheet, we believe that maintaining a full set of books (balance sheet and profit and loss) can provide a great deal of value to a taxpayer.
When a business owner maintains a full set of books and goes through all of the proper accounting procedures (reconciling bank statements, reconciling credit cards, validating other asset balances and liability balances via third party verification), the business owner and accountant or tax preparer can place a great deal of reliance on the financial statements, that the amounts reported are fairly accurate.
Paychex: From your experience, what advantages do you see with using an accounting software system?
Todd: In preparing a full set of books with an accounting software system, you'll get a great deal of information if someone needs to research the details of any particular transaction or transactions. In the event that a business owner is asked to produce all of the cancelled checks and receipts for any particular expense category, they can simply create a report that will produce the date of transaction, check number, amount of transaction, payee, etc.
Paychex: Can you talk a bit about the different types of financial statements business owners should use?
Todd: Let's start with a balance sheet. This provides balances as of particular date and can provide a great deal of information as to the health of a company. I'm going to go beyond the basics for a moment here and say it's important to report a company's financial records on the cash basis of accounting or the accrual basis. Although the cash basis method accounts for transactions as income is received and expenses are paid, an informed business owner may take money out of the company to make a purchase, when in reality the company doesn't have sufficient funds to cover all outstanding obligations.
Paychex: Can you give an example?
Todd: Suppose a business owner shows that they have $25,000 in their checking account (assume all deposits, checks, and charges have cleared the bank). The business owner uses $15,000 to make a purchase or pay her a draw/distribution, thus leaving the company with only $10,000. In this example, she made a fatal mistake, forgetting about the $20,000 expense that is due in a few days (assuming that no new deposits will be made into the bank account prior to the expense having to be paid). On the surface, it appeared that business had sufficient cash, when in reality it did not. A balance sheet will also indicate if the company is carrying too much debt.
Paychex: What other financial statements provide information about the health of a company?
Todd: Analyzing several factors on a profit and loss statement can also help determine a company's financial health. Although a net profit can indicate that a company is doing well, in reality the financial health of the company could be poor as indicated by poor cash flow and a constant low cash balance.
A profit and loss statement will report all income and expenses by category. It's up to the management of the company to determine the amount of detail they want to show on the profit and loss.
Paychex: What are the advantages and disadvantages to showing a lot of detail on the profit and loss statement?
Todd: Take a coffee manufacturer, for example. One business owner may want to report every variety of coffee they sell as its own sales line. Another business owner would be satisfied just reporting all of the coffee as one sales line. We stress to business owners to review the detail of each account line reported on the profit and loss to determine if that category of income or expense is properly reported.
In another case, a business owner may be reviewing rent expense and find that they entered a utility charge to that account. Although the expense misclassification will not affect the bottom line, it may affect expense ratios that the business owner is using to determine if their expenses are above industry norms.
Something we also stress to business owners is to compare income and expenses of the current year to those of prior years. This exercise can be very useful, as it will highlight any significant changes between years. In analyzing significant changes, one should apply a combination of the dollar difference and the percentage difference. Whenever an owner finds a significant change from one year to another, they should investigate and hold themselves accountable for the reason or reasons for the difference. An income or expense item could have been reported in the incorrect account. Or a difference could be due to a significant increase or decrease in sales activity. The company could have been charged incorrectly for an expense item, or experienced a large increase in the cost of a particular expense item. For example, the company did not change any insurance coverage of its insurance liability policy, but the insurance company increased the policy rates by 15 percent. By analyzing this, a company may realize it's time to start shopping for a new insurance carrier.
Paychex: Are there other financial statements that help a company determine its financial health?
Todd: A cash flow statement shows the change in the company's cash balance during a specific period of time. Not only will this statement indicate the change in the cash balance, but it will let you know how your cash balance changed. It will signal if you made or lost money from normal operations, if the company borrowed money, if it lent money, how much debt they paid back, and more.
About the CPA
Todd Zgoda is a certified public accountant with the firm Bruce M. Zgoda, CPA, in Clarence, NY, and has 15 years' experience. Todd is a MBA graduate of St. Bonaventure University, serves on the finance board of two not-for-profit organizations, and is a subcommittee chair for the Buffalo chapter of the New York State Society of CPAs.