Is your Small Business in a tight cash situation?

How to Dispose of Accounts Receivable

Article written by EricBank

Many a small business has found itself in a cash crunch from time to time. This can be especially vexing for business-to-business (B2B) companies, which extend trade credit to other businesses and therefore depend on accounts receivable for payments -- a process that can take weeks or months. Retail businesses usually rely on credit card and cash purchases, which are normally not problematic as payment is immediate or prompt. But B2Bs might have A/R balances that represent a substantial part of working capital. In a crunch, a B2B has several options to quickly turn an A/R balance into cash.

Factoring

A bank or finance company that buys your A/R book is called a factor. The factor assumes title to the invoices in your A/R book when it buys it. In some contracts, you must guarantee that the factor receives full payment for all invoices -- this a contract with recourse. When the factor assumes all the risk of payment, it's called a non-recourse contract. Obviously, you receive less cash for a non-recourse contract. You usually receive a certain percentage of the A/R's book value and possibly a percentage of collections once they exceed the percentage you received. For instance, you might receive 80 percent of book value and 40 percent of all collections received after the factor has collected the 80 percent from your customers. You also might have to pay the factor a fee.

Auction

An online receivables exchange is a handy alternative to a standard factoring arrangement. The way it works is that you select some or all of your A/R invoices and list them on the exchange. Bidding then commences among financial institutions and banks, hopefully helping to boost the amount you'll receive for the invoices. The auction is pretty flexible, because you get to choose which invoices to unload and there aren't any long-term commitments. The risk is that the bid will be lower than the percentage you would have received from a straight-up factoring arrangement.

Pledging

 

Maybe you don't want to sell your A/R book, but still need some fast cash. Consider pledging the book as collateral for a loan from a bank or finance company. This is a recourse arrangement, but you retain title to the invoices. One good feature is that the process is invisible to your customers -- they continue to pay you, not some third party. In some cases, the lender might have you set up a lock box to receive the payments, but it will be in your name. Your balance sheet continues to list the pledged A/R balance as an asset, although you might have to add a footnote if you publish your financials.

Assignment

Assignment is a hybrid of pledging and factoring. The financial company or bank (the "assignee") pays you cash for the rights to your A/R collections. You use the A/R book as collateral for a promissory note that you sign with the assignee. It's still your job to collect your A/R invoices, but you forward the money to the assignee. The assignee has recourse in case any of the customers are deadbeats. The balance sheet requirements are similar to those for pledging, though you'll also have to show notes payable.

Do you have an Inventory Nightmare to share?

FIFO and Inventory Valuation for Income Tax

Article written by EricBank

The cost to purchase raw goods and inventory is a major factor affecting the net income of manufacturing and merchandising companies. Typically, inflation causes costs to rise over time, which pressures businesses to increase prices so that they can maintain their profit margins. These higher costs translate into increased deductions for purchased inventory, and this helps to reduce the squeeze on margins. Falling prices, or deflation, is another, albeit rarer, story.

Cost Flow Assumptions

You allocate costs to the goods you sell by making cost flow assumptions. Under IRS rules, you have two alternatives: first in, first out (FIFO) and last in, first out (LIFO). FIFO is like a single-file queue, in which to apply cost to your inventory in the order of purchase. LIFO is like a stack of pancakes: you grab the top one first -- that is, you apply current costs in reverse order to purchase. You have to notify the IRS when you adopt LIFO and when you switch from one method to the other. You also must tell the IRS if you change the way you specify the cost of individual items -- something only sellers of high-priced items such as yachts and cars would do.

Normal Times

If you choose LIFO when prices are rising, you'll be applying the highest costs to inventory purchases first. This is good for you tax bill, because it increases your cost of goods sold (COGS), reducing your balance sheet inventory value, your gross profit and your taxable income. This stems from the equation:

COGS = beginning inventory + inventory purchases - ending inventory

This demonstrates that the higher cost of purchases boosts COGS and cuts inventory value. If you're in the 35 percent bracket, then after taxes, you only shell out 65 cents on each dollar of COGS cost. The bottom line: maximize COGS via FIFO to reduce your tax obligation.

When Times Are Tough

When the economy slows down, prices can fall, which means older costs are greater than new ones. In this situation, FIFO will result in a higher COGS and lower taxes. The IRS frowns on hopscotching between LIFO and FIFO with changing economic conditions. Rather, it wants you to use consistent accounting methods. If you want to alter your cost flow assumption, submit Form 3115 and hope that the IRS approves it.

LIFO Reserve

Unless we are in a deep recession or depression, you're going to prefer LIFO to FIFO. Of course, veterans of the 2007-08 economic storm know how quickly things can turn bad, and during that period, LIFO didn't help business make profits or even keep the doors open. You can quantify the FIFO vs. LIFO tax effects through a metric called "LIFO reserve." This is simply the difference in ending inventory values taken as FIFO minus LIFO. Usually, higher values of ending inventory makes LIFO reserve a positive number. When prices fall, expect a negative LIFO reserve, suggesting that LIFO would give you a higher ending inventory value, lower COGS and a higher tax bill -- assuming you have net income and actually have to pay taxes.

IRS is on YouTube

For those of you looking for quick answers, the IRS has quite a few videos on YouTube at
https://www.youtube.com/user/irsvideos

They also have some pretty good articles written for anyone just starting a business at
http://www.irs.gov/Businesses

As has been mentioned many times in this community, it's best to start out on the right foot & the proper organization of your business can mean a great deal of difference in how and when your taxes are due!

Ready to sell your baby?

Preparing Your Business for Sale

Article written by EricBank

You've determined that it's time to sell your small business and you want to earn the highest possible price for it. This requires you to spruce things up a bit: streamline operations, lower debt, create business plans and in general give the financial statements a thorough review. A makeover can add value to your company and actually improve the quality of your firm. The better the management of the company, the quicker it will sell. So ask yourself, what do buyers want to see in order to evaluate your company?

Financial Buyers

A financial buyer will be looking to finance most of the purchase price of the company, using the company's cash flow to repay the financing. You therefore want to maximize your cash flows. These buyers will put a three- to six-times multiple on earnings before interest and taxes (EBITA) after adjusting for expenses that will not continue with the new management. They subtract from this figure any interest-bearing debt they will assume with the company, so you may want to get rid of your debt before putting your firm up for sale. Of course, the downside of paying down debt is that it soaks up cash that you might otherwise use to generate profits -- for instance, by buying inventory. A sudden drop in revenues stemming from an inability to purchase merchandise for sale can hurt your firm's selling price, so you must evaluate debt reduction in this light.

Strategic Buyers

On the other hand, a strategic buyer will want to combine your business with others and achieve certain synergies. The buyer may be a competitor that already knows the industry and wants access to your confidential information. For instance, you may keep a secret list of sales leads that can be very valuable to a competitor. Therefore, you must be cautious dealing with a strategic buyer and make sure not to give away any proprietary information before the sale is complete. In the worst-case scenario, the bidder will extract valuable information from an eager seller and then suddenly withdraw the bid, or in the case of public corporations, attempt a hostile takeover at a lower price.

Accounting and Auditing

Of course, all your financial statements must be use proper accounting techniques and must be audited if you want to appear credible to a buyer. Bankers will not finance a deal without high quality, audited financial statements. However, if you are a very small business, it's likely you don't have audited statements, so if your buyer insists on them, use a reputable accounting firm that specializes in small businesses. In all cases, you want statements going back at least three years (assuming you've been in business that long) that reveal all pertinent information regarding sales, profits, depreciation, expenses, inventory, receivables, and all other important financial aspects.

Finally, make sure that you have a management team in place that can run the company without you. The new owner may or may not want to replace them, but having a team there will reassure the buyer that your company can survive the loss of you.

Intercompany Transactions

Unrealized Gross Profit Equity Method

Article written by EricBank

The equity method describes how an investing company (the investor) accounts for its stake in another company, the investee. Normally, the investor must own between 20 percent and 50 percent of the investee's voting shares to qualify for equity-method accounting. The unrealized gross profit equity method, or UGPEM, permits the investor to defer revenues generated from certain inter-company transactions with the investee. These include inventory sales between the two companies and the sale of depreciable assets.

Equity Method

According to the equity method, an investment in an investee company is booked by the investor as a long-term asset. To acknowledge the investor's share of investee profits and losses, it adjusts the investment's book value whenever earnings are announced by the investee. For example, suppose Medium Corporation buys 20 percent of Tiny Corp for $2 million. Medium's accountant would book the $2 million as a debit to its Tiny Corp long-term asset account and as a credit to cash. When Tiny Corp next announces quarterly results, it reports net income of $100,000. Medium's 20 percent share amounts to $20,000, which it debits to the Tiny Corp asset account and credits to an income account, with a name like "Tiny Corp Investment Income."

Unrealized Gross Profit

Under the investor-investee relationship of UGPEM, the inventory seller maintains partial ownership of the goods until the buyer sells them all. Until the buyer uses up or sells the inventory, the gross profit accompanying the sale of the inventory between investee and investor is not realized. This applies when the investee sells the inventory to the investor -- an upstream transfer -- and also when the investor is the seller, a downstream transfer.

Downstream Transfer Example

Let's imagine that Medium Corp sells inventory to Tiny that it paid $35,000 to acquire. Medium sell the goods for a 30 percent profit of $15,000, making the sale price $50,000. As of the end of the year, Tiny has sold 80 percent of the inventory -- $40,000 of its cost-- leaving another $10,000 in Tiny's ending inventory. When Tiny finally unloads the remaining inventory, Medium will garner 30 percent, or $3,000, of the profit. However, since Medium owns only 20 percent of Tiny, its unrealized gross profit will be $600, which is $3,000 times 20 percent. At year-end, Medium postpones the unrealized gross profit by booking $600 as a debit to investment income and as a credit to the long-term asset account. After Tiny sells the remaining inventory, Medium enters a reversal transaction and recognizes the $600 gross profit.

Upstream Transfer Example

Upstream sales also receive UGPEM treatment. For example, if Tiny sell Medium inventory costing $40,000 for $60,000, then $20,000 is the gross profit. From Medium's perspective, the $20,000 represents a 33.3 percent gross profit ratio. Now suppose $15,000 of the inventory is still owned by Medium at year's end. This means that 33.3 percent of $15,000, or $5,000, is still tied up in unsold goods. Multiplying this amount by the 20 percent ownership percentage yields an unrealized gross profit of $1,000. Therefore, Medium books the $1,000 deferral as a debit to the investment income account and a credit to the long-term asset at year-end. After disposing of the remaining goods, Medium reverses the deferral.

Who's in the cross hairs for an IRS audit in 2014 & 2015?

Here's really long, boring read, if you're looking for materials to put you to sleep!

<http://westerncpe.us2.list-manage.com/track/click?u=48c9757cae1cfd246a6cbcb02&id=cf426f160c&e=fc6aeb5bdb>  

However, it has some very valuable information about who and why the IRS will be narrowing down their audits and what the new areas of focus (red flags) will be for the upcoming audit season.

Here are a couple of highlights:
*  Of course the high-income taxpayers will always be a target audience.  They are the most likely to just pay to have the problem go away, then waste their time on pulling the documents necessary to prove their positions on the returns.  Also, these could lead to extension of the audit if there are flow-through entities involved in the personal audit.

*  Developers and real estate investors will be a target audience.  With partnership returns on the rise, the IRS has done some special training to target this growing target base.

*  Employers are always a target.  Specifically whether or not you have your employees properly classified (versus independent contractors), your form 1099 compliance and reasonable compensation for S Corporate officers.

*  Cash basis businesses.  This increase is due to the 1099-K reporting.  The IRS will be looking for filers who only report exactly what the merchant sales were as income, leaving out any possibilities of cash or check sales.  This is an easy and very profitable target audience.

Be aware of what might cause an audit and properly document your deductions!  It can make all the difference between whether or the IRS letter is a short correspondence, or an every expanding audit!!

And, because I'm also a tax preparer, DON'T EVER TALK TO THE IRS WITHOUT REPRESENTATION!  It's in your taxpayer bill of rights.  Even if you don't have one, get one, before going toe to toe with the IRS.  Politely take their card and let them know your representative will be contacting them shortly.  And then, of course, have your representative contact them .

How to allocate overhead

Overview: Reciprocal Method of Cost Allocation

Article written by EricBank

The topic of intra-company cost allocation can sometimes seem a little hairy. Many businesses are structured with departments that provide service and support to production departments and to other service departments. For example, your company might have a private gym and a food service department. Non-production departments can be costly to run, so using a cost allocation scheme ensures that production departments pick up their fair shares of these costs. One of three widely used techniques for allocating the costs of service departments is the reciprocal, or double-distribution, method. The direct and step-down methods are the two other popular ones, but as we discuss below, the reciprocal method usually gives the most accurate results.

Benefits of Cost Allocation

There is no better way to sensitize a department manager to the budgetary impact of service costs than to assign these costs to the manager's department. You know you are getting the manager's attention if the department suddenly adjusts its budget to reduce its utilization of overhead service from other departments once these services come with a price tag. Another benefit of overhead-cost allocation is to ration it, on the assumption that these costs involve scarce or expensive resources. For example, you might have a company with a central Information Technology Department that services requests from six other departments. No matter how many people you hire, you never have enough to quickly satisfy all requests. In this case, department managers might bid for IT services by rearranging their budgets to support more of this overhead. Presumably, those with the greatest needs would make the highest bids.

Cost Allocation Methods

The easiest technique for assigning service department costs is the direct method. That's because it allocates costs to production departments only and turns a blind eye to the overhead costs between service departments. For example, the food service department wouldn't charge the gym personnel for their snacks, and the gym wouldn't allocate costs to the food service employees who use the gym. The step-down method allocates service department costs in only one direction. For example, the company might allocate gym usage cost to the food service department but charge no food service costs to the gym. The reciprocal method would charge costs in both directions.

Reciprocal Method

The reciprocal method permits service departments to charge each other for the services they deliver. You must solve a set of simultaneous equations to use this method. Luckily, computer programs or spreadsheets provide this functionality. Some rational metric serves to allocate costs to each department. Metrics such as the physical square footage of a department or its number of employees are popular choices.

Example

Let's say your business has three support departments, A, B and C, and two production departments, M and N. To allocate costs using the reciprocal method, you first assign each support department a linear equation. Then you simultaneously solve all three equations. Suppose the annual budget of Dept. A is $70,000 and that it uses 9 percent of Dept. B's services. Thus, Dept. A's linear equation sets its assignable costs equal to $70,000 plus 9 percent of Dept. B's budget. Similarly, you set up linear equations for the other support departments, let the computer solve them, and then modify the budgets of the production departments to absorb these costs.