Objectives of Accounting System

Timely and accurate picture of performance Generate financial reports for management, lenders, creditors Facilitate filing of tax returns
(sales and payroll taxes more important than income tax)

Prevent and detect fraud, waste and theft

Methods of Accounting
Types of methods Cash basis Accrual basis Hybrid (modified cash or accrual)

Choice of Method
Tax Requirements
In general, cash basis is preferable for tax purposes Accrual required for tax if significant: Inventory Account receivable

Tax Vs. Book Accounting

Different overall accounting methods can be used for tax and financial reporting purposes Even if same overall method used, different specific methods can be used (i.e., depreciation)
Exception is LIFO inventory

Cash Basis Accounting

Simplest Method
Appropriate for many small businesses Not allowed for tax if significance inventories, or gross receipts exceed 5 million Cash can be used internally, and adjusted to accrual for year-end reporting

Accrual Basis Accounting

When significant receivables and inventory exist, cash basis accounting will not accurately reflect income
Accrual accounting does not accurately capture cash flow However, income is best predictor of future cash flows

Comparison of Cash vs. Accrual

Cash 20,000 120,000 (40,000) 100,000 Accrual 120,000 120,000

Beg. A/R Sales for month Ending A/R Reported Sales

Different Tax and Reporting Methods

Financial Tax 500,000 500,000 (480,000) (480,000) ( 2,000) (10,000)

Sales Other exp. Depr. Sec. 179

Net Income

18,000

10,000

LIFO Inventory
(Last-In, First-Out)

LIFO inventory reduces taxes when inventory prices are rising

Must also be used for financial statements (FIFO usually disclosed)

Provides additional deferral timing option

Taxes can be affected by timing of inventory purchases

LIFO Inventory
LIFO Pitfalls
Write-offs for obsolescence not allowed Unplanned inventory liquidation can result in large tax bill by including old, cheap inventory in cost of goods sold

Value of LIFO
Inventory Value in Yr. 1 (LIFO value) Inflation 5% FIFO value in 10 years (1.05)10 x 1,000,000 $ 1,000,000

1,628,900

Difference Tax Rate

Cumulative Tax Deferral

628,900 40%
$ 251,560

Accounting Systems
Integrated with inventory, accounts receivable Payroll - almost always better to use service bureau
dont have to worry about changes in law, rates

Dont get behind on payroll taxes!

Various Taxes

Tax
Sales Tax Withheld taxes
FICA&Med. Federal State

Form
State

Rate
7% (NY)

941

Varies

Employer
FICA Medicare FUTA State

941 940 State

6.2% 2.45% 0.8%

External Reporting
Type of Report Audit Level of Assurance Positive Est. Cost Expen. Est. Loan Size $1 mill +

Review

Limited

1/2 audit < $1 mill.

Minimal < $200k

Compilation None

Accountant Reports
Type of report may be negotiable with bank CPA reports can also be issued for forecasts and projections included in business plans or loan applications Dont place undue reliance on an audit report when evaluating a buyout candidate