Anderson ZurMuehlen Blog

GAAP vs. Tax-Basis Reporting: Choosing the Right Model for Your Business

 

Virtually every business must file a tax return. So, some private companies issue tax-basis financial statements, rather than statements that comply with U.S. Generally Accepted Accounting Principles (GAAP). But doing so could result in significant differences in financial results. Here are the key differences between these two financial reporting options.

GAAP

GAAP is the most common financial reporting standard in the United States. The Securities and Exchange Commission requires public companies to follow it. Many lenders expect private borrowers to follow suit, because GAAP is familiar and consistent.

In a nutshell, GAAP is based on the principle of conservatism, which generally ensures proper matching of revenue and expenses with a reporting period. The principle also aims to prevent businesses from overstating profits and asset values to mislead investors and lenders.

Tax-basis reporting

Compliance with GAAP can also be time-consuming and costly, depending on the level of assurance provided in the financial statements. So some smaller private companies opt to report financial statements using a special reporting framework. The most common type is the income-tax-basis format.

Tax-basis statements employ the same methods and principles that businesses use to file their federal income tax returns. Contrary to GAAP, tax law tends to favor accelerated gross income recognition and won’t allow taxpayers to deduct expenses until the amounts are known and other requirements have been met.

Key differences

When comparing GAAP and tax-basis statements, one difference relates to terminology used on the income statement: Under GAAP, businesses report revenues, expenses and net income. Tax-basis entities report gross income, deductions and taxable income. Their nontaxable items typically appear as separate line items or are disclosed in a footnote.

Capitalization and depreciation of fixed assets is another noteworthy difference. Under GAAP, the cost of a fixed asset (less its salvage value) is capitalized and systematically depreciated over its useful life. Businesses must assess whether useful lives and asset values remain meaningful over time and they may occasionally incur impairment losses if an asset’s market value falls below its book value.

For tax purposes, fixed assets typically are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which generally results in shorter lives than under GAAP. Salvage value isn’t subtracted for tax purposes, but Section 179 expensing and bonus depreciation are subtracted before computing MACRS deductions.

Other reporting differences exist for inventory, pensions, leases, and accounting for changes and errors. In addition, businesses record allowances for bad debts, sales returns, inventory obsolescence and asset impairment under GAAP. But these allowances generally aren’t permitted under tax law; instead, they’re deducted when transactions take place or conditions are met that make the amount fixed and determinable. Tax law also prohibits the deduction of penalties, fines, start-up costs and accrued vacations (unless they’re taken within 2½ months after the end of the taxable year).

Pick a winner

Tax-basis reporting is a shortcut that makes sense for certain types of businesses. But for others, tax-basis financial statements may result in missing or even misleading information. Contact us to discuss which reporting model will work the best for your business.

© 2017

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Reasons to Outsource Payroll and Obtain a Service Audit Report

With Labor Day starting out this week, it’s a good time to focus on how your business pays employees. Payroll reporting doesn’t have to be a laborious process. Consider using an outside company to manage your payroll function. Here’s why payroll outsourcing may be beneficial and how a service audit can provide assurance about your payroll provider’s internal controls.

Rewards and risks

Payroll can be an administrative nightmare if done in-house, especially for smaller companies. In addition to keeping up with employee withholdings and benefits enrollment, you must file state and federal payroll tax returns and follow union reporting requirements. Outside service companies that specialize in payroll administration can help you manage all of the details and minimize mistakes. Payroll providers can also handle expense reimbursement for employees and provide other services.

When payroll is outsourced, however, your company could be exposed to identity theft and other fraud risks if the service provider lacks sufficient internal controls. For example, sensitive electronic personal data could be hacked from your network and sold on the Dark Net — or old-fashioned paper files could be stolen and used to commit fraud.

Audits of payroll companies

Fortunately, CPAs offer two types of reports that provide assurance on whether an outside payroll provider’s controls over paper and electronic records are adequate.

Type I audits. This level of assurance expresses an opinion as to whether controls are properly designed.

Type II audits. Here, the auditor goes a step further and expresses an opinion on whether the controls are operating effectively.

When performing these attestation engagements, Statement on Standards for Attestation Engagements (SSAE) No. 18 requires:

  • The payroll company’s management to provide a written assertion about the fairness of the presentation of 1) the description of the organization’s control objectives and related controls and the suitability of their design; and 2) for a Type II audit, the operating effectiveness of those control objectives and related controls,
  • The auditor’s opinion in a Type II audit regarding description and suitability to cover a period consistent with the auditor’s tests of operating effectiveness, rather than being as of a specified date, and
  • Auditors to identify in the audit report any tests of control objectives and related controls conducted by internal auditors.

Further, auditors are prohibited from using evidence on the satisfactory operation of controls in prior periods as a basis for a reduction in testing in the current period, even if it’s supplemented with evidence obtained during the current period.

When an audit is complete, the service auditor typically will issue a report to the payroll company. As the customer of the service provider, it’s then up to you to obtain a copy of the audit report from the payroll provider and distribute it to your financial statement auditors as evidence of internal controls.

Outsourcing with confidence

Your financial statement auditors are required to consider the internal control environment for any services you outsource, including payroll, customer service, benefits administration and IT functions. Most service providers obtain service audit reports. If yours doesn’t, you might need to request permission for your CPA to contact and visit the payroll provider to plan their financial statement audit. Contact us for more information.

© 2017

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Credit loss standard: The new CECL model

A new accounting standard on credit losses goes into effect in 2020 for public companies and 2021 for private ones. It will result in earlier recognition of losses and expand the range of information considered in determining expected credit losses. Here’s how the new methodology differs from existing practice.

Existing model

Under existing U.S. Generally Accepted Accounting Principles (GAAP), financial institutions must apply an “incurred loss” model when recognizing credit losses on financial assets measured at amortized cost. This model delays recognition until a loss is “probable” (or likely) to be incurred, based on past events and current conditions.

The Financial Accounting Standards Board (FASB) found that, leading up to the global financial crisis, financial statement users made independent estimates of expected credit losses using forward-looking information and then devalued financial institutions before the institutions were permitted to recognize the losses. This practice made it clear that the requirements under GAAP weren’t meeting the needs of financial statement users.

New-and-improved model

Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326), introduces a new “current expected credit loss” (CECL) model. The CECL model requires financial institutions to immediately record the full amount of expected credit losses in their loan portfolios based on forward-looking information, rather than waiting until the losses are deemed probable based on what’s already happened. The FASB expects this change to result in more timely and relevant information.

The measurement of expected credit losses will be based on relevant information about past events (including historical experience), current conditions, and the “reasonable and supportable” forecasts that affect the collectibility of the reported amount.

Specifically, an allowance for credit losses will be deducted from the amortized cost of the financial asset to present its net carrying value on the balance sheet. The income statement will reflect the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have taken place during the relevant reporting period.

Companies will be allowed to continue using many of the loss estimation techniques currently employed, including loss rate methods, probability of default methods, discount cash flow methods and aging schedules. But the inputs of those techniques will change to reflect the full amount of expected credit losses and the use of reasonable and supportable forecasts.

We can help

The updated guidance doesn’t prescribe a specific technique to estimate credit losses — rather, companies can exercise judgment to determine which method is appropriate. Contact us if you need help finding the optimal method for identifying and quantifying credit losses, along with complying with the expanded disclosure requirements.

© 2017

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Timeless Counts in Financial Reporting

Do you procrastinate when it comes to closing your books and delivering year-end financial statements? Lenders and investors may think the worst if a company’s financial statements aren’t submitted in a timely manner. Here are three assumptions your stakeholders could make when your financial statements are late.

1. You’re hiding negative results

No one wants to be the bearer of bad news. Deferred financial reporting can lead investors and lenders to presume that the company’s performance has fallen below historical levels or what was forecast at the beginning of the year.

2. Your management team is inept, uninformed or both

Alternatively, stakeholders may assume that management is hopelessly disorganized and can’t pull together the requisite data to finish the financials. For example, late financials are common when a controller is inexperienced, the accounting department is understaffed or a major accounting rule change has gone into effect.

Delayed statements may also signal that management doesn’t consider financial reporting a priority. This lackadaisical mindset implies that no one is monitoring financial performance throughout the year.

3. You’re more likely to be a victim of occupational fraud

If financial statements aren’t timely or prioritized by the company’s owners, unscrupulous employees may see it as a golden opportunity to steal from the company. Fraud is more difficult to hide if you insist on timely financial statements and take the time to review them.

Get back on track

Late financial statements cost more than time; they can impair relations with lenders and investors. Regardless of your reasons for holding out, timely financial statements are a must for fostering goodwill with outside stakeholders. We can help you stay focused, work through complex reporting issues and communicate weaker-than-expected financial results in a positive, professional manner.

© 2017

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Close-up on Cutoffs for Reporting Revenues and Expenses

The Financial Accounting Standards Board (FASB) has amended U.S. Generally Accepted Accounting Principles (GAAP) to clarify the guidance on reporting restricted cash balances on cash flow statements. Until now, Accounting Standards Codification Topic 230, Statement of Cash Flows, didn’t specify how to classify or present changes in restricted cash. Over the years, the lack of specific instructions has led businesses to report transfers between cash and restricted cash as operating, investing or financing activities — or a combination of all three.

The new guidance essentially says that none of the above classifications are correct.

FASB members hope the amendments will cut down on some of the inconsistent reporting practices that have been in place because of the lack of clear guidance.

Prescriptive guidance

Accounting Standards Update (ASU) No. 2016-18, Statement of Cash Flows (Topic 230) — Restricted Cash, still doesn’t define restricted cash or restricted cash equivalents. But the updated guidance requires that transfers between cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents be excluded from the entity’s operating, investing and financing activities. In other words, the details of those transfers shouldn’t be reported as cash flow activities in the statement of cash flows at all.

Instead, if the cash flow statement includes a reconciliation of the total cash balances for the beginning and end of the period, the FASB wants the amounts for restricted cash and restricted cash equivalents to be included with cash and cash equivalents. When, during a reporting period, the totals change for cash, cash equivalents, restricted cash and restricted cash equivalents, the updated guidance requires that these changes be explained. These amounts are typically found just before the reconciliation of net income to net cash provided by operating activities in the statement of cash flows.

Moreover, a business must provide narrative and/or tabular disclosures about the nature of restrictions on its cash and cash equivalents.

Effective dates

The updated guidance goes into effect for public companies in fiscal years that start after December 15, 2017. Private companies have an extra year before they have to apply the changes. Early adoption is permitted. Contact us if you have additional questions about reported restricted cash or any other items on your company’s statement of cash flows.

© 2017

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Material Participation Key to Deducting LLC and LLP Losses

 

If your business is a limited liability company (LLC) or a limited liability partnership (LLP), you know that these structures offer liability protection and flexibility as well as tax advantages. But they once also had a significant tax disadvantage: The IRS used to treat all LLC and LLP owners as limited partners for purposes of the passive activity loss (PAL) rules, which can result in negative tax consequences. Fortunately, these days LLC and LLP owners can be treated as general partners, which means they can meet any one of seven “material participation” tests to avoid passive treatment.

The PAL rules

The PAL rules prohibit taxpayers from offsetting losses from passive business activities (such as limited partnerships or rental properties) against nonpassive income (such as wages, interest, dividends and capital gains). Disallowed losses may be carried forward to future years and deducted from passive income or recovered when the passive business interest is sold.

There are two types of passive activities: 1) trade or business activities in which you don’t materially participate during the year, and 2) rental activities, even if you do materially participate (unless you qualify as a “real estate professional” for federal tax purposes).

The 7 tests

Material participation in this context means participation on a “regular, continuous and substantial” basis. Unless you’re a limited partner, you’re deemed to materially participate in a business activity if you meet just one of seven tests:

1. You participate in the activity at least 500 hours during the year.
2. Your participation constitutes substantially all of the participation for the year by anyone, including nonowners.
3. You participate more than 100 hours and as much or more than any other person.
4. The activity is a “significant participation activity” — that is, you participate more than 100 hours — but you participate less than one or more other people yet your participation in all of your significant participation activities for the year totals more than 500 hours.
5. You materially participated in the activity for any five of the preceding 10 tax years.
6. The activity is a personal service activity in which you materially participated in any three previous tax years.
7. Regardless of the number of hours, based on all the facts and circumstances, you participate in the activity on a regular, continuous and substantial basis.

The rules are more restrictive for limited partners, who can establish material participation only by satisfying tests 1, 5 or 6.

In many cases, meeting one of the material participation tests will require diligently tracking every hour spent on your activities associated with that business. Questions about the material participation tests? Contact us.

© 2017

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Business ID Theft: Is Your Data at Risk?

The IRS and state tax authorities have made significant strides in curbing individual identity theft over the last two years. But cyber attacks against businesses are on the upswing. Here are some simple ways business taxpayers can help protect their data from hackers.

Trends in ID Theft

The IRS recently announced that the number of individuals reporting identity theft in the first half of 2017 has declined dramatically compared to 2015 and 2016. For the first five months of 2017, about 107,000 individual taxpayers reported stolen IDs. In comparison, 297,000 victims filed reports during the same time period in 2015 and 204,000 in 2016.

Put simply, individual ID theft dropped 47% over the last year. The IRS attributes the decrease to safeguards put in place during the 2016 Security Summit.

Unfortunately, the IRS has also noted an increase in ID theft involving business tax returns. While the number of businesses affected was relatively low, the potential dollar amounts were significant:

Year Estimated business ID theft cases through June 1 Estimated losses
2015 350 tax returns $122 million
2016 4,000 tax returns $268 million
2017 10,000 tax returns $137 million

The victims of business ID theft include corporations, estates and trusts, and partnerships. These days, hackers are bolder and increasingly tax savvy in their scams. For example, they may use stolen data to file bogus business tax returns and then collect refunds. Or they might post the stolen data for resale on the so-called “Dark Net” so other criminals can file fraudulent tax returns.

Tax professionals have been helping clients take appropriate security measures to prevent business ID theft, but problems persist. “We need help from the tax community to combat cybercriminals and raise security awareness,” IRS Commissioner John Koskinen noted.

Ways to Combat Business ID Theft

Because business ID theft can be so costly, prevention and early detection measures are critical. Here are some simple, but effective, security measures you should consider:

Make cybersecurity a top priority. Similar to an annual business plan, your company needs a formal cybersecurity plan that identifies a step-by-step approach for detecting ID theft. When breaches happen, your plan should trigger a prompt, thorough response.

Safeguard intellectual property. Companies should store all employee and customer data, along with other proprietary records, such as financial statements and prior years’ tax returns, in a safe location. Shred nonessential documents before throwing them out, and limit access to your employer ID number to parties with whom you initiated the contact. Share sensitive information via the Internet or email only if the recipient is trusted (such as your lender or tax preparer) and the site is secure.

Use the latest cybersecurity technologyThis includes firewalls, antivirus and antimalware software, and spam filters. Also exercise common sense: Don’t download files, click on links, or open pop-ups or attachments sent from unknown sources. Stored files should be encrypted for your protection and for the benefit of customers.

Educate employeesConduct periodic training sessions to remind employees about the latest scams, such as phishing emails where hackers pose as familiar businesses or colleagues to steal sensitive information. They should also be aware of your cybersecurity plan and each person’s role if a breach occurs.

Use prepaid credit cards for purchases. Prepaid employee credit cards limit your potential for losses when employees make purchases from suppliers and vendors. If a card is breached, the company can lose only what’s prepaid and you can immediately deactivate the card.

Monitor business credit reports. It doesn’t take much effort to monitor your company’s profiles from the three major business credit bureaus: Equifax, Experian, and TransUnion. Subscribe to their monitoring services for round-the-clock access. What’s more, you can choose to receive real-time email notifications about suspicious activities affecting your company’s credit rating.

Guard your master list. Some companies track all their accounts and passwords in a master list, which can be convenient, but dangerous. A dishonest employee or hacker who manages to gain access to that list has the key to all your company’s information in one fell swoop, so you’ll need to be extra cautious with security measures.

Finally, contact your tax professional promptly if you believe you’ve been victimized. He or she can help you get in touch with the appropriate law enforcement authorities, business credit bureaus and financial institutions.

No Guarantees

No preventive measure is 100% fail safe. The IRS and tax preparers are expanding their efforts to educate businesses and prevent breaches. You can also help lower your risk by crafting a formal cybersecurity plan, educating employees and implementing various other proactive security measures.

© 2017

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4 Tough Questions to Ask Before Expanding to a New Location

Is business going so well that you’re thinking about adding another location? If this is the case, congratulations! But before you start planning the ribbon-cutting ceremony, take a step back and ask yourself some tough questions about whether a new location will grow your company — or stretch it too thin. Here are four to get you started:

1. What’s driving your interest in another location? It’s important to articulate specifically how the new location will help your business move toward its long-term goals. Expanding simply because the time seems right isn’t a compelling enough reason to take on the risk.

2. How solidly is your current location performing? Your time and attention will be diverted while you get the second location up and running. Yet you’ll need to maintain the revenue your first location is generating — especially until the second one is earning enough to support itself. So your original operation needs to be able to operate well with minimal management guidance.

3. How strong is the location you’re considering? Just as you presumably did with your first location, ensure the surrounding market is strong enough to support your company. The setting should complement your business, not pose potentially insurmountable challenges.

Also consider proximity to competitors. In some cases, such as a cluster of restaurants in a small downtown, proximity can help. The area becomes known as a destination for those seeking a night out. But too many competitors could leave you fighting with multiple other businesses for the same small group of customers.

4. Can you expand in other ways that are less costly and risky? You might be able to boost sales by adding inventory or extending hours at your current location. Another option is to revamp your website or mobile app to encourage more online sales.

Investments such as these would likely require a fraction of the dollars needed to open another physical location. Then again, a successful new site could mean a substantial inflow of revenue and additional market visibility. Let us help you crunch the numbers that will lead you to the right decision.

© 2017

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3 Midyear Tax Planning Strategies for Individuals

 

In the quest to reduce your tax bill, year end planning can only go so far. Tax-saving strategies take time to implement, so review your options now. Here are three strategies that can be more effective if you begin executing them midyear:

1. Consider your bracket

The top income tax rate is 39.6% for taxpayers with taxable income over $418,400 (singles), $444,550 (heads of households) and $470,700 (married filing jointly; half that amount for married filing separately). If you expect this year’s income to be near the threshold , consider strategies for reducing your taxable income and staying out of the top bracket. For example, you could take steps to defer income and accelerate deductible expenses. (This strategy can save tax even if you’re not at risk for the 39.6% bracket or you can’t avoid the bracket.)

You could also shift income to family members in lower tax brackets by giving them income-producing assets. This strategy won’t work, however, if the recipient is subject to the “kiddie tax.” Generally, this tax applies the parents’ marginal rate to unearned income (including investment income) received by a dependent child under the age of 19 (24 for full-time students) in excess of a specified threshold ($2,100 for 2017).

2. Look at investment income

This year, the capital gains rate for taxpayers in the top bracket is 20%. If you’ve realized, or expect to realize, significant capital gains, consider selling some depreciated investments to generate losses you can use to offset those gains. It may be possible to repurchase those investments, so long as you wait at least 31 days to avoid the “wash sale” rule.

Depending on what happens with health care and tax reform legislation, you also may need to plan for the 3.8% net investment income tax (NIIT). Under the Affordable Care Act, this tax can affect taxpayers with modified adjusted gross income (MAGI) over $200,000 ($250,000 for joint filers). The NIIT applies to net investment income for the year or the excess of MAGI over the threshold, whichever is less. So, if the NIIT remains in effect (check back with us for the latest information), you may be able to lower your tax liability by reducing your MAGI, reducing net investment income or both.

3. Plan for medical expenses

The threshold for deducting medical expenses is 10% of AGI. You can deduct only expenses that exceed that floor. (The threshold could be affected by health care legislation. Again, check back with us for the latest information.)

Deductible expenses may include health insurance premiums (if not deducted from your wages pretax); long-term care insurance premiums (age-based limits apply); medical and dental services and prescription drugs (if not reimbursable by insurance or paid through a tax-advantaged account); and mileage driven for health care purposes (17 cents per mile driven in 2017). You may be able to control the timing of some of these expenses so you can bunch them into every other year and exceed the applicable floor.

These are just a few ideas for slashing your 2017 tax bill. To benefit from midyear tax planning, consult us now. If you wait until the end of the year, it may be too late to execute the strategies that would save you the most tax.

© 2017

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Private Companies: Consider these Financial Reporting Shortcuts

For years, private companies and their stakeholders have complained that the Financial Accounting Standards Board (FASB) catered too much to large, public companies and ignored the needs of smaller, privately held organizations that have less complex financial reporting issues. In other words, they’ve said that U.S. Generally Accepted Accounting Principles (GAAP) are too complicated for them. The FASB answered these complaints by issuing some Accounting Standards Updates (ASUs) that apply exclusively to private companies.

“Little GAAP”

Currently there are four ASUs that apply only to private companies:
1. ASU No. 2014-02Intangibles — Goodwill and Other (Topic 350): Accounting for Goodwill. Under this alternative, private companies may elect to amortize goodwill on their balance sheets over a period not to exceed 10 years, rather than test it annually for impairment.

2. ASU No. 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps — Simplified Hedge Accounting Approach. This alternative allows nonfinancial institution private companies to elect an easier form of hedge accounting when they use simple interest rate swaps to secure fixed-rate loans.

3. ASU No. 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intangible Assets in a Business Combination. This alternative exempts private companies from recognizing certain hard-to-value intangible assets — such as noncompetes and certain customer-related intangibles — when they buy or merge with another company. It doesn’t eliminate the requirement to recognize and separately value other intangible assets acquired in business combinations, such as trade names and patents.

4. ASU No. 2014-07, Consolidation (Topic 810): Applying Variable Interest Entities Guidance to Common Control Leasing Arrangements. This option simplifies the consolidation reporting requirements of lessors in certain private company leasing transactions. It’s important to note that the FASB is currently considering expanding this alternative: In June 2017, the FASB issued a proposal that would allow private companies that use variable interest entities (VIEs) to skip the consolidation guidance. Comments on the proposal are due on September 5.

No effective dates or preferability assessments

After the FASB issued these alternatives, it updated the guidance to remove the effective dates. It also has exempted private companies from having to make a preferability assessment before adopting one of these accounting alternatives. Under the previous rules, a private company that wanted to adopt an accounting alternative after its effective date had to first assess whether the alternative was preferable to its accounting policy at that time.

Forgoing an initial preferability assessment allows private companies to adopt a private company accounting alternative when they experience a change in circumstances or management’s strategic plan. It also allows private companies that were unaware of an accounting alternative to adopt the alternative without having to bear the cost of justifying preferability.

Right for you?

Simplified reporting sounds like a smart idea, but regulators, lenders and other stakeholders may require a private company to continue to apply traditional accounting models, especially if the company is large enough to consider going public or may merge with a public company. We can help private companies weigh the pros and cons of electing these alternatives.

© 2017

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