Anderson ZurMuehlen Blog

Cost Control Takes a Total Team Effort

“That’s just the cost of doing business.” You’ve probably heard this expression many times. It’s true that, to invoke another cliché, you’ve got to spend money to make money. But that doesn’t mean you have to take rising operational costs sitting down.

Cost control is a formal management technique through which you evaluate your company’s operations and isolate activities costing you too much money. This isn’t something you can do on your own — you’ll need a total team effort from your managers and advisors. Done properly, however, the results can be well worth it.

Asking tough questions

While performing a systematic review of the operations and resources, cost control will drive you to ask some tough questions. Examples include the following:

• Is the activity in question operating as efficiently as possible?
• Are we paying reasonable prices for supplies or materials while maintaining quality?
• Can we upgrade our technology to minimize labor costs?

A good way to determine whether your company’s expenses are remaining within reason is to compare them to current industry benchmarks.

Working with your team

There’s no way around it — cost-control programs take a lot of hard work. Reducing expenses in a lasting, meaningful way also requires creativity and imagination. It’s one thing to declare, “We must reduce shipping costs by 10%!” Getting it done (and keeping it done) is another matter.

The first thing you’ll need is cooperation from management and staff. Business success is about teamwork; no single owner or manager can do it alone.

In addition, best-in-class companies typically seek help from trusted advisors. An outside expert can analyze your efficiency, including the results of cost-control efforts. This not only brings a new viewpoint to the process, but also provides an objective review of your internal processes.

Sometimes it’s difficult to be impartial when you manage a business every single day. Professional analysts can take a broader view of operations, resulting in improved cost-control strategies.

Staying in the game

An effective, ongoing program to assess and contain expenses can help you prevent both gradual and sudden financial losses while staying competitive in your market. For further information about cost control, and customized help succeeding at it, please contact us.

© 2018

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Profits: How Low Can You Go?

If your profits are falling compared to revenue and assets, your financial statements may provide insight into what’s happening and how to improve your performance.

Watch for red flags

As you sell more and invest in additional assets, profits should, in theory, increase by a proportionate amount. However, that’s not always the case. Ratios to watch for a decline include:

  • Gross profit [(revenue – cost of sales) / revenue],
  • Net profit margin (net income / revenue), and
  • Return on assets (earnings before tax / total assets).

For all three profitability ratios, look at two key elements: changes between accounting periods and differences from industry averages.

Identify possible causes

If these ratios are declining, it’s important to find the cause. If the whole industry is suffering, the decline is likely part of an external trend. If the industry is healthy, yet a company’s margins are falling, perhaps management has lost its control of costs ? or maybe vendor or receivables fraud is to blame. To find the root cause, it’s often helpful to study the main components of the income statement.

Revenue. If the top line (gross sales or revenue) has declined, your overall profit margin will fall because there is less revenue to spread fixed costs over. To determine if this trend is company-specific or industrywide, look at revenue trends of public companies in the same industry. Also, monitor trade publications, trade associations and relevant online sources for information.

Cost of goods sold. This category of expenses is a function of raw materials, labor and overhead elements. Direct materials and labor should be controllable and historically represent a consistent percentage of revenue.

Overhead is mostly fixed and shouldn’t significantly increase unless the company has made changes (for example, purchased new equipment, changed its depreciation policy, or relocated its production facility). Examine those elements to determine whether overhead is increasing or decreasing and how the ebb and flow applies to the gross margin, which is simply revenue minus cost of goods sold.

Selling and administrative costs. Check whether selling and administrative cost items increased significantly. This section of the income statement can also be revealing if you’re trying to determine whether a profit margin decline arose from deteriorating industry conditions or weak management.

Find clues in your financials

Need help solving the mystery of your disappearing profits? Our auditors can use your financial statements to help compute financial statement ratios, identify problem areas and find solutions to get your performance back on track.

© 2018

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A Review of Significant TCJA Provisions Affecting Small Businesses

Now that small businesses and their owners have filed their 2017 income tax returns (or filed for an extension), it’s a good time to review some of the provisions of the Tax Cuts and Jobs Act (TCJA) that may significantly impact their taxes for 2018 and beyond. Generally, the changes apply to tax years beginning after December 31, 2017, and are permanent, unless otherwise noted.

Corporate taxation

  • Replacement of graduated corporate rates ranging from 15% to 35% with a flat corporate rate of 21%
  • Replacement of the flat personal service corporation (PSC) rate of 35% with a flat rate of 21%
  • Repeal of the 20% corporate alternative minimum tax (AMT)

Pass-through taxation

  • Drops of individual income tax rates ranging from 0 to 4 percentage points (depending on the bracket) to 10%, 12%, 22%, 24%, 32%, 35% and 37% — through 2025
  • New 20% qualified business income deduction for owners — through 2025
  • Changes to many other tax breaks for individuals — generally through 2025

New or expanded tax breaks

  • Doubling of bonus depreciation to 100% and expansion of qualified assets to include used assets — effective for assets acquired and placed in service after September 27, 2017, and before January 1, 2023
  • Doubling of the Section 179 expensing limit to $1 million and an increase of the expensing phaseout threshold to $2.5 million (these amounts will be indexed for inflation after 2018)
  • New tax credit for employer-paid family and medical leave — through 2019

Reduced or eliminated tax breaks

  • New disallowance of deductions for net interest expense in excess of 30% of the business’s adjusted taxable income (exceptions apply)
  • New limits on net operating loss (NOL) deductions
  • Elimination of the Section 199 deduction, also commonly referred to as the domestic production activities deduction or manufacturers’ deduction — effective for tax years beginning after December 31, 2017, for noncorporate taxpayers and for tax years beginning after December 31, 2018, for C corporation taxpayers
  • New rule limiting like-kind exchanges to real property that is not held primarily for sale (generally no more like-kind exchanges for personal property)
  • New limitations on excessive employee compensation
  • New limitations on deductions for certain employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation

Don’t wait to start 2018 tax planning

This is only a sampling of some of the most significant TCJA changes that will affect small businesses and their owners beginning this year, and additional rules and limits apply. The combined impact of these changes should inform which tax strategies you and your business implement in 2018, such as how to time income and expenses to your tax advantage. The sooner you begin the tax planning process, the more tax-saving opportunities will be open to you. So don’t wait to start; contact us today. 

© 2018

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Internal Control Testing: What Role Does Sampling Play?

Auditors must test the effectiveness of internal controls before signing off on your financial statements. But it’s impossible to analyze every transaction that’s posted to the general ledger, due to time and budget constraints. Instead, auditors select and analyze a representative sample of transactions to make assertions about the entire population. Here’s more on how sampling works — along with the pros and cons of using it during internal control testing.

Picking a sample

Auditors may use statistical techniques to develop a sample of transactions to test. For example, an auditor might select enough transactions to represent a specific percentage of 1) the total transactions in an account, or 2) the company’s total assets or revenue. Alternatively, a sample of transactions may be pulled randomly using statistical sampling software.

Auditors also can use nonstatistical sampling techniques based on a dollar threshold or professional judgment. These techniques tend to be more effective when the CPA has many years of audit experience to ensure that the sample chosen is representative of the population of transactions.

Unexpected outcomes

Before analyzing a sample, your auditor has expectations about the number of “exceptions” (such as errors and omissions) that will appear in the sample. If the actual exceptions exceed the auditor’s expectation, he or she may need to perform additional procedures. For instance, your auditor might expand the sample and conduct more testing to assess the degree of noncompliance.

Ultimately, your auditor might conclude that your internal controls are ineffective. If so, he or she will perform more work to estimate the magnitude of the control failure.

Pros vs. cons

Sampling helps keep audit costs down by streamlining the internal control testing process. It also reduces disruptions to business operations during audit fieldwork. When applied correctly, the results of sampling are theoretically as accurate as if the audit team had analyzed every transaction posted to the general ledger. But, in practice, sampling can sometimes cause problems during internal controls testing.

For example, sampling presumes that controls function consistently across the whole population of transactions. If an exception doesn’t appear in the sample — because the sample was too small or otherwise unrepresentative of the entire population — your audit team could reach the wrong conclusion about the effectiveness of your internal controls.

There’s also a risk that your audit team could rely too heavily on nonstatistical sampling. Relying more on judgment than statistical methods could result in errors, especially if an auditor lacks professional experience.

A collaborative process

You can help maximize the benefits of sampling by providing the audit team with document requests in a timely manner and following up on your auditor’s management points at the end of each year’s audit. It’s frustrating to both auditors and business owners when internal control weaknesses recur year after year. Our auditors have extensive experience testing internal controls, and we’d be happy to answer any questions you have on testing and sampling techniques.

© 2018

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Learn the Warning Signs of Earnings “Spin”

Management wants to paint the rosiest possible picture of a company’s financial performance. But aggressive earnings management, or “spin,” can mislead investors and lenders. Here are some ways U.S. Generally Accepted Accounting Principles (GAAP) can be manipulated to obscure the truth.

Creative accounting vs. cooking the books

Earnings management usually starts out small, but it can become increasingly aggressive and eventually cross the line into fraud if it goes unchecked. An external audit may help detect the red flags of earnings management, including:

Premature revenue recognition. Some companies recognize revenue early to make the income statement temporarily appear more attractive. This ploy is common when a company is applying for bank financing or up for sale.

Miscellaneous “cookie jar” reserves. Management can create a hidden reserve of funds during good times. Then the reserves can be tapped into to nourish earnings in lean times.

“Big bath” restructuring changes. Some companies overstate the costs associated with restructuring. This enables them to clean up their balance sheets and create reserves for a rainy day.

Immediate acquisition write-offs. Acquired companies may classify a portion of the purchase price as “in process research and development,” which they immediately write off. This reduces the amortization of the purchase price to future earnings.

Overreliance on EBITDA. Earnings before interest, taxes, depreciation and amortization (EBITDA) and other non-GAAP metrics have become popular ways to evaluate a company’s performance. But they aren’t usually audited, and they may be calculated differently from company to company.

EBITDA is generally intended to resemble cash flow. But this metric can obscure problems for start-up companies with major debt. Although their EBITDAs give these start-ups appeal, their debt service may mean they won’t be profitable for many years.

Too good to be true?

Pay attention when reviewing financial statements and corporate press releases — the opportunity and pressure to spin earnings is everywhere. Contact us for more information on how to identify when a business may have engaged in “creative” accounting practices to improve their financial picture.

© 2018

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Tax Document Retention Guidelines for Small Businesses

You may have breathed a sigh of relief after filing your 2017 income tax return (or requesting an extension). But if your office is strewn with reams of paper consisting of years’ worth of tax returns, receipts, canceled checks and other financial records (or your computer desktop is filled with a multitude of digital tax-related files), you probably want to get rid of what you can. Follow these retention guidelines as you clean up.

General rules

Retain records that support items shown on your tax return at least until the statute of limitations runs out — generally three years from the due date of the return or the date you filed, whichever is later. That means you can now potentially throw out records for the 2014 tax year if you filed the return for that year by the regular filing deadline. But some records should be kept longer.

For example, there’s no statute of limitations if you fail to file a tax return or file a fraudulent one. So you’ll generally want to keep copies of your returns themselves permanently, so you can show that you did file a legitimate return.

Also bear in mind that, if you understate your adjusted gross income by more than 25%, the statute of limitations period is six years.

Some specifics for businesses

Records substantiating costs and deductions associated with business property are necessary to determine the basis and any gain or loss when the property is sold. According to IRS guidelines, you should keep these for as long as you own the property, plus seven years.

The IRS recommends keeping employee records for three years after an employee has been terminated. In addition, you should maintain records that support employee earnings for at least four years. (This timeframe generally will cover varying state and federal requirements.) Also keep employment tax records for four years from the date the tax was due or the date it was paid, whichever is longer.

For travel and transportation expenses supported by mileage logs and other receipts, keep supporting documents for the three-year statute of limitations period.

Regulations for sales tax returns vary by state. Check the rules for the states where you file sales tax returns. Retention periods typically range from three to six years.

When in doubt, don’t throw it out

It’s easy to accumulate a mountain of paperwork (physical or digital) from years of filing tax returns. If you’re unsure whether you should retain a document, a good rule of thumb is to hold on to it for at least six years or, for property-related records, at least seven years after you dispose of the property. But, again, you should keep tax returns themselves permanently, and other rules or guidelines might apply in certain situations. Please contact us with any questions.

© 2018

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Blockchain May Soon Drive Business Worldwide

“Blockchain” may sound like something that goes on a vehicle’s tires in icy weather or that perhaps is part of that vehicle’s engine. Indeed it is a type of technology that may help drive business worldwide at some point soon — but digitally, not physically. No matter what your industry, now’s a good time to start learning about blockchain.

Secure structure

Blockchain is sometimes also called “distributed ledger technology.” It was introduced in 2009 to support digital “cryptocurrencies” such as bitcoin. Entries in each digital ledger are stored in blocks, with each block containing a timestamp and providing a link to the previous block.

Typically, a blockchain is managed on a secure peer-to-peer network with protocols for validating blocks. Once data is recorded, no one can change it without altering all other blocks — which requires approval by most network participants. Blockchain proponents argue that this process essentially authenticates all information entered.

Various uses

The financial industry led the way in recognizing blockchain’s potential, foreseeing that users could execute transactions without relying on banks and other third parties. Another potential application is in the M&A sphere. Buyers and sellers could shift due diligence documentation to blockchain, so financial and legal advisors wouldn’t have to spend as much time poring over so many different and disparate records. The M&A process could thereby be completed more quickly.

There are also many industries that could employ blockchain technology to conduct quicker and more secure transactions or simply track data more efficiently.

Take manufacturers, as well as virtually any supply chain business: Blockchain could provide safeguards against errors, fraud or tampering. This functionality could bolster trust among supply chain partners. Over the long run, blockchain may even eliminate the need for third-party payment processors.

Another example: the health care industry. Blockchain could be used to better secure electronic health information, improve billing and claims processing, and enhance the integrity of the prescription drug supply chain. All of this could positively impact the health care insurance market for every employer.

Ahead of the curve

Most business owners don’t need to scramble to incorporate blockchain-related technology right this minute. But you might want to get ahead of the curve by learning more about it now and pondering some ways that blockchain could affect your company. Let us know if you need further information or other ideas on the future of business.

© 2018

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A Joint Home Purchase Can Ease Estate Tax Liability

If you’re planning on buying a home that you one day wish to pass on to your adult children, a joint purchase can reduce estate tax liability, provided the children have sufficient funds to finance their portion of the purchase. With the gift and estate tax exemption now set at an inflation-adjusted $10 million thanks to the Tax Cuts and Jobs Act, federal estate taxes are less of a concern for most families. However, the high exemption amount is only temporary, and there’s state estate tax risk to consider.

Current and remainder interests

The joint purchase technique is based on the concept that property can be divided not only into pieces, but also over time: One person (typically of an older generation) buys a current interest in the property and the other person (typically of a younger generation) buys the remainder interest.

A remainder interest is simply the right to enjoy the property after the current interest ends. If the current interest is a life interest, the remainder interest begins when the owner of the current interest dies.

Joint purchases offer several advantages. The older owner enjoys the property for life, and his or her purchase price is reduced by the value of the remainder interest. The younger owner pays only a fraction of the property’s current value and receives the entire property when the older owner dies.

Best of all, if both owners pay fair market value for their respective interests, the transfer from one generation to the next should be free of gift and estate taxes.

The relative values of the life and remainder interests are determined using IRS tables that take into account the age of the life-interest holder and the applicable federal rate (the Section 7520 rate), which is set monthly by the federal government.

Consider the downsides

The younger owner must buy the remainder interest with his or her own funds. Also, while the tax basis of inherited property is “stepped up” to its date-of-death value, a remainder interest holder’s basis is equal to his or her purchase price. This step-up in basis allows the heir to avoid capital gains tax on appreciation that occurred while the deceased held the property.

But, in most cases where estate tax is a concern, the estate tax savings will far outweigh any capital gains tax liability. That’s because the highest capital gains rate generally is significantly lower than the highest estate tax rate.

Keep it simple

In a world where many estate planning techniques can be complicated, a joint purchase isn’t. Contact us with any questions.

© 2018

Could Your Next Business Loan Get “Ratio’d”?

We live and work in an era of big data. Banks are active participants, keeping a keen eye on metrics that help them accurately estimate risk of default.

As you look for a loan, try to find out how each bank will evaluate your default probability. Many do so using spreadsheets that track multiple financial ratios. When one of these key ratios goes askew, a red flag goes up on their end — and the loan may be denied.

Common metrics

To avoid getting “ratio’d” in this manner, business owners should familiarize themselves with some of the more common metrics that banks use to gauge creditworthiness.

For example, banks will compare cash and receivables to current liabilities. If this ratio starts slipping, you’ll likely need to push accounts receivable so money comes in more quickly or better manage inventory to keep cash flow moving. Other examples of financial benchmarks include:

• Gross margin [(revenue – cost of sales) / revenue],
• Current ratio (current assets / current liabilities),
• Total asset turnover ratio (annual revenue / total assets), and
• Interest coverage ratio (earnings before interest and taxes / interest expense).

Some banks may also calculate company- or industry-specific performance metrics. For instance, a warehouse might report daily shipments or inventory turnover, not just total asset turnover. Meanwhile, a retailer might provide sales graphs that highlight product mixes, sales rep performance, daily units sold and variances over the same week’s sales from the previous year.

Other methods

Bear in mind that not every bank uses ratios to evaluate performance, or they may combine ratio analysis with other benchmarking tools. Some use community-based scoring, by which a selected group of finance professionals rate and review companies based on their payment histories. Others use proprietary commercial-scoring models that use creditor reports to develop credit scores for businesses.

Preventing disappointment

When a strategic initiative fails to launch because your business can’t obtain financing, it can be crushing. To prevent such disappointment, have your financials in order and target as many common ratios as possible. Please contact our firm for help evaluating your performance and determining where you may need to improve to obtain a loan.

© 2018

Feeling Lucky? How to Find a Pot of Gold in Your Financials

 

Every business experiences occasional cash shortages. When this happens, owners often assume they should go out and sell more. But this strategy can sometimes compound money troubles over the short run. Why? The answer lies in a concept known as the “cash gap.” Understanding this concept can help your business generate extra cash to meet working capital needs. Here’s how.

Focus on the balance sheet

The cash gap is a function of the timing difference between 1) when companies order materials and pay suppliers, and 2) when they receive payment from their customers. This difference can lead to cash shortages if the company doesn’t have extra savings, doesn’t qualify for additional bank financing or doesn’t want to draw on a line of credit. It’s also important to keep in mind that cash gaps funded by bank financing incur interest costs.

Boosting sales generally isn’t the solution, because, when cash is tight, selling more will often widen the cash gap. That’s because the company will need to front the incremental cost of sales while new orders are fulfilled, invoices are sent and customers remit payment. This concept explains why start-ups and high growth companies tend to experience cash shortages.

Finding hidden treasures 

If the company finances its cash gap, shaving a day or two off the gap could save thousands of dollars in interest expense over the course of a year. Minimizing the cash gap requires you to focus on its underlying variables:

Inventory. There are numerous ways to minimize your investment in inventory. For instance, you might search the warehouse for slow-moving items and then either return stale items for credit, trade them with another supplier or competitor, or sell the items for scrap.

You can also revise your company’s purchasing policies. For example, some materials and parts suppliers may agree to discounted bill-and-ship or consignment arrangements in exchange for exclusive or long-term contracts.

Receivables. The faster a company can get money in the door, the smaller its cash gap will be. Your business can encourage faster payments from customers by sending out past-due reminder letters and following up with phone calls. Also evaluate invoicing procedures to minimize the days in receivables. Poor communication among billing, sales and production staff can cause invoicing delays.

Payables. Think of trade payables as a form of interest-free financing. But, beware, there are limits to how far a company can extend its payables. Slow-paying businesses may forgo early-bird discounts or receive less favorable treatment from suppliers, such as slower delivery, higher rates or cash-on-delivery terms. Delayed payments can also harm a company’s credit rating, as well as its reputation among its pool of eligible suppliers.

Put it to work for you

The cash gap can be a helpful management tool, because it pinpoints hidden treasures in your balance sheet. Put simply, companies with shorter cash gaps tend to experience fewer cash shortages and rely less on bank financing. Contact us for help measuring your cash gap and using it to manage working capital more efficiently.

© 2018