Stan Snyder, CPA and expert bean counter
Most of us dread income taxes. If you're like many small business owners, you put off thinking about income taxes until the last minute. Let's face it: preparing your income tax return is one of the most unpleasant tasks you face. However, there are five things that you can do to make tax time easier:
- Review and adjust your balance sheet accounts
- Review the detail of your income and expense accounts
- Create a file for all of your tax documents
- Print out your reports and create a backup of your company file
- Sit back and relax
1. Review and adjust your balance sheet accounts
Your balance sheet accounts — assets, liabilities and equity — are your permanent accounts. They have a balance that carries over from year to year. Contrast these with the profit and loss accounts: income and expense. Income and expense accounts are closed out at the end of each year and begin the new year with a zero balance. If the balance sheet accounts are not reviewed and adjusted on a regular basis, they can accumulate garbage from year to year making it a nightmare to figure out what the balance in the account represents.
Assets — Bank accounts
Your most vulnerable asset is your bank account. Reconcile it monthly, fixing discrepancies that you'll find between your books and your bank statement. Review the outstanding transactions for entries that shouldn't be there. For example, if you see a check payable to the Department of Revenue that hasn't cleared the bank for three months it may be the reason that you have not received your business license. Or you may be receiving dunning notices because a check was lost in the mail.
A deposit to your account should clear your bank in two or three days. All uncleared transactions should be reviewed, but if you have old outstanding deposits on your bank reconciliation, they need to be addressed immediately.
Your tax accountant will want to see a copy of your bank statements and reconciliations to verify the accuracy of your bank account and ensure that all transactions have been recorded.
Tip Reconciling and adjusting your bank account on a monthly basis will make each consecutive month's reconciliation much easier.
Assets — Accounts receivable
Your accounts receivable account is a critical asset. The account balance represents money that has been earned, but not collected. Review your customer accounts often by producing an accounts receivable aging report. This report shows amounts due from customers arranged in columns based on how old they are. Studies show that the older a receivable becomes, the less probability there is that it will be collected. Your tax accountant will want to know that your accounts receivable have been reviewed and are accurate. Tax time is good time to write off those old accounts that are really bad debts.
Tip Review your accounts receivable monthly — or more often — and make phone calls to collect delinquent accounts. This task will not only help you collect your receivables and improve your cash flow, you may find this is a good opportunity to get feedback and improve communications with your customers.
Assets — Inventory
If your business has inventory, it is one of your most important assets. Taking a physical inventory is the best way to ensure that your cost of sales is accurate. Most small business owners loathe taking inventory, but tax time is a good time to verify that you have an accurate inventory and that your cost of sales is correct.
Assets — Fixed assets
Create a detailed report of changes in your fixed assets. Your tax accountant will have a list of your fixed assets, known as a depreciation schedule. You need to give him or her details of the changes in your fixed assets.
Here's a way make this task a breeze: When recording new asset purchases, enter a detailed description of the asset in the memo field. Then, at tax time, create the following report showing the changes in fixed assets:
- Create a balance sheet as of the end of your fiscal year
- Double-click the total fixed assets number to "drill down" and create a detail report
- Change the date range of this report to include the entire year
The resulting report will contain the date of purchase, a check or invoice number, vendor name, description of the fixed asset and the amount of the purchase. This is the information your accountant needs to update your depreciation schedule.
Liabilities — Credit card accounts
Due to the volume of transactions, your credit card account is an account that has the potential to get out of control. Reconciling this account monthly to your credit card statement will help to ensure that you have all of your tax deductions recorded.
Tip Enable on-line banking with your credit card accounts so that you can download all of your credit card transactions into your accounting software. This puts specific details of each credit card transaction into your register and, because it has been downloaded from the credit card company, you know the information will match your statement.
Liabilities — Accounts payable
Accounts payable to vendors should be reconciled to your vendors' statements monthly. Keeping these current will not only make your vendors happy, but will ensure that you have accurate records at tax time, and have not missed any deductions.
Liabilities — Notes payable
To verify the accuracy of your notes payable, compare the balance per your general ledger to your bank's balance. Payments on amortizing loans must be broken out into principal and interest. The principal is applied to the liability balance and the interest recorded as an expense.
This is an area where small business owners often make mistakes, ending up with inaccurate financial statements. Posting the entire loan payment to the interest expense account will overstate your expense, resulting in understated net income. Likewise, posting the entire payment to the liability account will understate interest expense and overstate net income.
When your lender sends you a monthly breakdown of principle and interest, it's only an estimate. The actual amounts applied to your loan balance will vary based on when the bank received and posted your payment to your account.
Tip Use the bank's monthly estimate to record your payments, but request a loan history at year-end to adjust your accounts to agree to the bank's records.
Liabilities — Sales tax and payroll taxes payable
Sales tax and payroll tax liability accounts should be reviewed monthly when making your tax payments. Verifying these accounts is not only necessary to know that you're paying the proper amount; it will ensure that your year-end liabilities are correct.
2. Review the detail of your income and expense accounts
Once you've reviewed your balance sheet, it's time to review the profit and loss report. This is an easy task and can be an enjoyable review of the past month or year. Create a profit and loss for the previous year. Beginning with the income accounts, Double-click each line item to produce a detailed report for that account. Review the detailed report for consistency. (Consistency may be called the "hobgoblin of little minds," but in accounting, it is a virtue.) Make sure that the transaction types are proper for that account, that vendor or customer names make sense, and that the amounts, either positive or negative, are appropriate. Continue through the report double-clicking each account until you have reviewed the entire profit and loss report.
Next, create a comparative profit and loss report with a column showing the previous year. Compare each income and expense account to the previous year. Have revenues increased or decreased? Does this make sense based on your knowledge of the business? Compare each expense account to the previous period. There should be some consistency between periods. Do you see expenses that were not there in the previous period? Are there expenses that you know should be there based on history, but that don't show up? This process may uncover unrecorded or misclassified transactions.
If you sell products, review your cost of sales percentages. Calculate the cost of sales percentage for each cost of sales account to verify that the percentages are reasonable.
To calculate your cost of sales percentage, divide the cost — the numerator — by the revenue — the denominator — . With sales of $200,000 and costs of $100,000, your cost of sales percentage is 50%. (100,000/200,000 = 50%).
Verify that these numbers are accurate, consistent with past periods, and that they make sense to you.
3. Create a file for all of your tax documents
At the beginning of the new year, you will receive an abundance of tax forms in the mail. Your desk will soon be cluttered with forms from your bank, brokerage house, vendors and state and federal governments.
Label a file folder "Tax forms for my accountant". Now you have a place for all of those 1099s, 1040s, 1120s and other forms you'd rather not deal with. Include this file folder in the package you take to your tax accountant.
If you receive a tax notice about a delinquency or past due amount, send it to your accountant immediately!
4. Print out your reports and create a backup of your company file
Your tax accountant will want to look at your balance sheet and your profit and loss report. Print out a balance sheet as of the end of the tax year and a profit and loss report for the entire year. As you review your accounts (steps one and two), make notes about what you've found on the printout.
Since you've done the research, document any anomalies for your accountant. Create a backup of your company file as of the current date. Your accountant can restore the backup file to view transactions and create detailed reports. In addition, your accountant will want the following documents:
- Accurate inventories
- Copies of sales tax returns
- Copies of payroll tax returns
- Details of accounts receivable and accounts payable
- A schedule of fixed assets additions — and any deletions
- Copies of notes payable
- Any tax forms received in the mail
When your accountant has made their adjusting entries, and you have entered those adjustments in your accounting system, create another backup.
Tip Burn a copy of the backup, with adjustments, to a CD-ROM disk, label it "archive," and put it with your copy of your tax return. It may be very useful if your tax return is audited in the future.
5. Sit back and relax
Not just yet! Here's my most important tip: Hire a competent tax professional and pay them well. Small business owners tend to be self reliant, independent individuals. They often attempt to prepare their own income tax return. However, when it comes to income taxes, you need to hire a competent tax professional.
With the complexity of today's tax code and constantly changing regulations and interpretations of that code, income taxes are just too complex for the small business owner.
A successful businessman once responded, when asked about the secrets of his success, "Always pay your lawyer and your accountant well." A good CPA can not only save you money on your income taxes, he or she can help you streamline your business, help you to make it more profitable and assist with tax planning, retirement planning and estate taxes.
Even the best tax adviser will be handicapped by bad information. It is your responsibility to give your CPA good information to work with. Reviewing and adjusting your general ledger accounts and understanding what the balances represent are the first steps in providing accurate information to your tax adviser, which will not only help you at tax time but will also give you a solid basis for decision making throughout the year. Now, sit back, relax, and pat yourself on the back.
About the author
Stan Snyder is a certified public accountant with over 25 years experience dealing with the accounting and computer problems that small business owners face. He teaches at Colorado Mountain College, and regularly consults with small business owners using accounting software of all types. If you have questions about this topic or another accounting topic, send Stan some feedback by responding to the question below "Was this article helpful?" Stan may use your questions or topic ideas in an upcoming column.