Three Painless Lessons in the Art of Accounting
God I hate accounting.
Let me be more precise. I loathe accounting. I despise it with a passion reserved for in-laws and root canals. Not to put too fine a point on the matter, but I’d rather have dinner with Jeffrey Dahmer than untangle the difference between debits and credits. (And frankly, apart from accountants, who really cares?)
But I’m also a realist. I’ve owned and run my own business for years, and much as I hate it, I know there’s no way around this minor evil. I’ve learned enough about QuickBooks to field some midnight calls on April 15, mostly from clients and friends in need of ninth-inning help. Like most of us, I do my daily bookkeeping myself—writing the checks, paying the bills and so on—and leave the hard stuff—the taxes and financial planning—to an accountant. Along the way I’ve learned a few tricks of the trade.
Rule 1: Don’t Go It Alone
Trust me: You need an accountant. With a little knowledge of QuickBooks, Quicken or Microsoft Money, you can do the basics yourself and let the software pick up the slack, but where do you turn when you need to know whether or not to expense or depreciate your new computers under Section 179? Given, it may seem like an arcane or even rhetorical question, but the answer could save a small business like yours and mine a few hundred bucks (or frankly, a few thousand) in taxes.
Another case in point: There are legal reasons to choose one business form over another. A corporation, for one, gives you some hefty protection against personal liabilities in case of a lawsuit. And a limited partnership may be a fine solution if you’re going into business with a friend or partner. But do you know the tax rules for each? Do you know how to pay dividends to yourself or take an owner’s draw? Or which is cheaper than salary, with its tagalong bevy of payroll taxes and add-ons?
These are hefty, thorny questions. They’re no fun to research and less fun to answer. And by and large, they require an expert’s touch. If you make a mistake, you could end up losing thousands of dollars to an involute system of tax laws and strange accounting rules you’ve never heard of. The best way to avoid the problem, of course, is to stop it before it starts. So drag out the phone book, call a CPA (Certified Public Accountant) and set up a meeting. Don’t be afraid to ask questions and get personal. After all, this person will see all your banking and business records, so make sure you start from a position of comfort. And vet his resume with care.
Remember, the few hundred bucks you pay an accountant can equal thousands of dollars of tax savings or bottom-line profit. Just as important, it can save you from trouble with the IRS, and I assure you, you’d rather have surgery with no anesthesia than run afoul of the boys in Washington.
Cash? Accrual? What?
That said, let’s tackle the first accounting question you’ll meet. Sooner or later, you’ll have to decide between cash and accrual, two different ways of keeping your books. In fact, if you follow the first rule above—don’t go it alone, on pain of death—this is one of the first topics you’ll broach with your bean counter.
Cash basis refers to a type of accounting where revenue (the money you earn) and expenses (the money you spend) are recorded on your books when the money is actually received or spent. In other words, if you give a client a bill for $100 on Monday but don’t get paid until Friday, you record the income on Friday, the day you received the cash. The same goes for something you buy. If you buy a computer in March but use your Visa card and don’t pay until May, you record the expense in May, on the day you cut and sent the check and not a moment before.
Not so with the accrual basis. Here, income and expenses are recorded when they’re earned or incurred, regardless of when you receive or write the check. Let’s go back to our first example. If you bill your client on Monday and she pays you on Friday, you record the sale—and hence the income—on Monday, the day it was earned. If you buy a computer in March and pay for it in May, you record the expense in March, on the day you slapped down your plastic and brought it home.
Why so much fuss over dates? Believe it or not, it can save you a bundle (or cost you a fortune, if you’re not careful). Consider this: If you make a sale in December but don’t get paid until March, you’ll owe income tax on the money you’ve made (income tax is assessed, by and large, at the end of the year) before you ever see the money. The government wants its share based on the accrual method, whether or not you’ve seen the cash you’re owed. And speaking of cash, if you’d used the cash method of accounting, you’d record the sale in March when the check arrives in the mail, meaning you won’t owe a dime in income tax until you have the money to pay for it.
Simple, right? Think again. It may seem like cash is the way to go, but like most rules of accounting, the best application depends on context. Say you’ve had a banner year; you’ve booked record numbers of sales. Good for you! We should all be so lucky in a bad economy. Of course, under the rules of accrual accounting, you’ll owe the government its share of your income no matter when you receive the payment, even if some of your clients are lazy or late and wait a year to pay you. So how do you lower your income tax bill? If you’ve been planning on making a big purchase, say, for pricey software that costs thousands of dollars, make it now, even if you have to buy it on credit. Why? In the accrual system, you can record the expense the moment you buy the software, even if you don’t pay your Visa bill for months. This lessens your net income and hence, your income tax, a perk you won’t get with cash accounting.
Deciding between cash and accrual can mean a difference of several hundred—or several thousand—tax dollars at year’s end. Among other factors, the choice depends on the type of business you do and when you get paid. Keep in mind that it’s hard (and sometimes, nearly impossible) to switch your accounting method once you’ve chosen it, so you’ll need the advice of a good accountant to make the right decision.
Tax, Tax, and Tax
The first aim of accounting is simple: to give you a good look at your financial health or lack thereof. But the second goal—namely, to lessen your tax liability—is far harder. Hence the third and final lesson in the art of accounting: Never make a major transaction (say, anything over $500) unless you know its tax effects, and plan accordingly.
For example, take the money you pay yourself. Should you do it as salary, dividend or owner’s draw? They all have different accounting rules and tax effects. If, for example, you incorporated for its many benefits and pay yourself a salary from corporate earnings, you’ll have to deduct the Social Security tax (6.2 percent), the Medicare tax (1.45 percent) and federal withholding from your paycheck. Ouch. What’s more, the corporation will have to pay its own share of Social Security (6.2 percent, again), Medicare (1.45 percent, again) and the Federal Unemployment Tax (yet another 6.2 percent, this time on your first $7,000 dollars of salary). Just as bad, you’ll have to fill out the 940s, 941s and other tax forms the IRS requires and make your monthly deposits or face stiff penalties. That’s a lot of work—and a lot of expense—for something as simple as paying yourself.
Not so for the sole proprietor, who pays nothing in employment tax at the end of each month, but pays a Self Employment Tax (or SET) at the end of the year. The SET’s current rate is 15.3 percent, the same amount you’ll pay in personal and corporate tax for Social Security and Medicare. But there’s no Federal Unemployment Tax (which saves you 6.2 percent on the first $7,000 of income you make), and what’s more, you can deduct half the SET on your personal income tax