My readers have asked me for more business writing and less recipes. So I will today's post to a topic that I think is of vital importance to most of you starting a small business. That topic is the importance of applying basic accounting concepts to your business as your year progresses. Although all of you will undoubtedly be using the services of a professional accountant when it comes time to file your tax return, professional accountants bill on time spent and their hourly rates can be as high as $400 per hour.
Thus you can save yourself a lot of money at year end if you arm yourself with a basic understanding of some accounting concepts and you apply them as your year progresses.
The basic concepts that you need to know are:
1. The concept of a shareholder loan and the importance of keeping business and personal finances separate.
2. How to allocate costs of bulk inventory purchases across the individual items so that you can accurately cost your inventory.
3. How to account for the purchase of equipment and machinery.
4. What types of documentation you need to maintain for expenses and how to keep it organized so that you can support your expense deductions in the event of an audit by the taxation authorities.
There are others, which I will address in future posts. But for now these are the most important ones that I saw in my time as a professional accountant.
The Concept of A Shareholder Loan
If you have a company, it is a separate taxable entity from you. Chances are though, particularly at the beginning of your business, the line between your personal finances and business finances are blurred: you are using everything you have for the business and are living off all the money earned from sales. The problem is that at year end, you have to account properly for not only for the sales and expenses of the business, but where the money came from. If you don't keep proper track of the money you have lent the company or borrowed from it, you can find yourself facing a very nasty surprise years down the road when your local taxation authority decides to audit your business.
It is a good idea to maintain separate credit cards and bank accounts for your business and to use these wherever possible for the business. However, this is not always possible: sometimes you need to transfer monies between business and personal bank accounts or you need to use your personal credit card for business expenses.
It is good idea to maintain an Excel spreadsheet ledger showing the continuity of your shareholder loan balance. Each time you take money out of the company in the form of advances, they should be documented on a separate line with the date, and each time you incur business expenses, they should also be documented on a separate line with the date, name of the vendor and amount of the expense.
If your shareholder loan is a credit balance (positive) at the end of your fiscal year then it means that the company owes you money and you can take this money out of the company tax-free. On the other hand, if it is a debit balance (negative) then it means that you owe the company money. Most tax authorities prohibit shareholders from indefinitely borrowing from their companies because it would be a way for them to avoid paying themselves a salary or dividends which would otherwise be taxable to them. In situations like this, your accountant will usually tell you that you either have to put the money back into the company's bank account, or you will have to include either a salary or a dividend in your personal income for the year. There is a lot of factors that he or she will consider in advising you which course of action to take, and that is beyond the scope of this post. But for now you should be aware of what your accountant means when he or she tells you that you have a "shareholder credit" or "shareholder debit".
Allocating Inventory Costs
If your business involves buying in bulk and then reselling piecemeal, it is a good idea to account for these costs as you place items in stock rather than trying to figure it all out at the end of the year. Most tax authorities require you to allocate costs to inventory using specific identification of purchase invoices with items purchased. However, in situations where you buy and sell a high volume of largely homogeneous items, you can allocate costs based on averages.
For example in my business, there are some stamps that I purchase specifically, but most of my purchases involve more than two stamps. So I allocate the cost of those stamps to each stamp based on an averaging method. The method I use is relative selling price. So for example:
I buy 3 stamps for $500, plus HST of 13%, plus shipping of $8.95 for a total for $573.95
Stamp 1 has a selling price of $2,000
Stamp 2 has a selling price of $500
Stamp 3 has a selling price of $750
What is my cost for each of these stamps using relative selling price?
The total selling price is $3,250 for all stamps. So I take the $573.95 and divide by the total $3,250, which gives me a percentage equal to 17.66%. I then apply this percentage to my selling price to get my cost:
Stamp 1: 17.66% of $2,000 = $353.20
Stamp 2: 17.66% of $500 = $88.30
Stamp 3: 17.66% of $750 = $132.45
Excel makes this easy with the ability to copy and paste formulas across multiple cells. You will find this task much easier to do as you go along during the year.
Purchases of Equipment and Machinery
Some confusion often arises among business owners over how to handle large equipment and machinery purchases. Most business owners usually know that large equipment purchases cannot be claimed as an expense in the year of purchase and must be recorded as assets and amortized at some basis over their lives. Where the confusion usually arises, is over how to treat ancillary costs like:
1. Installation costs
2. Transportation costs
3. Warranty costs.
4. Training costs where training is provided by the seller
5. Removal costs, where the seller removes and disposes of the old equipment
The guiding principle in most tax jurisdictions is that the cost of an asset is determined using Generally Accepted Accounting Principles (GAAP). Generally speaking GAAP states that any cost incurred to make an item of equipment serviceable to an entity is to be included in its cost. So on this basis all five of the above costs would be included in the cost of the asset.
Failure to capitalize these types of expenses is one of the most common sources of unfavourable audit adjustments against a small business.
Supporting Documentation and How to Organize it
Most business owners are aware that they need to keep receipts to support business expenses. But what they are often not aware of is that many taxation audits now are questioning the purpose of expenses that used to be accepted as business expenses without question. Restaurant meals, travel costs and car expenses were always subject to a lot of scrutiny because of the fact that a business owner could have their business pay a large amount of their personal expenses by running them through the company. But even expenses like purchases of office supplies, accounting fees, postage are under increasing scrutiny with many legitimate expenses being denied on the basis that they "were not incurred to earn income". So what to do?
1. Understand that credit card statements are not usually sufficient. Keep the flimsy receipts for all your business expenses paid by credit card and on them in pen write what the purpose of the expense was. If you entertained a client at a restaurant, write their name and what the meeting was about. Auditors will not usually question documentation like this as it was maintained contemporaneously.
2. On other receipts for things like office supplies and postage, it is a good idea to document the business purpose as well.
3. If you are claiming sales taxes paid against your sales tax remittances, usually your receipts have to show the taxation account number of the vendor as well as the amount of sales tax you paid.
4. Where you only own one car that you use for both business and personal use, you MUST maintain a log that shows the business trips you took and the KM traveled on each trip, as well as the odometer reading at the beginning of the year and at the end. Many taxpayers are having their claims for auto expenses thrown out for failure to maintain these logs.
Where the problem becomes even more acute is where you are claiming a portion of an expense as business, like where you have a home office and you want to claim a portion of all the expenses to maintain your home. There are two ways to do this:
1. Measure the square footage of your home office and then your entire home. Keep all your receipts and then calculate the percentage used for business. Bear in mind though that most taxation authorities require that you be able to prove that your home office was used for business, and only business at all times. This can be difficult to prove.
2. Another way to accomplish the same thing is to draw up a rental contract between yourself and your company for the use of your space. The company pays you for the use of the space and it is a good idea to actually have the company issue you the cheque for the rental charge. You set the rental amount to be more or less equal to what the business proportion of your expenses would be. The business will get a tax deduction for the rent paid and then you will report rental income from the business, against which you will deduct rental expenses. If you set the amounts properly you will wind up with either a very small amount of rental income, or a small rental loss.
I like the second method better because it is not necessary to get into the issue of whether the space was used 100% for business. You only have to show that the expenses were incurred to earn the rental income that the company paid and that is generally much easier to do.
What accounting questions keep you up at night?