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ACCOUNTING METHODS

What is the difference between cash basis and accrual basis accounting?

Cash Basis accounting records transactions when cash (or other form of currency) changes hands. That is when the customer pays for the product. Accrual accounting records the transaction when the buyer and seller agree that a sale has occurred, i.e. when an order is placed or a contract is signed which is usually before the cash is actually received. For tax purposes, the cash basis results in lower taxes when a business usually gets paid after they have paid for their expenses related to the sale. When the company usually is paid up front, and then incurs expenses, the accrual basis produces a lower tax.

What are the advantages of cash basis accounting over accrual based accounting?

Generally speaking accrual based accounting is a more accurate measure of the performance of your business, however for tax purposes, cash basis will often result in a lower net income and accordingly less taxes.  Please note that the IRS requires all businesses that have inventory to use the accrual method and that you are not allowed to arbitrarily switch back and forth.  Furthermore in cases were you are generally paid up front such as in the snow plowing business the accrual method would produce lower taxes.  Finally contractors are generally required to use a variation of the accrual method called the completed contract method.  Be sure to talk to your accountant or tax preparer to make sure that you are using the method which is best for your business.

When is Last In First Out (LIFO) better than First In First Out (FIFO) for inventory costing purposes?

Using LIFO will show higher income for either financial statement purposes or tax purposes when the cost of your product is dropping. For example if you sell computer chips which tend to decrease in value relatively quickly, using LIFO will expense the cheaper (more recently purchased) chips first minimizing costs and maximizing profits. If on the other hand your product tends to become more expensive like say diamonds, LIFO would result in lower profits since the more expensive diamonds (purchased recently) would be expensed before the cheaper diamonds purchased earlier. In addition, there are IRS imposed restrictions on switching between methods and AICPA reporting requirements for Reviewed and Audited statements. Consult your tax advisor based on your specific facts regarding which method to use and whether you can use different methods for book and tax purposes.

I have a small business and would like to know a simple accounting system to keep track of my income and expenses?

Generally speaking, how complex your accounting system needs to be depends on how many checks you write each month, how much you buy and sell on credit, if you are in a construction business or manufacturing and how many different types of inventory you carry.  The simplest method is to keep a daily or monthly calendar and track all income, expenses, mileage, etc. right on the calendar.  Then summarize the numbers by month and transfer to a sheet of columnar paper listing the months down the leftmost column and the amounts in columns marked sales, purchases, supplies, utilities, mileage, etc.

ASSETS (Go to Table of Contents)

Automobile

I have an opportunity to purchased a well maintained car coming off lease at year end. Should I pay cash $14k or search for a used car loan?

Any decision regarding paying cash versus financing boils down to what are your alternative uses for the cash.  If your cash will be sitting in a savings or money market account earning 2-5% interest, then it makes no sense to finance at 8-10%.  On the other hand if using this cash will require you to borrow other money for your business at 12% then finance the auto and save the cash for your other purposes.

Equipment

I am just starting out, and have $12,000 budgeted for furniture and equipment.  What should I do to make sure that I am getting the most for my money?

There are a couple of  factors to consider.  First does the furniture and equipment have to be new?  Second what is your financing structure?    The first factor is based on how your customers will react if you have used furniture rather than new.  In most cases this should not be significant, but it will be a factor in high profile professions where image is important to customer satisfaction.    Otherwise the simplest way to stretch your budget is to buy used equipment.    Ideally find someone in a similar business to yours who is going out of business and buy up all their furniture and equipment for as little as 10% of the cost of buying new.  With a little cleanup and  minor repairs you should be way ahead of budget.  The second factor is based on your financing structure.  Another alternative to buying new is to lease or rent the furniture and equipment.  The benefit to leasing or renting is that it significantly reduces your up front costs.    The downside is that it will increase your expenses which will affect your ability to attract financing.  Furthermore banks may loan money to purchase furniture and equipment, but not to lease it.  Therefore be sure to consider how renting will affect your financing and budgeting.

I want to buy a new computer, but don't want to spend $2,000.   Does anyone sell cheap computers anymore?

The cheapest way to buy a computer is used.  Check out the classified ads in your area to find used computers for sale.  However, used computers are not always the best computers.  Factory refurbished or computers that are two tiers below cutting edge (cutting edge is usually over $3,500, the next tier is around $2,500 - $3,500 and the second tier is around $2,000 - $2,500) can be purchased online.  For example, you can buy an Intel 300 MHz machine with a monitor and all the bells and whistles including a scanner for less than $1,000 as proven by my recent experiment.     These machines still have their factory warranty and haven't been beaten up by a previous owner.

Inventory

How do I calculate the appropriate inventory level for my business?

The trick to carrying inventory is to not carry too much since it ties up cash, costs more to store, greater risk of loss from depreciation, obsolescence or theft, costs more to insure, etc. but still carrying enough to not lose sales due to lack of product on hand.  For general office supplies like paper and paper clips the cost of record keeping usually exceeds the cost of carrying too much, so you are better off stocking a little extra of those types of inventory.  For other inventory, the following basic mathematical formula can be used to calculate your appropriate inventory size.

Market research or previous history should determine annual sales.  The appropriate Cost of Goods Sold as a percentage of sales and Inventory Turnover ratios can be obtained from trade associations or services such as Financial Research Analysis or Robert Morris & Assoc. (see your local library).    The Cost of Goods sold refers to the price, including shipping, of the product being sold to you.  Inventory Turnover is the number of times that you replace your inventory in a given period. 

Once the average inventory level is calculated, you can fine tune the number for a given period based on seasonal fluctuations.  For example if you are a toy retailer your sales in November and December will be higher than other times during the year and therefore require higher inventory levels.  Furthermore, even if you have 12 inventory turns a year, you may require 4 inventory shipments during those two months, but may need to order three weeks in advance.  In other words, factors such as lead time (the time between placing and receiving an order), and peak sales times can affect the required inventory levels.