2. HOW GOOD ACCOUNTING AND TAX MANAGEMENT CAN HELP YOU CONTROL, PROTECT AND ENHANCE YOUR BUSINESS ENTERPRISE

WHAT RECORDS SHOULD YOU KEEP? | USE OF ACCOUNTING RATIOS | BUDGETING | TAX PLANNING | CAN YOU SAVE TAXES BY LEASING EQUIPMENT? | YOUR DEPENDENT CHILDREN AS EMPLOYEES MAY HAVE TAX ADVANTAGES | APPROVED METHOD IN CUTTING YOUR INCOME FOR TAX PURPOSES | REPORTING YOUR DEDUCTIONS FOR BEST TAX RESULT | MAXIMUM TAX DEDUCTIONS FOR SUCCESSFUL OPERATION | WHAT DEDUCTIONS DO YOU GET FROM YOUR BUSINESS INCOME? | MANY BUSINESSMEN USE PART OF THEIR RESIDENCES AS A PLACE OF BUSINESS OR OFFICE | WHEN YOUR AUTOMOBILE IS USED FOR BOTH BUSINESS PURPOSES AND PERSONAL USES | SOMETIMES INDIVIDUALS GET THEIR PERSONAL EXPENSES ALL MIXED UP WITH THEIR BUSINESS EXPENSES.

Accounting is essential to your success in starting a small busi­ness. Bad use of accounting controls is one reason so many small businesses fail. Some recent studies of small business bankrupts show that almost one-third kept no records. Less than one-fourth kept adequate records.

To initiate your system of records you should utilize the services of a certified public accountant. Your bank, lending institutions and many of your creditors require that your state­ments be prepared by CPAs. So why not start off on the right foot?

WHAT RECORDS SHOULD YOU KEEP

Your CPA will organize an accounting system for you. But its day-to-day operation will depend upon you or one of your employees. Your CPA will come in only for periodic con­sultations and audits.

The exact contents of your accounting system will vary with the type and magnitude of your business operation. You should, of course, retain all of your business papers, such as cancelled checks, vouchers, bills, contracts and any others relat­ing to your day-to-day financial transactions. Your system should also include appropriate journals and ledgers. It is through these that your accounting information will flow to the final end product in which you are interested, the profit and loss statement and the balance sheet.

The value to you of a comparative profit and loss statement is immeasurable. The P & L statement can be likened to a moving picture film of your business operations for the period covered.

You can see in concise tabular form what you started with, what you did with it and how you ended up. Comparing this information with the same information recorded in previous years will give you excellent control over the scope of your operations. From this statement you will get ideas of inefficiency in your operations, possible larcenies or frauds, increasing expenses and an idea of the inter-relation between current economic conditions and your business.

The balance sheet, on the other hand, serves a slightly different purpose. It is like a candid picture taken at one moment of time and recording the state of your business for that precise moment. It should suggest to you ideas for financing and refinanc­ing your operations, and for dividend declarations. When used in a comparative form (with other years) it, too, should suggest ideas for increasing the efficiency of your operations.

USE OF ACCOUNTING RATIOS

A most useful source of information for the small business­man is a method known as ratio analysis. This involves com­paring one item with another on the balance sheet or on the P & L statement or comparing items selected from the two state­ments. These ratios, some of which are listed below, are most useful when compared with similar ratios of your previous oper­ating periods as well as ratios of other firms engaged in similar enterprises. You can obtain information on other concerns from such organizations as Dun & Bradstreet of New York, or the Inquiry Reference Service leaflets of the U.S. Department of Commerce.

The most commonly used and perhaps the most significant ratio for indicating financial condition is the current ratio: that is, current assets divided by current liabilities. This ratio indicatesthe amount of working capital. The working capital reflects the ability of a business to finance its current operations after allow­ing for payment of its current liabilities. The current or working-capital ratio for a store or a factory should ordinarily be at least two. While this figure is somewhat flexible, you can best determine your own ratio figure by studying statistics available from similar concerns.

Another interesting and commonly used ratio is liabilities divided by net worth. This ratio reveals the proportion of debt to ownership. It shows whether a larger share of business assets is being held by the owner, or whether business assets are being acquired through borrowing from creditors. It is usually pre­ferable, that business operations from year to year result in an increased proportion of ownership in the hands of the proprietor.

BUDGETING

Budgeting is an important concern to your business opera­tions. You should certainly utilize the services of a CPA when preparing your annual budget. Careful budgeting enables you to engage in timely financing—borrow when you know you will need money and you will have it in time for your use. Careful budgeting will go far to help you prevent waste and inefficiency. It will also restrain unwise expansion. Each undertaking is based on cold facts before commitments are made rather than on over-enthusiasm and loose thinking. Budgeting also serves to fix re­sponsibility, since all participate directly in formulating budgets covering their activities.

TAX PLANNING

The high percentage of failures among new business con­cerns is attributed to management failures—bad financing, failure to understand the sales market, unfamiliarity with problems of supply or competition and very often to the overpayment of taxes.

The small businessman who engages a competent doctor as a matter of course for his personal health is often too over­confident or too suspicious to call in competent counsel for the health of his business. Far too few seek such aid.

Taxes being what they are, good tax information permits sizeable savings. The problem of how can best be expressed by questions of this sort (there are many others):

Does it pay to incorporate? to operate as a proprietorship (single ownership)? to form several units, as partner­ships or corporations?

Will a family partnership cut taxes enough to make it worth while?

How should costs of building and equipment be financed?

Do tax savings make leased equipment cheaper than out­right purchase? Should the building be rented or purchased?

How may the business be financed most cheaply? How should books be kept—cash or accrual? With what tax year?

Can dependents help out without losing tax deductions?

CAN YOU SAVE  TAXES BY LEASING EQUIPMENT?

The answer depends on your current financial position and your future plans. You have to evaluate leasing against purchasing in the terms of a true net after taxes. And you must not minimize this important fact: excluding short-term leases, rental payments will generally total more than a purchase price. For example, in a usual leasing arrangement of a $15,000 machine with a useful life of 15 years, rental payments will approximate the original purchase price in about six years. This is because the lease usually calls for large payments in the first few years, the exact amount varying with the minimum length of the lease. Therefore you can safely say that a typical lease arrangement would potentially cost you more than an outright purchase. If this is true, then why lease?

As important as this potential larger cost is, it may be over-weighed by the important advantages you may secure through a leasing in your particular business:

1. Leasing is cheaper in the beginning because it requires only a minimum cash outlay, especially when that outlay is re­ duced by the deduction of rental payments. And if you are short of cash, leasing may offer you the only way to obtain new equip­ ment.
   
   
2. Capital freed from the down payment can be invested profitably  for  other  business  needs.   Furthermore,  your  credit position is better because you show no debt financing of new equipment.
   
   
3. The new equipment may be of a highly technical na­ture, requiring frequent adjustments or repairs that will be borne by the less or. If you had to assume this expense, the true cost of the equipment may come to more than you had originally intended to pay.
   
4. Leasing arrangements shift to the lessor the risks of obsolescence   arising  from   new  inventions,   changing  economic conditions or excessive use. And because he is a dealer in equip­ment, he is in a better position to dispose of it than you would be as the outright owner.
   
   
5. Leasing arrangements can fit your short-range needs, particularly when you are in doubt as to the long-range poten­tialities of the specific equipment. A short-term lease can protect you from the risk of not being able to adapt the equipment to new and unforeseeable situations.

Will a leasing arrangement save you taxes? The answer depends on a comparison between the amount of depreciation you are entitled to on an outright purchase and the amount of the rental payments. A leasing firm may promote the lease ar­rangement emphasizing the full deductibility of rental payments in contrast to a purchase price which is not deductible. However, the purchase price can be written off via depreciation spread over the useful life of the equipment. And because of the ac­celerated depreciation methods available for new equipment (such as the declining balance and sum of the years-digits methods), the deductions for depreciation may equal or even exceed the tax deductions for rental payments. Whether this is true in your case has to be figured dollar by dollar. Because of the increased advantages due to new accelerated depreciation rates, leasing firms have scaled down rental charges to approximate and in some cases even to better the advantages furnished b.y deprecia­tion. Again, this possibility has to be figured accurately before you decide whether to lease or buy.

If you do decide to lease, a few words of warning are neces­sary. The danger exists that any lease which provides for high rental deductions in earlier years and then permits continued use of the equipment at a reduced cost with an option to buy at a low price is vulnerable to Treasury attack. The Treasury suspects that many lease arrangements are disguised purchases through which the "buyer" is attempting to deduct his purchase price as rent. In such a situation it may try to disallow the rent deduction. However, it agrees that there is a leasing where a contract calls for payments based on an hourly, daily or weekly rate, or on production use. But even here the payments must not be related to the normal purchase price. And the option price must be close to the equipment's fair market value on the option date.

YOUR  DEPENDENT CHILDREN  AS  EMPLOYEES MAY  HAVE   TAX  ADVANTAGES

You may employ your child in your business and pay him a reasonable salary. That gives you a deduction for the fair pay you give him—plus the exemption you get for supporting him. On top of that, he gets a $600 exemption on the pay he receives.

You get the exemption even if you pay him $600 or more— as long as he is under 19 or a full-time student. If he is 19 or over and does not go to school, you can still get an exemption if he earns less than $600 during the year.

APPROVED METHOD IN CUTTING YOUR INCOME FOR TAX PURPOSES

You can defer sales income to next year this way: arrange to ship merchandise on consignment this year to be sold next year. Or you may arrange to sell merchandise on approval this year, to be accepted next year.

If you use the accrual basis of accounting (as you must do if you have inventories), trade and cash discounts give you a control of income. Give trade discounts on your sales if you want a deduction. Take cash discounts on your purchases if you want the income. A trade discount reduces your sales (or pur­chases) at the time of the transaction. A cash discount is a deduction only at the time payment is made.

Example: In December, 1959, you sell $1,000 mer­chandise subject to a 10 percent trade discount, while you buy $1,000 merchandise subject to a 2 percent cash discount. Both bills are paid in 1960. You accrue, in 1959, $900 sales and $1,000 purchases.

Can you use the installment sales method? If you regularly sell your merchandise on the installment basis, you can defer the gross profit to the year when you collect. Nor is it necessary to make all your sales by that process. You can use the install­ment method on your installment business, provided you regularly sell that way. If you sell refrigerators and pianos, and allow installment payments only on the first, you qualify.

The income reported on installment sales is found this way:

INCOME
TOTAL COST OF GROSS     COLLECTIONS  REPORTED
YEAR	SALES	SALES	PROFITS	PROFITS %	IN 1960	IN 1960
1958	$50,000	$25,000	$25,000	50	$20,000	$10,000
1959	80,000	48,000	32,000	40	30,000	12,000
1960	60,000	42,000	18,000	30	10,000	3,000

Expenses and other deductions are deducted in the year when paid (cash basis) or when incurred (accrual basis). They are not allocated to the years when income upon collection is reported. When would good tax management suggest that you use the installment basis?

If you are on the accrual method of accounting and you want to change to the installment method, make sure you are not taxed twice in the changeover. When you change, your collec­tions may include income that was accrued in a prior year. This income is reported again and taxed.

If you are in the installment business, you probably ought to use a corporation.

Do not take advance deposits of any kind from your cus­tomers or contractors unless you are prepared to pay a full tax on those receipts. If you have use of the money, it may be taxed to you. But your deduction of expenses incurred to earn the deposit may have to be spread over the life of the contract or lease. This denies you the privilege of allocating income to a year other than the year of actual receipt.

Since unrestricted advance payments are income, you may take advance income in years when your business has lost money. Then taking advance income will eliminate income from taxed years.

REPORTING YOUR DEDUCTIONS FOR BEST TAX RESULTS

Some expenses can be controlled and placed in the year in which they will give you the most benefit. You may elect to spend money this year for repairs, redecoration, advertising, etc. Or you can delay them until next year, if that will give you a greater tax benefit.

Does good business dictate that any of your expenses be rearranged to a percentage of sales or of net profit? For example, can your rent be based upon a percentage of sales or profit? Your job is to control costs so they will be low when your net income is low.

If you own assets (say machines or automobiles used in your business) and are about to trade them in, remember this: a trade-in produces no gain or loss. If the allowance is more than the depreciated cost of your asset, trading is best, since the gain is not taxed. But if it is less, sell the asset for cash and get the loss. Then use the cash to buy the replacement.
You can get no deduction now for costs which you may have to make good later on present-day sales. The classic example is the contractor who must include his full contract receipts in income today, even if he remains responsible in the future for his guaranty of his work.

Tax economy may mean detailed study of this list to find what you should do about clearing up in high tax years costs such as:

Guaranties and warranties that will carry on after this year—they are a deduction if you pay this year.

Expenses contingent upon the customer paying his bill, like discounts, salesmen's commissions, etc.— you might get a deduction only in the year when he makes a payment; the courts disagree on this point.

Sometimes you can gain tremendously, taxwise, by liquidat­ing (in high tax years) obligations that will carry into more difficult years. For example, you probably can get an immediate deduction if you settle in cash for:

Bad leases that are likely to be burdensome in later years.

Contracts for services or materials that eventually will be expensive and difficult to carry in later years, or sales contracts which may be difficult to perform.

Many kinds of adverse litigation or contingent lia­bilities, and all related expenses. Liquidate them now when taxes are high.

Obligations for a purchased asset that will not be used in later periods. See if you can get a present deduction by returning the asset and taking your losses now.

MAXIMUM TAX DEDUCTIONS FOR SUCCESSFUL OPERATION

The proprietor includes his business income or loss in his own tax return. He adds it to—or subtracts it from—the rest of his income.

The same rule generally applies to the partner in a business. He treats his part of the profit or loss as an addition to—or subtraction from—the rest of his income.

Let's assume you understand the occasional peculiarities of the tax accounting for partnerships. If you do, then the fol­lowing principles also apply to their income.

First, what deductions do you get from your business income? The general principle is that you can deduct all the ordinary and necessary expenses to earn your income. But watch these rules:

Personal expenses are never deductible. That is so even if you pay for them out of your business. For example, if you write out a business check for the purchase of furniture for your home, that is not a business ex­pense. It is part of your drawings from the business. Your own drawings or salary are not deductible.

Typical business expenses of a mercantile establishment are amounts paid for advertising, hire of clerks and other employees, rent, light, heat, water, stationery, stamps, telephone, property insurance and delivery expenses. The expenses of a manufacturing business include labor, supplies, repairs, light, heat, power, selling costs, administration and other similar charges.

Capital costs cannot be deducted. Generally, the cost of acquiring an asset or of prolonging its life is a capital expendi­ture. The current expenses of running a business are not capital expenditures. Strictly speaking, every pur­chase of an asset or property (other than inventory) is a capital expense. Yet the law permits a deduction if the useful life of the item purchased is less than a year. For this reason, the cost of small tools, pencils, etc., is deductible. Although capital expenditures are not deductible in the year paid or incurred, their cost may usually be recovered. This is done through the deduction permitted for depreciation.

These deductions which you take in the business schedule are in addition to the normal deductions given everyone, i.e., taxes, interest and contributions. You are not per­mitted to take a deduction twice. If you deduct interest or taxes as an expense of your business, you cannot again deduct them in another part of your return.

Many businessmen use part of their residences as a place of business or office. Then a division of the various household ex­penses must be made between business and personal use. Only the portion allocated to your business may be deducted. No official ruling exists to guide the apportionment. Any reasonable plan will be approved. Here are some aids:

If you own the house in which you maintain both your business and your residence, you may deduct the portion of the heat, light, telephone, repairs, depreciation, etc., that may be fairly allocated to the business.

If you rent the house or apartment, you may make a similar allocation of some of these deductions together with your rental expense. The apportionment might be made on the ratio of the number of rooms devoted to business to the total number of rooms in the house. Another method in use is the ratio of the area of the business rooms to the total area of all the rooms.

You may have a place of business or office elsewhere and merely see a casual or incidental customer or client in your residence. That is not using part of your home as a business. Neither would there be business use if you rarely used your home for business operations. To get a deduction for the fair share of the expenses allocated to your business activities, you must actually maintain an office and regularly receive customers or clients. Or you must regularly conduct other business activities.   You   are  then  entitled  to  the  deduction.

You get it even though you use your residence as a place of business only during the evenings or during special hours, and even though your main business is elsewhere.

When your automobile is used for both business purposes and personal uses, an apportionment of your depreciation, repairs and operating expenses may also be made. Only the portion allo­cated to your business purposes may be deducted. It is advisable to keep records of mileage, number of trips, etc., in order to prove your fair apportionment.

Sometimes individuals get their personal expenses all mixed up with their business expenses. Here is a check list of deductible costs. It may help you unscramble bad bookkeeping.

Advertising expenses essential to earn your income.

Automobile expenses paid by you if your car is used directly in your business.

Books purchased for business if their useful life is short. (If they have a long useful life, an annual depreciation deduction may be taken.)

Cards, notices and stationery paid for by you and essential to earn your income.

Coaching lessons. (Lessons for the general improve­ment of your talent are not deductible.)

Compensation for employees where paid by you essen­tial to your business.

Contributions and assessments paid to chambers of commerce and professional associations and made for business purposes.

Cost of attending meetings or conventions of your business or profession.

Cost of bonding employees or assistants.

Damages, court costs and other expenses paid by you in connection with civil lawsuits affecting your business.

Depreciation on your tools, instruments and equipment with a useful life of more than one year and used in your business.

Display expenses—hotel and sample room costs paid for by you and required by your occupation.

Embezzlement or defalcation losses to the extent they are not compensated for by insurance. (This may be deducted only in the year the loss occurs. The cost of apprehending the thief is not deductible.)

Entertaining expenses if necessary for your business. (Include dinners, drinks, flowers, lunches, parties, tickets to concerts, sporting events and theaters, etc.) Fees paid to agents where essential in order to earn your income.

Fire, casualty or theft losses to the extent they are not compensated for by insurance.

Gifts required for business purposes.

Instruments or apparatus necessary to earn your in­come which you rent or lease—cost of renting or leasing.

Instruments and equipment used in your profession which you must buy—cost, if the useful life is short; if not, annual depreciation charges and main­tenance cost.

Laundering or cleaning working clothes or uniforms where the cost of purchasing them would be a deductible item.

Legal expense of defending suit against you—except that if you are found guilty in a criminal action, no deduction is allowed.

Loss on sale or scrapping of old depreciable equip­ment or machinery used in your occupation. You may deduct its present depreciated value (cost less depreciation), less the amount received for it.

Machines and heavy equipment—annual depreciation only.

Magazines and newspapers purchased for the use of customers.

Maintenance expense of business premises. Include cleaning, electricity, heat, insurance, light, paint, repairs, water and incidental alterations.

Membership fees paid to your trade association for a business purpose.

Messenger service used in earning your income.

Miscellaneous or unusual expenses paid by you which were directly necessary to earn your income.

Moving expenses incurred in transferring your business to a new location.

Office furniture, if its useful life is short. (If it has a long useful life, you may deduct only the annual depreciation.)
Office supplies, postage, and stationery.

Patent infringement judgments if paid by you.

Patterns or designs purchased by you and required for your business.

Press agents' fees paid by you.

Professional or trade magazines, journals, and peri­odicals.

Publicity expenses paid by you, incurred in earning your income.

Rent paid for business premises. (If you use part of your residence for business purposes, only that por­tion of your rent is deductible.)

Repairs to tools, instruments and equipment used in earning your income.

Royalties paid for the use of copyrighted or patented items.

Signs used—cost if the useful life is short; otherwise annual depreciation charges.

Telephone and telegraph expenses directly essential to earning your income.

Traveling and other expenses in earning your income. Include railroad and other fares, meals, lodgings, tips, telephone and telegraph, baggage charges, in­cluding insurance, attendance at business conven­tions, display expenses (such as hotel sample room costs), automobile expenses, etc.

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