Acuity Blog

Got multiple locations? Expect auditors to keep a close eye on inventory……

Do you remember the high-profile fraud that happened at drugstore chain Phar-Mor in the 1990s? Executives manipulated the company’s financial statements to hide approximately $500 million in losses.

A key ploy that perpetrators used in the Phar-Mor case was to overstate inventory balances at individual stores. Management became adept at hiding the scam from their financial statement auditors by shifting inventory from location to location and overstating unit prices. Dishonest managers also stocked the shelves at locations they knew their auditors would visit, leaving shelves barren at unaudited locations.

CPAs have learned a lot about fraud since the 1990s, and they’ve beefed up their inventory auditing procedures to prevent similar shenanigans. Here are some of the techniques that auditors use today to evaluate inventory as part of a multilocation audit.

1. Reviewing the inventory manual

Before venturing into the field to view inventory in person, your auditors will request a copy of the company’s inventory manual. This helps them understand the policies and procedures you use to manage inventory. Throughout the audit, auditors will compare the company’s inventory records against the manual for discrepancies and exceptions.

2. Conducting in-depth analytical procedures at each location

In order to safeguard against bloated inventory balances, your auditors will review the company’s accounting records. This helps them understand the process to allocate and assign inventory units and costs to individual locations. It includes verifying that the balances and associated value conform to U.S. Generally Accepted Accounting Principles (GAAP).

3. Counting inventory

Depending on the size of your company’s inventory, the auditor may conduct independent inventory counts or observe physical inventory counts that are conducted in-house or by third parties. As part of the inventory observation process, your auditor team may randomly select a sample of items and verify that those items are included in the inventory count. Alternatively, the auditor may select an item that appears in the inventory count and then attempt to locate that item in the company’s stores. At the conclusion of the physical count, the auditor may also perform statistical sampling to test the accuracy of the physical inventory count.

4. Analyzing general ledger entries

The perpetrators of the Phar-Mor fraud periodically made fictitious journal entries to the general ledger to allocate losses to the individual stores. So, auditors have learned to pay close attention to large or suspicious journal entries that reallocate losses or manipulate inventory balances. If anomalies are detected in general ledger transactions, your auditor will ask for documentation and detailed explanations from management regarding the purpose of the entry.

A custom approach

Inventory manipulations have played a key role in countless frauds. So, auditors have learned to pay close attention to the inventory account. The scope and depth of inventory auditing procedures depend on a number of factors, including the number of locations you operate. Contact us for more information about what to expect as auditors review your inventory balances in the coming audit season.

© 2017

 


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Tax Cuts and Jobs Act: Key provisions affecting businesses

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The recently passed tax reform bill, commonly referred to as the “Tax Cuts and Jobs Act” (TCJA), is the most expansive federal tax legislation since 1986. It includes a multitude of provisions that will have a major impact on businesses.

Here’s a look at some of the most significant changes. They generally apply to tax years beginning after December 31, 2017, except where noted.

  • Replacement of graduated corporate tax rates ranging from 15% to 35% with a flat corporate rate of 21%
  • Repeal of the 20% corporate alternative minimum tax (AMT)
  • New 20% qualified business income deduction for owners of flow-through entities (such as partnerships, limited liability companies and S corporations) and sole proprietorships — through 2025
  • Doubling of bonus depreciation to 100% and expansion of qualified assets to include used assets — effective for assets acquired and placed in service after September 27, 2017, and before January 1, 2023
  • Doubling of the Section 179 expensing limit to $1 million and an increase of the expensing phaseout threshold to $2.5 million
  • Other enhancements to depreciation-related deductions
  • New disallowance of deductions for net interest expense in excess of 30% of the business’s adjusted taxable income (exceptions apply)
  • New limits on net operating loss (NOL) deductions
  • Elimination of the Section 199 deduction, also commonly referred to as the domestic production activities deduction or manufacturers’ deduction — effective for tax years beginning after December 31, 2017, for noncorporate taxpayers and for tax years beginning after December 31, 2018, for C corporation taxpayers
  • New rule limiting like-kind exchanges to real property that is not held primarily for sale
  • New tax credit for employer-paid family and medical leave — through 2019
  • New limitations on excessive employee compensation
  • New limitations on deductions for employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation

Keep in mind that additional rules and limits apply to what we’ve covered here, and there are other TCJA provisions that may affect your business. Contact us for more details and to discuss what your business needs to do in light of these changes.

© 2017

 


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Make budgeting part of your New Year’s resolution

2017 review and 2018 trends. Rubber Stamp on desk in the Office. Business and work background

It’s important to resist the temptation to rely on gut instinct or take shortcuts when budgeting for 2018. Creating a solid budget that’s based on the three components of your company’s financial statements will help you manage profits, cash flow and debt.

1. Income statement

Start the budgeting process with your income statement: Analyze revenues, margins, operating expenses, and profits or losses. If times have been tough, you may not even want to know how little income you’re pulling in, but it’s important to be aware of the specifics.

From an overall budgetary standpoint, gross profit margin is a critical metric. If your margin is declining, you may need to pivot quickly to increase your revenues or lower your costs. For example, you might plan to hire a new sales person, launch a new marketing campaign, discontinue an unprofitable segment or negotiate lower prices with a supplier.

It’s easy to get hung up on analyzing your income statement — particularly if your company is profitable. Yet bear in mind that this part of your budget doesn’t reflect cash-related activities such as buying new equipment or borrowing money from the bank. Today’s profitability may diminish in the face of tomorrow’s risks and threats. And the money you’ve earned may be dangerously tied up in working capital and other financial assets or obligations.

2. Statement of cash flow

Though gross margin is important, the center point of an effective budget is the statement of cash flow. It begins where the income statement leaves off — with your net income. From there, the statement is typically divided into three subsections:

  1. Operating cash flow (activities associated with running the business),
  2. Investing cash flow (activities associated with growing the business), and
  3. Financing cash flow (activities associated with obtaining money).

For many companies, cash ebbs and flows throughout the year. And, if you have large contracts or experience seasonal fluctuations, it can be hard to stay fiscally responsible when cash balances are high. Predicting exactly when cash will come in (or dry up) is tricky — but your CPA can help you make reasonable assumptions based on your historical payment data.

3. Balance sheet

Think of your balance sheet as a snapshot of your company’s financial condition on a given date. The balance sheet lists assets, liabilities and shareholders’ equity. Elements such as these can help you realistically shape your budget going forward.

For instance, budgeted balances for certain working capital accounts (such as accounts receivable, inventory and accounts payable) are typically driven by revenue and cost of sales. Loans will be repaid in accordance with their amortization schedules. So, the “plug” figure in a budgeted balance sheet is often a line of credit or shareholder loan. That is, if cash goes below a certain threshold, you’re likely to take on debt to make up for the shortfall.

Getting help

Companies that operate without a budget can quickly become cash poor and debt heavy. We can help review your financial statements and establish a feasible budget that puts you on the road to success in 2018 and beyond.

© 2017

 


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PREPAYMENT OF CERTAIN 2018 EXPENSES BY CASH BASIS TAXPAYERS MAY YIELD DEDUCTION BENEFIT IN 2017 DUE TO POTENTIAL TAX REFORM

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PREPAYMENT OF CERTAIN 2018 EXPENSES BY CASH BASIS TAXPAYERS MAY YIELD DEDUCTION BENEFIT IN 2017 DUE TO POTENTIAL TAX REFORM

Summary

As the Tax Cuts and Jobs Act makes its way through the House and Senate Conference Committee and put up for vote in both houses of Congress this week, cash basis taxpayers may be considering prepaying certain expenses in order to obtain relief from some of the Act’s provisions that eliminate or place limitations on tax deductions for taxable years beginning after December 31, 2017.  For federal income tax purposes, cash basis taxpayers generally can take into account amounts representing allowable deductions in the taxable year in which paid.  However, prepaying a 2018 liability or expense in 2017 without an obligation to do so is not a valid deduction, even for a cash basis taxpayer.  Based on case law, the prepayment of the liability or expense could be challenged by the Internal Revenue Service because the payment lacks business purpose or fails to clearly reflect income.  Further, if the benefit period or useful life associated with the prepaid expense exceeds 12 months, the payment is required to be capitalized and amortized.  That said, to the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability relates has been provided by year-end, and the benefit period does not exceed 12 months, cash basis taxpayers that prepay expenses in 2017 for 2018 expenses can claim a deduction in 2017.

Details

Tax Reform
On December 15, 2017, the House-Senate Conference Committee members working on the House and Senate tax reform bills signed off on a revised bill.  Issued that evening, the full language of the Tax Cuts and Jobs Act (H.R. 1) encompasses over 1,000 pages, including a 570-page joint explanatory statement describing key differences, if any, between the House and Senate tax reform bill, and a summary of the resolution of such differences in the revised bill.  The revised bill will be sent to both houses of Congress during the week beginning December 18, 2017, for a vote and could set the stage for the bill to be signed by the President prior to the end of 2017.

Among the many provisions affecting individuals and businesses, this alert specifically discusses the (1) modification of deduction for taxes not paid or accrued in a trade or business; (2) repeal of certain miscellaneous itemized deductions subject to the two-percent floor; and (3) entertainment expenses.

Modification of deduction for taxes not paid or accrued in a trade or business (section 164 of the Code) Under the revised bill, individuals generally can deduct State, local, and foreign property taxes and State and local sales taxes only when paid or accrued in carrying on a trade or business, or an activity described in section 212 (relating to expenses for the production of income).  Accordingly, the provision allows only those deductions for State, local, and foreign property taxes, and sales taxes, which are presently deductible in computing income on an individual’s Schedule C, Schedule E, or Schedule F on such individual’s tax return.  For example, in the case of property taxes, an individual may deduct such items only if these taxes were imposed on business assets (such as residential rental property).

Under the provision, in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.

The provision contains an exception to the above-stated rule.  Under the provision, a taxpayer may claim an itemized deduction of up to $10,000 ($5,000 for married taxpayer filing a separate return) for the aggregate of (i) State and local property taxes not paid or accrued in carrying on a trade or business, or an activity described in section 212, and (ii) State and local income, war profits, and excess profits taxes (or sales taxes in lieu of income, etc. taxes) paid or accrued in the taxable year.  Foreign real property taxes may not be deducted under this exception.

The above rules apply to taxable years beginning after December 31, 2017, and beginning before January 1, 2026.

The conference agreement also provides that, in the case of an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, the payment shall be treated as paid on the last day of the taxable year for which such tax is so imposed for purposes of applying the provision limiting the dollar amount of the deduction.

Observation: An individual may not claim an itemized deduction in 2017 on a pre-payment of state or local income tax for a future taxable year in order to avoid the dollar limitation applicable for taxable years beginning after 2017.  The prepayment in 2017 would have no direct link to taxable income for the 2018 tax year; therefore, a payment made to a state or local government in 2017 to apply against the taxpayer’s 2018 tax liability is merely a deposit for which no tax deduction is permitted.  However, if the taxpayer has an estimated income tax payment due in April of 2018 based on 2017 taxable income, prepaying the tax in 2017 rather than 2018 would yield a proper deduction in 2017 and possibly generate the benefit of time value of money if tax rates fall in 2018.

Repeal of Certain Miscellaneous Itemized Deductions Subject to the Two-Percent Floor (Sections 62, 67, and 212 of the Code)
The conference agreement temporarily suspends all miscellaneous itemized deductions that are subject to the two-percent floor under present law.  Miscellaneous itemized deductions include, for example, fees to collect interest and dividends, investment fees and expenses, tax preparation expenses, and unreimbursed business expenses incurred by an employee.  Thus, under the provision, taxpayers may not claim items as itemized deductions for the taxable year beginning after December 31, 2017, and before January 1, 2026.

Observation: To the extent that the taxpayer has an invoice in hand by year-end or the consideration to which the liability has been provided by year-end, thereby establishing an obligation to pay on the taxpayer’s part, a cash basis taxpayer prepaying the expense in 2017 rather than in 2018 could reasonably claim a deduction in the earlier year, so long as the prepaid benefit period does not exceed 12 months. 

Entertainment, etc. expenses (Section 274 of the Code)
Under the conference agreement, no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or (3) a facility or portion thereof used in connection with any of the above items.  As a result, the provision repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions).

In addition, the provision disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.
Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).  For amounts incurred and paid after December 31, 2017, and until December 31, 2025, the provision expands this 50-percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer.

The provision generally applies to amounts paid or incurred after December 31, 2017.  However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025, are not deductible.

Observation: A cash basis taxpayer should take action to immediately pay any entertainment expense invoices and expense reports during 2017.  If commitments exist for the 2018 year which are budgeted for (e.g., 2018 season tickets), the taxpayer is advised to request an invoice from the seller before year-end so that the amount can be prepaid in 2017.  

Other Types of Expenses
There are a number of expenses that cash basis taxpayers may wish to consider prepaying in order to obtain a tax benefit in 2017.  The federal tax treatment below assumes that the benefit period associated with the prepaid expense does not exceed 12 months.

MOVING EXPENSES
The conference agreement generally suspends the deduction for moving expenses for taxable years 2018 through 2025.  However, during that suspension period, the provision retains the deduction for moving expenses and the rules providing for exclusions of amounts attributable to in-kind moving and storage expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces (or their spouse or dependents) on active duty that move pursuant to a military order and incident to a permanent change of station.  Taxpayers outside of the Armed Forces exception may wish to prepay an invoice in 2017 for 2018 moving expenses in order to take advantage of the moving expenses deduction before suspension.

HOME MORTGAGE INDEBTEDNESS
The conference agreement suspends the deduction for interest on home equity indebtedness.  Thus, for taxable years beginning after December 31, 2017, a taxpayer may not claim a deduction for interest on home equity indebtedness. The suspension ends for taxable years beginning after December 31, 2025.  In this regard, cash basis taxpayers should consider prepaying “points” charged in 2017 in order to take advantage of the home equity indebtedness deduction before the suspension period. Although a taxpayer must capitalize interest that is properly allocable to a period that extends beyond the close of the taxable year and amortize it over the period to which it applies, section 461(g)(2) provides an exception for points paid in respect of any indebtedness incurred in connection with the purchase or improvement of, and secured by, the taxpayer’s principal residence to the extent that such payment of points is an established business practice in the area in which such indebtedness is incurred and the amount of such payment does not exceed the amount generally charged in such area.  Points paid in refinancings may not meet the exception.

PREPAID RENT
Accelerating a deduction from 2018 to 2017 can provide time value of money benefits to the extent that the tax rates drop in 2018.  Generally speaking, prepaid rent can be deducted by a cash basis taxpayer in the year of payment so long as the lease agreement calls for rent to be prepaid prior to the beginning of the month to which the rent payment relates.  Cash basis taxpayers must also be aware that the prepaid benefit period cannot exceed 12 months.  Thus, for example, if the lease agreement requires January 2018 rent to be paid by the end of December, the lessee can claim an accelerated deduction by prepaying for the next month.  On the contrary, if the lease agreement calls for January 2018 rent to be due on the first day of that month, prepaying in 2017 would not result in an earlier deduction.

 


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Should you buy a business vehicle before year end?

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One way to reduce your 2017 tax bill is to buy a business vehicle before year end. But don’t make a purchase without first looking at what your 2017 deduction would be and whether tax reform legislation could affect the tax benefit of a 2017 vs. 2018 purchase.

Your 2017 deduction

Business-related purchases of new or used vehicles may be eligible for Section 179 expensing, which allows you to immediately deduct, rather than depreciate over a period of years, some or all of the vehicle’s cost. But the size of your 2017 deduction will depend on several factors. One is the gross vehicle weight rating.

The normal Sec. 179 expensing limit generally applies to vehicles with a gross vehicle weight rating of more than 14,000 pounds. The limit for 2017 is $510,000, and the break begins to phase out dollar-for-dollar when total asset acquisitions for the tax year exceed $2.03 million.

But a $25,000 limit applies to SUVs rated at more than 6,000 pounds but no more than 14,000 pounds. Vehicles rated at 6,000 pounds or less are subject to the passenger automobile limits. For 2017, under current law, the depreciation limit is $3,160. And the amount that may be deducted under the combination of Modified Accelerated Cost Recovery System (MACRS) depreciation and Sec. 179 for the first year is limited under the luxury auto rules to $11,160.

In addition, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If the business use is 50% or less, you can’t use Sec. 179 expensing or the accelerated regular MACRS; you must use the straight-line method.

Factoring in tax reform

If tax reform legislation is signed into law and it will cause your marginal rate to go down in 2018, then purchasing a vehicle by December 31, 2017, could save you more tax than waiting until 2018. Why? Tax deductions are more powerful when rates are higher. But if your 2017 Sec. 179 expense deduction would be reduced or eliminated because of the asset acquisition phaseout, then you might be better off waiting until 2018 to buy.

Also be aware that tax reform legislation could affect the depreciation limits for passenger vehicles, even if purchased in 2017.

These are just a few factors to look at. Many additional rules and limits apply to these breaks. So if you’re considering a business vehicle purchase, contact us to discuss whether it would make more tax sense to buy this year or next.

© 2017

 


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