Acuity Advisors

How to minimize surprises during physical inventory counts

Counting inventories of raw materials, work in progress, finished goods, and parts and supplies is necessary for accurate recordkeeping, but it can be tedious. There’s almost always a variance between what’s on the shelves and what’s in your perpetual inventory system or general ledger. A relatively small difference shouldn’t give rise to panic. But a variance that exceeds 3% to 5% is a cause for concern. Here are some ideas for minimizing discrepancies.

Finding the cause

Most differences result from timing gaps between order entry, physical receipt of inventory items and invoice entry. Open orders and returns also cause legitimate discrepancies. But some variances signal problems, such as careless receiving and ordering practices, billing and data entry errors, poor communication between the production, warehouse and accounting departments, and even fraud.

Monthly inventory counts can catch errors before they spiral out of control. Your objectives: Identify sources of any discrepancies; locate missing, damaged or inaccurately priced items; and train employees to prevent mistakes from recurring.

Implementing safeguards

Inventory can be a prime target for thieves inside and outside your organization. To prevent shrinkage, conduct background checks on personnel and consider such physical controls as:

Locking inventory storerooms even during business hours,
Limiting access to the storeroom and its keys,
Installing security cameras, alarms and mirrors,
Recording serial numbers or tags for high-value items, and
Spot-checking inventories periodically.

The cost of these safeguards is recouped with fewer write-offs for lost, stolen or damaged items. They also create a sense of accountability for personnel with access to the storeroom.

Outsourcing your count

A third-party count not only may be more objective than one done by employees — especially in case of fraud — but also can be faster. We participate in dozens of physical counts each year and know the most efficient approach. Contact us for help counting and managing your inventory.

Stay up to date! Subscribe to our future blog posts!

Borrowing from your corporation? Structure the transaction carefully

Whenever cash or property passes between a closely held corporation and its shareholders, there are generally tax consequences. You can control the consequences by documenting your intentions for the transactions and by following through accordingly.

For example, let’s say a shareholder takes withdrawals from a corporation’s accounts that are intended as tax-free loans — but they aren’t properly documented. In an audit, the IRS will likely recharacterize them as constructive dividends with capital gains tax due.

Important factors

The IRS and courts examine a number of factors to determine if payments to a shareholder are proceeds from a tax-free loan or a taxable corporate distribution. Some questions:

Was there a written promise to repay the loan evidenced by a note or other document?
Was there a stated interest rate, repayment schedule or balloon repayment date?
Were principal and interest payments made on time?
Was there adequate security or collateral for the loan?
Did the borrower have a reasonable prospect of being able to repay the loan?
Did the parties conduct themselves as if the transaction was a loan? For example, did the shareholder show loans owed to the corporation as liabilities on his or her personal balance sheet?

When transactions are intended to be loans, the factors above should be considered and respected. Otherwise, the IRS could recharacterize the transactions in ways that have negative tax consequences for shareholders, their corporations, or both.

Plan ahead

Properly structuring corporate loans is critical to getting the best tax and financial results. Contact us for assistance plotting the best strategy.

Stay up to date! Subscribe to our future blog posts!

Financial statement disclosures: A closer look at materiality

Shakespeare thinking.

The concept of “materiality” helps management identify what’s important enough to a company’s financial well-being to warrant additional disclosures in the financial statements. Unfortunately, the FASB doesn’t currently define what information should be considered “material” under Generally Accepted Accounting Principles.

Investors don’t generally view materiality in terms of rule-of-thumb percentages. Instead, they see it as a qualitative, legal concept. The U.S. Supreme Court’s description of materiality is a “substantial likelihood” that omitting the information would be viewed by a reasonable investor or creditor as having “significantly altered” the total information available to make a decision.

Proposals attempt clarity

In late 2015, the FASB released two related proposals to guide businesses on when to include information in a footnote disclosure and when to omit it. Under the proposals, businesses would be required to assess whether investors will find the information useful and whether the information fits the legal concept of materiality.

Concerns mount

Many businesses are concerned that the Supreme Court’s definition of materiality could evolve over time — and potentially morph into something that’s overly prescriptive or otherwise undesirable from a financial reporting perspective. So, the FASB is considering omitting any specific references to the Court’s definition.

To further complicate matters, if the FASB adopts these proposals, its definition of materiality could differ somewhat from the definition set forth by the International Accounting Standards Board.

Materiality is a gray area

The proposed changes to the materiality framework are designed to help facilitate management’s decision-making process. They aim to eliminate unhelpful, boilerplate information in the footnotes that makes it harder for investors to get at important facts.

During a March 2016 meeting, the FASB reviewed comments letters on its proposals. Now the project is back in the re-deliberation phase. Contact us for the latest information about this fundamental financial reporting concept.

Stay up to date! Subscribe to our future blog posts!

Demystifying the percentage-of-completion method

Businessman depressed

Long-term projects usually require a different approach to recognizing revenues called the “percentage-of-completion” method. It’s used by homebuilders, developers, creative agencies, engineering firms and many other types of companies. Here’s how it works.

Dueling methods

Contracts that last for more than one calendar year can be reported two ways:

The completed contract method. It records revenues and expenses upon completion of the contract terms.
The percentage-of-completion method. It ties revenue recognition to the incurrence of job costs.

GAAP generally prescribes the latter method, as long as you can make estimates that are “sufficiently dependable.” Most companies with long-term contracts also must use this method for federal income tax purposes. (An exception is permitted for companies with less than $10 million in annual revenues.)

Project status

Companies typically compare the actual costs incurred to expected total costs to estimate percentage complete. Alternatively, some may opt to estimate the percentage complete with an annual completion factor. To support this technique, the IRS requires detailed documentation.

Balance sheet effect

The percentage-of-completion method can also impact your balance sheet. Suppose you’re working on a $1 million, two-year project. You incur half of the expected costs in Year 1 ($400,000) and bill the customer $450,000. From a cash perspective, it seems like you’re $50,000 ahead because you’ve collected more than the costs you’ve incurred. But, you’ve actually underbilled based on the percentage of costs incurred.

So, at the end of Year 1, you’d report $500,000 in revenues, $400,000 in costs, and an asset for costs in excess of billings of $50,000. If you had billed the customer $550,000, however, you’d report a $50,000 liability for billings in excess of costs.

Confounding factors

This method necessitates subjective estimates about expected costs. It’s further complicated by job cost allocation policies, change orders, changes in estimates, and differences between book and tax accounting methods. Contact us for help training your staff on how this method works — or we can perform the analysis for you.

Stay up to date! Subscribe to our future blog posts!

Unexpected retirement plan disqualification can trigger serious tax problems

It’s not unusual for the IRS to conduct audits of qualified employee benefit plans, including 401(k)s. Plan sponsors are expected to stay in compliance with numerous, frequently changing federal laws and regulations.

For example, have you identified all employees eligible for your 401(k) plan and given them the opportunity to make deferral elections? Are employee contributions limited to the amounts allowed under tax law for the calendar year? Does your 401(k) plan pass nondiscrimination tests? Traditional 401(k) plans must be regularly tested to ensure that the contributions don’t discriminate in favor of highly compensated employees.

If the IRS uncovers compliance errors and the plan sponsor doesn’t fix them, the plan could be disqualified.

What happens if qualified status is lost?

Tax law and administrative details that may seem trivial or irrelevant may actually be critical to maintaining a plan’s qualified status. If a plan loses its tax-exempt status, each participant is taxed on the value of his or her vested benefits as of the disqualification date. That can result in large (and completely unexpected) tax liabilities for participants.

In addition, contributions and earnings that occur after the disqualification date aren’t tax-free. They must be included in participants’ taxable incomes. The employer’s tax deductions for plan contributions are also at risk. There are also penalties and fees that can be devastating to a business.

Finally, withdrawals made after the disqualification date cannot be rolled over into other tax-favored retirement plans or accounts (such as IRAs).

Voluntary corrections

The good news is that 401(k) plan errors can often be voluntarily corrected. We can help determine if changes should be made to your company’s qualified plan to achieve and maintain compliance. Contact us for more information.

Stay up to date! Subscribe to our future blog posts!