Tony’s Five  Minute (or so) Accounting Course

Take this for what it is worth.  I have tried to simplify (as much as possible) what you really need to know to understand where you are, and where you are heading financially.  Even more importantly, what the IRS thinks about what you are doing.

 

I have been in business since 1978, and incorporated in 1981. In 1985 our company starting selling a significant amount of computers and supplies.  We soon acquired a significant inventory.

 

Prior to 1985 we used the Professional Accounting Method to balance our books, and pay tribute to the IRS. The Professional Accounting Method is a very simple method where you just work out of your checkbook. All checks you write are expenses, all deposits are profits. At the end of the year, if anything is left, it is your profit. The government takes everything left as taxes, and you go to the next year.

 

A few centuries ago a bunch of monks devised a new system called Two Column General Ledger Accounting using the Accrual Method. This is a very clever way of stating your company’s yearly activity. It provides the mechanisms to carry credits and debits across accounting periods (year to year).  Please understand that I am not a CPA, so only accept this information as coming from a lay person’s (taxpayer’s) point of view. Most accountants will find something imperfect with my simplistic explanation, and that is how they make their livings. They are  much like priests.

The IRS seems to feel that once your inventory on hand becomes a "significant" part of your business, you must "Capitalize" the inventory. Capitalize is a polite way of saying that the items in inventory are NOT an expense item, but rather part of your companies "capital". JUST AS THOUGH IT WERE CASH.  Inventory is only considered as an expense at the time an item is sold.

 

 

That means YOU!!

 

It usually takes several attempts at thinking about this in order to fully understand.  Most people just don't believe that the math can work this way:

 

Let's say you start an accounting period with $25,000 in inventory.

 

You add $100,000 worth of inventory during the period (you have written checks for that amount).

 

You sales of books is $175,000  (you essentially have used some of your profit to fund the additional inventory shown above.)

 

Your inventory count at the end of the year is $60.000

 

Cost of inventory used = $125,000 - $60,000 = $65,000

 

Profit = $175,000 - $65,000  = $110,000

 

Where did your extra $35,000 ($100,000 - $65,000) go?  You might think this is an additional cost to you, but it is NOT!  Your starting inventory count for the new period has increased by that value.  It is just like having the extra money in your checking account.

 

STOP and think about this for a second, OOOOOUCH!!

Unless you know about this and plan for it, the year you first start capitalizing your inventory will put the financial hurts on you on a scale you have never seen in your life! When and how does this transition happen? It occurs in one of two ways:

 

I have spent the better part of the last 25 years consulting with hundreds of Veterinarians.  CRT Systems has computerized hundreds of clinics and hospitals all over the country.  Many of these were very small businesses when we first started working with them.  Many owners were youngsters, just out of Vet School.  All of them started small, and used professional accounting.  When they were ready to really start growing, many of them (in the east and mid west, at least) employed an internationally known accounting firm in Cleveland, Ohio specializing in the Veterinary Business Practices.  In order for them to help, the accounting firm insists that the hospital first capitalize their inventory since the principal partner of the accounting firms considers not doing so as tax fraud.

 

Here’s how it goes down. You must do a complete inventory count, and place a value on each book you have in stock. You value each inventory item in either (the lesser of)… how much you Paid for it, or how much it will sell for (its worth). Yes, this provides for a little gray area, and this is truly the genius of this method of accounting, Please be certain, however, that the IRS agents are not fools. Ok, you did this, and let’s say the inventory value is $50,000. Start thinking right then of how you are going to come up with $15,000 to pay your State and Federal Income Taxes. Sounds unfair? Maybe It is! This is one method the government uses to insure that a small businessman does not become a large businessman. In actuality it prevents you from acquiring non-taxed wealth. Taxing in this way assures that you "pay as you go". In the early days of the twentieth century, many tycoons became multi millionaires by placing their profits into inventory, thus protecting it from taxes.  You wouldn't want to become wealthy, would you?

 

Used books present a rather unique problem. In my discussions with several CPAs, the thinking goes something like this. You didn't pay anything for the books, therefore they have no value…. But wait, you make a living selling these items…. Also, you are giving store credits when you take these books, and the credits offset the sale of other used books. More obscurely…. you have some labor involved in evaluating, and stocking these items, so you have an accrued cost /value in these items. In other words, since you can write off salary as an expense, you shouldn't write off the part of salary dealing with handling books, if you say they do not have any value. The proceeding notion is admittedly very obscure, but very real when viewed in the overall scheme of things.

 

Another notion is... do you have the contents of your place of business insured?  Are the books insured?  How about your personal and business financial reports that you give to your banker.  Do they tell the same story as your taxes?

 

To keep everybody happy, I value all of my used books at thirty cents each.

 

I do believe, however, that you can depreciate your inventory on a three-year basis.  Contemporary books become less valuable as time passes by, and you have some wear and tear on the books as they sit on your shelf.  Check this out with you accountant.

 

How about the credits you are giving and honoring? A neat argument can be made that these credits should be some sort of a deduction/credit against inventory or future sales. Yes, that’s a good argument, the exact one that I tried to make. The problem is that the airlines tried to make the same argument about frequent flyer miles. The courts ruled against this saying that frequent flyer miles may indeed be used at the time a ticket was issued. The ticket should cost $600 - 30,000 frequent flyer miles were used instead (THEN), so $600 into sales minus $600 in credits, just zeroes the transaction. Too bad!! The courts will rule against you too.  The credits can only be used to offset your "pre credit" price on the books at the time they are sold.  Therefor if you sold a $4.00 book for $2.00 plus $2.00 credit you only need report $2.00.  So... no help.

 

Now this brings up the question of why should you specifically account for outstanding credits..  They do you no good, tax wise, but I'll bet dollars to donuts that a prospective buyer of your business will want to deduct credits as a liability against your future sales and inventory when evaluating the value of your business.

 

But wait, there are a few more components to Accrual Accounting.

 

It you owe money (to others) on your inventory, or other items, this is called Accounts Payable. Some of these are used to offset your cash and inventory. Because of another term called depreciation, you must employ an accountant to figure this out. For example when you purchase that new RV, used to attend book conventions, $100,000 of its costs MAY be used the first year as Accelerated Depreciation. Just be sure that your accountant will be just as positive about his facts during your visit to the IRS as he is with you today. Those new bookcases that you installed for $4,000 probably cannot be expensed the first year. Go figure! To become wealthy, by the IRS allowing you to keep some of your profits, you need to learn the rules of the game, and become a pro at playing.

What about sales taxes?  This varies from state to state.  In my state, you need to collect sales taxes on the amount of money paid of a book, after the trade credits are applied.  $4.00 book, minus $2.00 in credit.  $2.00, this is the amount to be taxed.  Some states are a bit more clever.  They consider a trading book store a barter business, so they want to tax the full value of the book BEFORE any credits are applies.  This means even if the customer pays for the entire transactions with credits.  So regardless of how much you collected for the $4.00 book, you must collect tax on the original $4.00.

 

If you maintain any Accounts Receivables (someone owes you money), you must add this into your profits, just like it was listed as cash in your checkbook. This seems silly also. What if you cannot collect? You can eventually write the amount off as a bad debt. But alas, all this does is take this money out of your virtual checkbook. Remember, you’ve already paid taxes on it  Writing this debt off at least allows you to recoup the taxes you have earlier paid. The IRS insists, however, that you have done everything possible to collect the debt.  Your final revenge (if you know the debtor's SSN) is to file a 1090 on the amount owned by him.

 

So, what’s the point of all of this?

The point is....  if you wish to increase the size of your business, you must learn how all of the decisions you are making will affect your owed income (and other) taxes. This is knows as Tax Planning. Although it is technically illegal to perform a transaction just to get on the better side of a tax problem, all successful businesses do so (Tax Planning). Knowing where you are at, especially when approaching the end of your fiscal year, is critical.  Let's say you have a book on hand with a cost of $10.00 when you do your inventory.  Remember, this book takes $10.00 out of your cash flow, plus $3.50 that you are going to pay in Federal and State Taxes (assuming your business shows a profit this year).  Having a few is good, having thousands of these (that are not selling on a weekly basis) might present a problem.

 

In order for a bookstore’s sales to grow, I know that on-hand inventory is important. People like to shop stores with "lots of different books". You need information, on a regular basis to make intelligent inventory buying decisions. Having three books of the same title, when one will do makes no sense at all (to me). Since book distributors, such as Ingram, will deliver books that you order overnight.  Having accurate daily sales information allows you to precisely control your inventory costs, thus your tax liabilities.

 

In summary... real time information about your business is vital to its success.  Using software that makes this job easy for you will pay for itself over and over, time and time again.

 

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