Mission Critical Elements: Accounting and Tax Considerations

 

Mission Critical Elements

Accounting system

Method of accounting

Accounting policies

Budget, cash flows, projections

Internal controls

 

 1. Accounting System

Quickbooks or similar programs offer a flexible, off the shelf, inexpensive solution

 

 2. Create Chart of Accounts appropriate to your business

3. Choose an Accounting Method

Make an informed choice based on your business:

Cash: easier to maintain, won’t work with inventory-based businesses (but investors and banks generally need more information than what this method provides)

Accrual: more transaction intensive, but more clear to investors, others

OCBOA (tax): a hybrid method which gives a clearer picture from a tax point of view  

Consider:

Does accounting method work for your tax issues (incl. state tax and nexus issues)?

Depreciation methods?

What is deductible?

 4. Create Accounting Policies

Include how you’ll handle:

Revenue recognition

Capitalization

Equity

Look to the SEC, to industry, to GAAP rules to provide direction appropriate for your business

Revenue recognition: Different Approaches

GAAP: comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions.  

SEC: Must meet all the following criteria :

Persuasive evidence of an arrangement exists,

Delivery has occurred or services have been rendered,

The seller's price to the buyer is fixed or determinable, and

Collectibility is reasonably assured.

Tricky parts are:

Revenue arrangements with multiple deliveries

Bill-and-hold arrangements

When does delivery occur, what about immaterial remaining obligations

Non-refundable up-front fees  

Capitalization

An accounting method used to delay the recognition of expenses by recording the expense as long-term assets. Consider how to treat:

Long lived assets

R&D

Software development

Equity

You can give away the farm here if not careful

Stock options

Hybrid instruments

Donated / in-kind services How these agreements are structured will help point the way in terms of how the accounting takes place

 5. Tax Consequences of Formation

Neither a corporation, a partnership, nor an LLC is ordinarily taxed on the receipt of capital contributions by shareholders, partners, or members (as applicable).

 Shareholders, partners, or LLC members may be taxed on the contribution, depending on the nature of

the contribution  

Contributions of Property

The contribution of property in exchange for shares of corporate stock (including shares in an S corporation) is a taxable event for the contributing party unless the transaction constitutes a tax-free exchange (transfers to a controlled corporation).

If a contribution of property to a corporation is taxable, it will be treated as a sale of the property in exchange for the shares of corporate stock and the shareholder will usually be taxed on the difference between the shareholder's basis in the property and the property's fair market value.

The contribution of property in exchange for an interest in either a partnership or an LLC is generally not a taxable event, and will not subject the contributing partner or member to tax liability. If the contributed property is subject to a liability, the contributing partner or member may recognize gain.

 

Sweat equity and the LLC

If a person contributes services to an LLC in exchange for a member's interest, the contributing member will not generally be taxed so long as he or she receives only an interest in the profits of the LLC.

If the contributing member receives an interest in the capital of the LLC in exchange for past or

future services, he or she will be deemed to have received taxable compensation income equal to the value of the capital interest. The LLC will have a corresponding deduction for compensation paid.

Services in exchange for stock are generally taxable

 6. Financial Statement Characteristics:

Understand the need/use

Prospective financial statements have four characteristics. If a presentation lacks any one of the four, it is not a prospective financial statement. Prospective financial statements should

a. Include certain minimum financial statement elements  

b. Cover a future period  c. Be prepared for an entity  d. Be the responsibility of the responsible party

Minimum Items The minimum items that are required, to the extent that they are applicable, include:

Minimum Financial Statement Elements

Sales or gross revenue

Gross profit or cost of sales.

Unusual or infrequently occurring items

Provision for income taxes.

Discontinued operations or extraordinary items.

Income from continuing operations

Net income.  

Significant changes in financial position

Required Disclosures

A description of what the responsible party intends the presentation to present, a statement that the assumptions are based on the responsible party's judgment at the time the prospective information was prepared, and a caveat that the results may not be achieved.

Summary of significant assumptions.

Summary of significant accounting policies.

 7. Internal Controls:

A system of specific policies and procedures designed to provide management with reasonable assurance that the financial objectives can be met. Should be applied to manual and computerized systems.

Why have them?

Support operational efficiency

Provide confidence in financial information

Safeguard your assets and records

Have proper authorization for transactions

Comply with regulations and investor expectations

Attract more capital

Reduce opportunity for fraud

Your Control System should include:

Tone at the Top: strong highly ethical ownership / senior management team which sets the tone that permeates the corporate culture (i.e. talk the talk, walk the walk)

Segregation of Duties: Separate incompatible functions; remove possible temptations and opportunity (e.g. can’t steal and conceal)

Analysis of potential exposure and systems to mitigate risk

Clear procedures for authorization

Principal incompatible duties to be segregated are:

– Custody of assets

– Authorization or approval of related transactions affecting those assets

– Recording or reporting of related transactions