5 Things You Should Expect From Your CPA

And There Are More

What should you expect from your CPA? What in-grained traits do you want them to have? You expect them to be honest, of course. That’s critically important. But what else? Do you want your accountant to be an air traffic controller watching and safeguarding your business assets and transactions? Many company controllers take that role. In this article, we drill down to the core to see what makes a good accountant tick. And from that, we identified the following five traits your CPA should possess.

Organization and Concise Clarity. Organization is the defining attribute of an accountant. It’s the cornerstone. Without organization, there is chaos. You should expect your accountant to be able to take an overwhelming amount of disjointed and seeming unrelated information and sift it down to concise clarity. He or she should be able to explain to you what it means. That’s what a business needs. Too much information is, well, just that – too much information. Management cannot reach meaningful decisions without concise clarity. And clarity cannot be achieved without organization. What does this pile of numbers mean? That’s the question your CPA should be able to answer.

I recall an anecdotal story about President Reagan. A member of his staff presented him with a behemoth report. In his non-threatening manner, the President requested the aide to summarize it to about one or two pages. One or two pages, sir, the aide asked? To which Reagan replied… you’re right, make it one page.

Even the most complicated areas of physics, when properly understood, can be expressed in a very concise way. Albert Einstein synthesized his special theory of relativity’s complexities to the now-famous equation of E = mc 2. And James Maxwell described the non-intuitive interrelation of electric and magnetic fields with only four equations. It’s called organization and concise clarity.

Communication. Communication doesn’t have to dazzle. But to be authentic, communication must be understood.

CPAs, as a group, are not exactly known for their communication skills. Think Louis Tully (played by Rick Moranis) in Ghostbusters. Or the accountant joke, What do you call an accountant that speaks to one person a day? Popular.”

I recall a time several decades ago when, as a young CPA, I attended a local country club’s annual membership meeting. Of course, a fine meal was included. My firm performed the yearly audit. That evening, my job was to hand-deliver the audit report to the club’s treasurer (a partner for a then Big-Eight accounting firm) and brief him in private before he made the presentation to the membership group. As it turned out, when the treasurer stood before the large group to deliver the report, he mentioned that I was there and turned the presentation over to me. That fine steak I was enjoying suddenly turned sour in my stomach. The presentation did not go well. However, I think the membership group had a very good time. One thing for sure, though, it did impress upon me the importance of communication.

Communication is an essential skill for a CPA. And your CPA should have the ability to communicate with clarity. When there is a need to renegotiate the company’s bank line of credit, the CPA will be involved. If it’s discussions with the company’s surety regarding a problematic project, the accountant will be front and center. Conversations with project managers regarding project evaluations will need input from the company’s CPA. And, discussions of quarterly financial results with the ownership group or the company’s board of directors require a combination of the communicative and diplomatic skills of the CPA. It’s called communication.

Analytical. Being analytical for an accountant is somewhat akin to critical thinking. It’s objectively reasoning through a complicated situation to come to a (hopefully correct) judgment.

My observation is that many, if not most, students attracted to the accounting profession are drawn to it because they are analytical by nature. They enjoy and are successful at working through puzzles. They find that this attribute is helpful in many of the accounting courses they take in college.

Solutions to accounting issues are not always apparent. Accordingly, your company’s CPA should be well-versed in the use of research tools. Research is critical in tax planning. Research is essential to financial reporting. The answer to most difficult questions is “maybe yes and maybe no, it ain’t necessarily so.” Analytically reasoned judgment is required.

Most of accounting is not black and white. For example, the area of accounting estimates is problematic. They can make a significant difference in the company’s financial statements and taxable income. Areas affected by accounting estimates include the determination of contract gross profit, depreciation, and warranty reserves. An analytical approach is beneficial in arriving at an appropriate range of values for estimates.

Your accountant should be analytical. An analytical mind can unravel a thorny problem and come to reasonable conclusions. But beware. It can also drive you up a wall. What may seem clear to you may not strike your CPA the same way. They want to explore a few more avenues. Turn over more stones. Be professionally skeptical. But, on the whole, you should expect your CPA to possess this characteristic. It’s called analytical.

Accurate. Your CPA should be accurate. Precise information is necessary when drafting your company’s ongoing business strategy, determining bonuses, and developing tax projections. Much of that information comes from your accountant. To be a trusted business advisor, your accountant should provide reliable data.

But just how precise should you expect your CPA to be? After all, accountants deal in numbers, and since numbers are pretty exact, there is only one correct answer, right? Well, not really. As described above, accounting estimates are just that — estimates. There may be a range of acceptable values. Any value within that range will be considered accurate, even if later, it’s found not to be very close.

Furthermore, for financial statement reporting, the concept of accuracy is intertwined with the concept of materiality. Misstatements are considered material if there is a substantial likelihood they would influence the judgment made by a reasonable user based on the financial statements.

If the financial statements are somewhat inaccurate, but those inaccuracies do not mislead a “reasonable user,” then the financial statements are not materially misstated. In other words, even though the financial statements are not precisely accurate, they are accurate enough if the end-user would otherwise come to the same conclusion.

So, yes. You should expect your accountant to be accurate. But you don’t want him or her chasing every penny. The particular accounting area and the task drive the degree of accuracy expected. For example, you should expect a much higher degree of accuracy in the area of cash than you do in the area of prepaid insurance. It’s a matter of professional judgment. It’s called accurate.

Business Savvy. You want an accountant that has an interest in your industry. A CPA that likes what you do. Someone fascinated with your work will naturally learn more and understand more about your business sector because they have that interest.

I know CPAs who practice in the construction industry. They are very good at what they do. They frequent heavy equipment auctions during their off-hours because they enjoy it. They like the smell of asphalt and are fascinated by the engineering that goes into highway construction. They know the names of your subcontractors. They understand the types of contracts you enter into. They follow the bid tabs. They are good at what they do because they know the business itself. They understand where profit leaks can develop. They know the soft areas susceptible to fraud. They have an antenna up for the business risks and are familiar with ways to minimize those risks.

You should expect this in your CPA. It’s called business savvy.

How About Another Accounting Quiz? (Along with a Few More Answers)

Part II

Last month we presented some questions (along with suggested answers) related to the Paycheck Protection Program. Part II of this Q&A blog will focus on construction accounting. Specifically, the spotlight will be on accounting for long-term construction contracts.

Construction accounting can be somewhat counter-intuitive. For example, billings and revenue generally are not the same thing. Also, an asset nicknamed underbillings may cause considerable concern to end-users of the financial statements, such as the company’s surety. At the same time, a liability referred to as overbillings may be construed in a favorable light. So, without further ado, here we go.

  1. Did the relatively new revenue recognition standard (ASC Topic 606) eliminate the percentage of completion accounting for long-term construction contracts?
    • a. No. Percentage-of-completion revenue recognition method was incorporated into ASC 606 without any variances from the prior approach under ASC 605.
    • b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.
    • c. Yes. ASC 606 specifically eliminated the percentage-of-completion approach to revenue recognition for long-term contracts.
    • d. Yes. All construction contracts are accounted for on either the cash or accrual method, whichever best approximates the transfer of goods and services to the customer.

  2. In job cost accounting for a construction company, unsubstantiated reclassification of cost from one contract to another (aka cost-shifting) may be done to:
    • a. Fraudulently increase construction revenue and gross profit for financial statement presentation.
    • b. Conceal a loss contract.
    • c. Increase project manager bonuses based on contact performance.
    • d. All of the above.

  3. 3. Under ASC Topic 606 for a construction contractor, wasted cost, such as the purchase and installation cost of materials that do not meet specifications, and therefore must be replaced:
    • a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.
    • b. Are charged to job cost and included in the percentage-of-completion calculation with both the percentage-of-completion numerator and denominator adjusted accordingly.
    • c. Are captured as inventoriable job cost and subject to write-off at the end of the job, based on contract evaluation.
    • d. Are charged to indirect job cost not subject to allocation to work-in-progress contracts. It is presented as a mezzanine classification on the statement of income between gross profit from operations and general and administrative expenses.

  4. 4. A general contractor negotiates a new revolving-line-of-credit secured by accounts receivable and the personal guarantees of the company’s members. The bank promissory note specifies a maturity date of three years. How should the LOC be classified on the balance sheet at the end of the first year?
    • a. As a current liability, since the company assets securing the obligation are presented as current assets.
    • b. As a current liability, if the company expects to repay the outstanding balance during the next subsequent year.
    • c. As a long-term liability, but only if the company is contractually permitted and intends to delay repayments until maturity.
    • d. As a long-term liability, since the term of the promissory note has a long-term maturity date.
    • e. It depends.

  5. Our construction company obtained a contract in a specialty that is new to us. Therefore, we experienced a reasonably steep learning curve during the first half of the contract. How should we account for the learning curve cost?
    • a. The learning curve cost should be capitalized and amortized straight-line over the entire term of the contract. Otherwise, you bunch up the revenue during the first half of the job and may end up showing a loss in the second half.
    • b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.
    • c. Learning curve costs should be presented as general and administrative expenses. If charged to job cost, the contract would earn more revenue during the inefficient learning curve stage.
    • d. Since learning curve costs do not contribute to the contract’s performance, those costs should be excluded from the percentage-of-completion calculation.

Here are the answers:

1b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.

The percentage-of-completion method survived under ASC 606 as a type of input method, but it’s not front and center. What are front and center is the new five-step method of determining revenue recognition from customers. The basic premise of ASC 606 is that “…an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” This premise is embodied in the five-step method of recognizing revenue from customers:

  1. Identify the contract with the customer
  2. Identify the performance obligation in the contract
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue as performance obligations are satisfied.

2d. All of the above.

Cost shifting is deceptively dangerous. On the face of it, it looks like reclassifying costs from one contract to another will not affect the overall gross profit. Not exactly correct. It can have a considerable effect if, for example, $1 million of cost is improperly reclassified (shifted) from a completed contract showing a loss to a very profitable uncompleted contract at 50% complete. Consider the following example where a company performs two contracts for the year:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $6 million
    • Gross loss of $1 million
  • Uncompleted contract 50% complete with the following at year-end:
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $5 million (50% of $10 million projected revenue)
    • Cost-to-date of $4 million
    • Gross profit to date of $1 million

The project manager is responsible for both contracts and has system rights to reclassify costs between jobs. The PM is very unhappy with his combined gross profit of zero because his annual bonus is paid on contract profitability. Therefore, he quietly moves $1 million from the completed loss job to the profitable uncompleted job. Here is the effect:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $5 million
    • The job breaks even with a gross profit of $0.
  • Uncompleted contract (now 62.5% complete with the following at year-end):
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $6.25 million (62.5% of $10 million projected revenue)
    • Cost-to-date of $5 million
    • Gross profit to date of $1.25 million

So, at year-end, the PM picked up $1.25 million with a sleight of hand. However, this will come back to haunt him the following year. His uncompleted contract will finish with only $1 million job-to-date gross profit instead of the original projected $2 million. Additionally, the current year’s gross profit will be a loss of $250,000.

3a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.

For some contractors, this is a change from legacy ASC 605. Before the effective date of ASC 606, many contractors who measured revenue using cost-to-cost percentage-of-completion would include wasted cost in both the numerator and denomination. However, under ASC 606, wasted cost is not included in the cost-to-cost revenue measurement if it does not contribute to satisfying the performance obligation. Instead, such wasted cost is included in job cost but excluded from the percentage-of-completion revenue measurement. Accordingly, this generally will have the effect of accelerating the reduction of the contract’s gross profit at the end of the accounting period compared to gross profit recognition under legacy ASC 605.

4e. It depends.

Not enough information is provided in the question.

Answer “a” is incorrect. The balance sheet classification of the assets securing the debt has no bearing on the debt classification. However, suppose the debt is an asset-based financing arrangement. In that case, the asset securing the debt could have a bearing if the estimated amount of the borrowing base (accounts receivable) at any point during the next year is less than the debt amount at the balance sheet date. In that case, the gap between the debt balance at year-end and the estimated low point of the borrowing base the next year should be classified as current debt. However, this distinction relates to the estimated future amount of the security, not the security’s classification as current.

As for answers b, c, and d, it depends on whether you give greater weight to the company’s intent or the debt’s contractual provisions. If the company anticipates repaying part or the total amount of the line-of-credit the following year, many practitioners suggest that amount should be presented as current. Other practitioners look more to the date the debt is contractually due to be settled because of the uncertainty of future repayment and that contractual stipulations should carry greater weight than mere intent. Those practitioners would classify the debt as long-term in our example.

The Financial Accounting Standards Board has issued Proposed Accounting Standards Update No. 2019-780 (revised September 12, 2019). If the exposure draft is issued in its present form, it will simplify some of the complexities highlighted in question #4. Proposed ASU No. 2019-780 would establish a principle for classifying debt as noncurrent if it meets either of the following criteria as of the balance sheet date:

  • The liability is contractually due to be settled more than one year after the balance sheet date.
  • The entity has a contractual right to defer settlement of the liability for a period greater than one year after the balance sheet date.

5b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.

The cost associated with a learning curve is generally anticipated between the contractor and the customer during contract negotiations. Therefore, they are not considered wasted costs which are excluded from the cost-to-cost percentage of completion calculations. Nor are they capitalized. Instead, they should be charged directly to job cost as incurred and drive revenue recognition. In theory, they will lead to greater efficiencies and cost savings in the latter part of the contract.

How About An Accounting Quiz? (Along with a Few Answers)

Part 1

I recall from my college days when Dr. Baker, the dean of the business administration department, casually mentioned that we would have a quiz the very next class. So I prepared for a quiz, which was barely any preparation at all. As it turned out, the “quiz “was a 200-question mammoth examination, weighted to be half our course grade. Holy drop-the-course, Batman.

Well, here’s an accounting quiz for you. But it’s not 200 questions, you do not have to prepare for it, and you will not be graded. You will find what I consider to be the best answers at the end. Here we go.

  1. If the SBA forgives my company’s PPP loan, will I pay federal income tax on the forgiven amount?
    • a. Yes. Because the related expenses are not deductible. This effectively makes it taxable.
    • b. No. The loan forgiveness income is not taxable, and the related expenses are deductible.
    • c. It depends. If your company’s taxable income exceeds $2 million, exclusive of the PPP loan forgiveness amount, then yes, it is taxable.
    • d. Maybe. If the company fails to make the first loan payment on the date stipulated in the lender’s promissory note, the entire amount that the SBA would potentially forgive is deemed taxable income by the IRS.
  2. If my company accounts for our PPP loan as an in-substance government grant under IAS 20, can the grant income be presented as operating income in our GAAP basis income statement?
    • a. No. Receipt of the grant income is ancillary to the company’s primary operations.
    • b. No. GAAP prohibits its presentation as income from operations because it is both unusual and infrequent.
    • c. Yes. IAS 20 requires its presentation as income from operations.
    • d. Maybe. It’s permissible to classify PPP grant income as either operating or nonoperating income, depending on the company’s policy election.
  3. Our company’s PPP promissory note stipulates that our first loan payment is due on the seventh month after the note’s date. However, we expect the SBA will forgive the entire debt, so we have made no payments, even though we are three months past the due date. Are we in default, and, if so, how should this default be disclosed in our financial statements?
    • a. Yes. The bank elected not to revise the promissory note and did not extend the loan deferral date. Disclose the default, and if you account for the PPP loan as debt, it all becomes current.
    • b. Yes. The Paycheck Protection Flexibility Act of 2020 extended the payment date, but this extension did not apply to loans made before the Flexibility Act. Disclose the default, and if you account for the PPP loan as debt, it all becomes current.
    • c. No. The Paycheck Protection Flexibility Act of 2020 retroactively extended the deferral period for loan principal and interest payments.
    • d. Maybe. Under the Paycheck Protection Flexibility Act of 2020, companies must formally apply and received an extension from the bank.
  4. If my company treats our PPP loan as debt for financial statement presentation, how do we determine the classification between current and long-term debt if we are confident the SBA will forgive the loan after application for forgiveness?
    • a. Since the expectation is that the debt will be forgiven and not paid, the entire debt should be classified as long-term because it will not be paid within one year.
    • b. Since the expectation is that the debt will be forgiven and not paid, the entire debt should be classified as current because it will be settled within the next year.
    • c. The debt should be classified as current or noncurrent under ASC-470-10-45, without regard to the expectation that the debt will be forgiven.
    • d. The company should make it simple and present an unclassified balance sheet.
  5. If my company decides to account for the PPP loan by analogy to IAS 20, the company must conclude that it is reasonably assured (i.e., ”probable”) it will comply with the forgiveness term of the CARES Act and SBA rules. Under GAAP, probable means:
    • a. A 75% or greater likelihood.
    • b. More likely than not.
    • c. A very high threshold.
    • d. Likely to occur.

Here are the answers:

  1. 1b. No. The loan forgiveness income is not taxable, and the related expenses are deductible.

    Under the CARES Act, the congressional intent was that the PPP debt forgiveness income be non-taxable, and the expenses that the PPP income defrayed be deductible. Unfortunately, Congress was silent about the deductibility of the expenses to be defrayed by the PPP loan. But the IRS was not quiet. The IRS opined that other areas of the tax code and regulations prohibited the deductibility of those expenses. Congress later corrected this in the Consolidated Appropriations Act, 2021 (“the Act”), signed into law on December 27, 2020. Under provisions of the Act, qualifying expenses related to PPP debt forgiveness are retroactively deductible. Therefore, the PPP debt forgiveness income is not taxable, and the costs defrayed are deductible.

  2. 2d. Maybe. It’s permissible to classify PPP grant income as either operating or non-operating income, depending on the company’s policy election.

    GAAP is somewhat opaque as to the classification of items in the statement of income. Therefore, it becomes a matter of the company’s policy. Suppose the company presents income from operations as a subtotal in the statement of income. In that case, we believe it is acceptable to include the grant income in that subtotal. Since the grant income is intended to defray certain operating expenses (payroll, rent, utilities, etc.), we believe it is acceptable to present the grant income as a separate line item to operating income. For example, you can show PPP grant income below general and administrative expenses in a section captioned Other Operating Income.

    However, the company’s accounting policy may call for the grant income to be presented as non-operating income. In that case, the grant income can be presented as a separate line item below income from operations in the Other Income section.

  3. 3c. No. The Paycheck Protection Flexibility Act of 2020 retroactively extended the deferral period for loan principal and interest payments.

    Under the CARES Act, the principal and interest deferral period ends six months from the date of the note. Accordingly, many early PPP promissory notes stipulated that payments were to begin on the seventh month. However, the Paycheck Protection Program Flexibility Act of 2020, enacted in June 2020, (Flexibility Act) retroactively extended the deferral period for payment of principal and interest on all PPP loans to either:

    1. The date that the SBA remits the borrower’s loan forgiveness amount to the lender,
    2. Or, if the borrower does not apply for loan forgiveness, ten months after the end of the covered period. (Note: The “covered period” is either the 8-week or 24-week period after the loan is made, during which the borrower must incur the qualified expenses).

    The SBA required lenders to give immediate effect to the deferral period’s statutory extension under the Flexibility Act and to notify the borrowers of the change. However, the SBA did not require a formal modification to the promissory note. Therefore, many PPP promissory notes may have incorrect dates for when payments commence.

  4. 4c. The debt should be classified as current or noncurrent under ASC-470-10-45, without regard to the expectation that the debt will be forgiven.

    Even if the SBA forgives the entire PPP loan after year-end and before the financial statements are issued, the debt should be classified as current and long-term based on the promissory note’s terms, as modified by the Flexibility Act. The Flexibility Act makes the initial payment date uncertain. As described above, the Flexibility Act specifies that the deferral period for payment of the PPP loan ends on either:

    1. The date that the SBA remits the borrower’s loan forgiveness amount to the lender,
    2. Or, if the borrower does not apply for loan forgiveness, ten months after the end of the covered period. (Note: The “covered period” is either the 8-week or 24-week period after the loan is made, during which the borrower must incur the qualified expenses).

    Determining the initial payment date requires significant judgment and is based on facts and circumstances specific to the company. Of course, this determination will impact how much of the debt, if any, will be classified as current.

  5. 5d. Likely to occur.

    Under GAAP, probable means likely to occur. Probable is understood (though not defined this way in GAAP) as a very high threshold to clear. Many CPAs consider probable to be a 75% or greater likelihood of occurring, but this percent is not mentioned in GAAP. Therefore, if the probability of loan forgiveness does not rise to this high threshold, then the PPP loan should probably be accounted for as debt.

    Given the current environment of perceived loan application misstatements of the good-faith certification, the SBA may put loans of $2 million or larger under greater scrutiny for compliance after the submission of the forgiveness application. Therefore, larger loans may find it more difficult to reach the high hurdle of forgiveness probably.

Next month, we’ll have Part 2 of this accounting quiz. It will focus on construction accounting.

Income Taxes Changes For 2020 Tax Returns

And A Few Things to Cheer About

Below are some of the changes to expect in your 2020 tax returns. Except for the increases in the standard deduction, all were the result of Federal legislation drafted and passed in 2020 designed to keep the economy afloat during the COVID pandemic. And all were favorable to us as taxpayers. Even in such a year as challenging as 2020, that’s a little something to cheer about.

BUSINESS TAX

Deductibility of Expenses Related to PPP Loans. Congress stepped in the latter part of December 2020 and corrected an oversight they made in the CARES Act. The CARES Act, signed into law on March 27, 2020, established the Paycheck Protection Program (“PPP”) to provide limited relief to small businesses during the COVID pandemic. The PPP provided forgivable SBA loans to qualifying businesses to cover payroll costs, including benefits, mortgage interest, rent, and utilities. Assuming the company complies with the eligibility criteria for forgiveness, the loan principal and accrued interest will be forgiven by the SBA. Additionally, under the CARES Act, this forgiveness will not result in taxable debt cancellation income or the loss of tax attributes.

This sounded good. However, later during the year, the IRS opined that all was not well. In their view, the payroll cost and other qualifying expenses that gave rise to PPP loan forgiveness were not deductible. The IRS reminded Congress that other areas of the tax code and regulations prohibited deductions (and other favorable tax attributes) for expenses related to non-taxable income. The CARES Act was silent regarding the deductibility of the qualifying expenses. The IRS effectively turned the non-taxability of PPP loan forgiveness upside down.

Congress corrected their prior legislative oversight in the Consolidated Appropriations Act, 2021 (“the Act”), signed into law on December 27, 2020. Under provisions of the Act, qualifying expenses related to PPP debt forgiveness are retroactively deductible.

Therefore, the original intent of Congress was satisfied. PPP loan forgiveness is not taxable income, and the qualifying expenses related to PPP are deductible. This is a much needed and sizable benefit to many closely held companies.

INDIVIDUAL TAX

Recovery Rebate Credit. Congress passed two rounds of economic impact payments (a.k.a stimulus payments) in 2020 directed to individual taxpayers to help alleviate the financial impact of the COVID pandemic. The CARES Act provided for payments up to $1,200 per person. The Consolidated Appropriations Act provided the second round of payments up to $600 per person.

The payment amounts are intended to be based on adjusted gross income, filing status, and qualifying dependents as presented on your 2020 individual tax return. Of course, your 2020 Form 1040 will not be filed until sometime in 2021, as late as October 15. To get funds in the hands of the American people as quickly as possible, the IRS sent “advance payments” based on either your 2018 or 2019 tax returns. In other words, the IRS, for the sake of expediency, assumed your tax status (adjusted gross income, filing status, dependents, etc.) would be the same in 2020 as they were on either your 2018 or 2019 Form 1040.

However, your tax situation may have changed in 2020. For example, your income may have decreased, or the number of dependents may have increased. Therefore, you may need to true-up the amount you received. This true-up is reported on Line 30 of the 2020 Form 1040 and styled “Recovery rebate credit.” The IRS provides a worksheet in the Form 1040 instructions to calculate the additional amount of stimulus payment the IRS owes you.

The good news is that the true-up can only result in a larger stimulus payment in the form of a rebate credit. If the IRS’s original advance payments were, in fact, too much (because your situation improved in 2020), you are not required to pay it back.

Another bit of good news, the stimulus payment is not taxable.

Charitable Contributions. Last year, you could only deduct charitable contributions if you itemize deductions. However, the majority of Americans do not itemize but, instead, take the standard deduction. Therefore, most individual taxpayers received no tax benefit for their 2019 charitable contributions. However, the CARES Act and clarification by the recently passed Consolidated Appropriations Act, 2021 provides a small “above the line” benefit on your 2020 tax return for cash contributions to charities if you take the standard deduction. A deduction up to $300 ($600 for joint filers) is permitted on Line 10b of Form 1040.

Standard Deduction. As described above, most taxpayers take the standard deduction. The 2020 standard deduction for all filing statuses increased for 2020, as follows:

  • Single: $12,400 ($200 increase)
  • Married filing jointly and surviving spouse: $24,800 ($400 increase)
  • Married filing separately: $12,400 ($200 increase)
  • Head of household: $18,650 ($300 increase).

The 2020 additional standard deduction for those 65+ or blind remains unchanged:

  • Single: $1,650
  • Married filing jointly and surviving spouse: $1,300
  • Head of household: $1,650

For those both 65+ and blind, the above amounts are doubled.

Many More Changes. The above is a summary of just a few of the changes for the 2020 tax year. There are many more that impact both your 2020 and 2021 tax returns. Please contact us for the details.

Sensitive Areas Of A Construction Company Audit

Or — Things That Make You Go “Humph”

The majority of construction companies are private entities closely held by a small group of owners engaged in management. Many owners/managers began the company from scratch and remain active in the company’s day-to-day operations. While very competent in their chosen trade, many are not as comfortable or interested in the accounting related to their construction activities, except for tax savings and strategic planning.

Some construction companies choose to have an annual financial audit. However, most have an audit because it is required by the company’s surety, banker, or a governmental entity. Therefore, audits may be viewed as a necessary but inconvenient part of business ownership.

This article describes and attempts to explain the reason for certain aspects of a construction financial audit that may puzzle or even exasperate operational personnel.

CPA Independence and Professional Skepticism. “Why does the auditor check out the things I tell him? I’ve always been straight with him.” Auditors make a significant amount of inquiries. However, auditors are generally not permitted under generally accepted auditing standards (“GAAS”) to rely on inquiry alone, despite management’s trustworthiness.

The CPA who audits financial statements is required under the AICPA Code of Professional Conduct to be independent. What does independent mean? It means that the CPA is an advocate of his/her own opinion, not management’s opinion. At times, this opinion may be contrary to the views of the company’s management. The end-users of the financial statements expect this independence. Without independence, the assurance provided to the end-users regarding the fairness of the financial statements is useless.

At the heart of this assurance is what is known as professional skepticism. Professional skepticism is defined as “(A)n attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence.” (AU-C § 200.14). Under the concept of professional skepticism, “(T)he auditor neither assumes that management is dishonest nor assumes unquestioned honesty.” (AU-C § 200.A26). Management could misunderstand professional skepticism as distrust or implication of misdeeds. However, it’s an audit state of mind that perhaps can be best summed up by an old Russian proverb often spoken by President Reagan, “Trust but verify.”

Financial Statement Materiality and Audit Sampling. “The auditor is chasing a small amount that makes little difference – who cares?” At times, management may question why the auditor is raising questions about a small dollar amount. There are two possible explanations. One relates to materiality, and the other to audit sampling techniques.

Materiality is an essential concept in the financial audits of construction companies. Without the materiality concept, audits would never be completed or take much longer than they do. Everything cannot be audited, so auditors use materiality and risk assessment to sort through and determine what should be examined. But it’s not as simple as it may seem.

Materiality is used to determine which financial statement areas should be examined and to evaluate potential misstatements identified during an audit. “In general, misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users that are taken based on the financial statements.” (AU-C § 200.07). However, materiality involves both a quantitative and qualitative analysis. Accordingly, materiality is determined by both the size and the nature of the misstatement. For example, a small amount may be considered material if the misstatement is related to fraud, such as cost-shifting from one project to another. Additionally, a slight variance may be significant if it results in a loan covenant violation or places project managers in a lower or higher bracket for bonus calculation.

The nature of audit sampling drives another reason an auditor may examine a small dollar item. Certain approaches to audit sampling will result in both large and small amounts selected for testing. Any misstatements that are identified in the sample are then extrapolated to the population as a whole. While this saves considerable time because an entire population is not tested, it may result in questions about smaller dollar items.

Fraud Inquiries. “Why was I selected for an interview? Does the auditor think I’m stealing?” GAAS requires auditors to inquire of those charged with governance, management, and others in the company whether they have any knowledge of fraud. (AU-C §240.18 &.21). The auditor performs these inquiries as part of the risk assessment related to fraud and compliance with laws and regulations. In a standard financial audit, and almost without exceptions, those chosen for interviews are not suspected of fraud. They are chosen primarily because of the type of job duties they perform (accounting, shipping and receiving, project management, CFO, etc.). The focus is to inquire of personnel who are in a position to observe a broad spectrum of situations and events, including some that give them concern. The fraud interview is a forum that allows them to voice those concerns in a non-threatening conversation.

Unpredictable Audit Procedures. “No auditor has ever done this before. Why is it necessary this time?” Doing an unexpected procedure, or performing a routine procedure at an unexpected time, for example, is a requirement of GAAS. (AU-C §240.29c). Performing an unpredictable audit procedure “…is important because individuals within the entity who are familiar with the audit procedures normally performed on engagements may be better able to conceal fraudulent financial reporting.” (AU-C §240.A42). The reason is no more complicated than that. Auditors are required to mix things up as a safeguard to thwart those who may be inclined to commit fraud.

Audit Scope Limitation. “I’m not sure we want to pay you to do that audit procedure.” If you’ve been in the audit business long enough, someone in management has probably non-maliciously suggested that an audit procedure is unnecessary. And truthfully, that is management’s prerogative. If management communicates to the auditor that he/she not do a particular audit step, the auditor must abide by their wishes. However, if the auditor cannot obtain sufficient audit evidence due to management’s prohibition, the auditor may have a scope limitation.

A scope limitation occurs when “the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement.” (AU-C §705.07b).

A scope limitation is not a good thing. If the auditor cannot obtain sufficient appropriate audit evidence to base an opinion but concludes that the possible effects, if any, on the financial statements could be material but not pervasive, he may qualify his opinion on the financial statements.

Or, if the auditor concludes that the effects, if any, on the financial statements could be both material and pervasive, he may go so far as to disclaim an opinion on the financial statements as a whole.

Neither option is beneficial to the company. The best approach is to politely explain the consequences of a scope limitation to management and request that the audit procedure be permitted.

Five Myths About Accounting

The Bob Cratchit Stigma

Accounting is all about math. Is it? Little could be further from the truth. Do you recall the math courses you took in school; calculus, geometry, algebra, and trigonometry? They gave me nightmares. But accounting somehow made sense. When it comes to the number part of accounting, it’s more addition, subtraction, multiplication, and division. Those are not advanced mathematical topics. It’s more arithmetic than high-level math.

Accounting is about concepts and principles, analytics and organization, simplifying complex situations, clarity, and concise communication. True, it may borrow from statistics in certain areas, such as selecting sample sizes for audit testing. But in the end, accounting is about taking what appears to be an overwhelming amount of data and analyzing, organizing, summarizing, and simplifying that information whereby management can make sound financial decisions. It’s about using sound judgment to apply the appropriate accounting principle to a complicated situation. And all of that is done without relying too much on math.

An audit assures that the financial statements are 100% accurate. Does it? Not really. Auditors perform audits under the concepts of materiality and fair presentation. The auditor gives his/her opinion after obtaining a high level of assurance (called reasonable assurance) that the financial statements are not materially incorrect. Put another way; the auditor renders an unmodified opinion when the financial statements are presented fairly in all material respects. Misstatements or omissions in the financial statements are immaterial when, in the auditor’s professional judgment, those misstatements or omissions would not reasonably be expected to influence the end-users’ economic decisions. Therefore, it’s possible, even likely, that many audited financial statements have immaterial misstatements or omissions that would not affect the end-users’ conclusions. From a practical standpoint, to audit financial statements to the point that the auditor concludes they are 100% accurate would be unnecessary and cost prohibited.

Also, under professional standards, the auditor uses sampling and is not required to test every transaction. Therefore, the financial statements may have undetected material misstatements. The auditor must only obtain reasonable assurance, but not the absolute certainty that the financial statements are fairly presented.

Accounting is an exact science that leads to one correct answer. Not exactly true. Accounting is an art, not a science. While clients and company management expect accuracy in the end product, ideas and creativity are what’s truly appreciated. The Financial Accounting Standards Board has, for the last several years, moved the profession toward a principle-based approach instead of a rules-based approach. A principle-based framework creates guidelines rather than the rigorous rules found in a rules-based approach. Accordingly, under the principle-based approach, reasonable accountants may arrive at different conclusions when faced with similar facts and circumstances.

Additionally, many accounting transactions inherently have more than one appropriate treatment. Significant judgment is required for accounting estimates surrounding revenue recognition, depreciation, accounts receivable valuation, self-insurance liabilities, and warranty liabilities. The path to a fair presentation is often more art than science.

Financial statement materiality can be expressed as one number. Maybe yes and maybe no; it ain’t necessarily so. The bottom line is that materiality at the financial statement level is a matter of the accountant’s professional judgment. It involves both a quantitative and qualitative analysis. Many auditors use a quantitative approach to determine materiality for purposes of planning the audit. Planning materiality is used to determine sample size and to evaluate variances found during test work. However, they will use a combination of quantitative and qualitative analysis to assess materiality at the financial statement level. For example, a potential adjustment that would decrease pre-tax income by a relatively small immaterial amount (quantitative analysis) may be very material if the adjustment results in a loan covenant violation (qualitative analysis).

Accounting is boring. Not really. Well, it’s not performing a spacewalk, but it’s not Bob Cratchit either. Sure, there are number-crunching episodes, tight deadlines, and some long hours. However, the nature of the work will also bring you face-to-face with mission-critical issues for the business. As a trusted advisor for the company, the accountant will find himself/herself a significant player in management/stockholder meetings. Communication is vital in any organization, and the accountant is often central in channeling information throughout the company. The accountant is in a pivotal position to interact and understand the company and its industry from top-to-bottom. It’s a balance of people-to-people interaction, number crunching, and research. And at times, it will be anything but boring.

Paycheck Protection Program

The Art of Accounting

Our FAQ section briefly describes possible approaches to account for loans received under the Paycheck Protection Program (“PPP”). This article will go into a bit more depth.

To address the economic issues caused by the COVID-19 pandemic, the CARES Act, signed into law on March 27, 2020, established the PPP to provide loans to qualifying businesses to pay up to 8 weeks of certain qualifying expenses. The PPP Flexibility Act, signed June 5, 2020, extended the pay period to 24 weeks. Qualifying expenses include payroll costs, including benefits, mortgage interest, rent, and utilities. The SBA administers the program. Under the program’s provisions, the loan and interest may be forgiven, provided the business meets the eligibility criteria for forgiveness.

The program intends to keep employees employed, and the doors open for business. And, by doing so, the loan and interest are subject to forgiveness by the SBA. So how does a for-profit business entity account for the loan? And when and how do you recognized the income if the loan is subsequently forgiven?

Most CPAs who have practiced accounting for some time realize that financial accounting is more art than science. Math is a science, but accounting is not math. Generally accepted accounting principles (“GAAP”), certainly for the last several years, are not a list of specific rules, per se. To a large degree, it is broad principles applied to the facts and circumstances fairly and consistently. When we say consistently applied, it means the same company consistently uses the accounting principle from period to period. It does not mean that GAAP is applied consistently across all companies. Therefore, it’s possible and acceptable for one company to account for a transaction one way, and another company to account for a similar transaction another way with different results. Because of numerous accounting elections available to account for a PPP loan, companies may present a similar transaction differently and still comply with GAAP.

The Financial Accounting Standards Board (“FASB”) is the organization responsible for establishing accounting and financial reporting standards in the United States. In other words, it determines GAAP. It has issued numerous authoritative pronouncements over the decades. Yet, none of the pronouncements seem to adequately address the accounting for a non-governmental business entity that receives an SBA forgivable loan if specific requirements are satisfied. That leaves us to look to other sources for guidance.

The AICPA, in its Q&A Section 3200.18, notes that while the legal form of a PPP loan is debt, in substance, it could be construed as a governmental grant. Q&A Section 3200.18 outlines the following nonauthoritative approaches to account for a PPP loan:

  1. Debt. The legal form of the funds is that of a debt. So, it is always permissible to account for the PPP loan under FASB ASC 470 – Debt. Our impression is that most companies will account for the PPP loan as a debt, even if it expects the debt and interest to be forgiven. If the stated interest rate is below market, interest will not be imputed because government-guaranteed obligations are excluded from this requirement. Under further guidance in FASB ASC 405-20-40-1, the loan remains recorded as a liability until it is paid off or forgiven, either in whole or in part. If forgiven, the debt liability is reduced by the amount forgiven, and gain on extinguishment of debt would be recorded.

    This approach’s appeal is twofold: a) The legal form of the funds received is debt; it is an SBA loan. b) It removes the requirement of estimating if it is probable the SBA requirements for the forgiveness of debt will be met. (See #2 below). Under the debt method, gain recognition and debt derecognition are postponed until the accounting period the loan is forgiven (i.e., legally released).

  2. Deferred Income Liability. If the company estimates that it is probable it will meet the PPP’s eligibility criteria for loan forgiveness, it may conclude that the loan is, in substance, a government grant. Therefore, it may account for the PPP loan as a grant by analogy to the provisions of International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance (“IAS 20”). Bear in mind, though, that the likelihood of forgiveness must meet the probable threshold under GAAP, a high bar to reach. The standards define “probable” as a future event or events that are likely to occur. While no percentage threshold is given in authoritative accounting standards, in practice, many CPAs consider a 75% or greater likelihood of occurrence as necessary to meet the probable requirement.

    Under the IAS 20 model, the PPP loan funds are initially recorded as a deferred income liability. The liability is reduced as income is recognized “on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate.” In other words, as qualifying expenses are incurred during the 8 or 24-week period, an equal amount of income is recognized.

    Under IAS 20, the PPP income is presented in the statement of income as either:

    1. A separate caption or under a general caption such as Other Income, or
    2. As a reduction to the related expenses.

      Many companies present income from operations on its statement of income. Under option #1 above, the company’s accounting policies determine if PPP income is included in operating income. However, if the company elects to net the income against the related expense, as described in option #2 above, then the PPP income would necessarily be included in operating income.

      We expect that most companies who choose the IAS 20 model would elect to present PPP income as either a separate caption or under a general caption such as Other Income, as described in #1.

      If all or a portion of the previously recognized income is deemed repayable in a subsequent accounting period, it will be accounted for prospectively as a change in estimate.

  3. Refundable Advance. Suppose a business entity anticipates complying with the eligibility criteria and expects the loan to be forgiven. Another acceptable approach would be, by analogy, to follow the not-for-profit model (“NFP model”) described in FASB ASC 958-605-25-13. Under the NFP model, a conditional contribution is “…accounted for as a refundable advance until the conditions have been substantially met or explicitly waived by the donor.” Therefore, the SBA loan would be carried on the balance sheet as a refundable advance until the criteria for forgiveness are substantially met or explicitly waived. At that time, recognize the refundable advance as income.

    When are the criteria for forgiveness substantially met? Is it:

    • When the qualifying expenses are incurred?
    • When the company submits all required documentation to the lender for forgiveness?
    • When the lender submits approval of the application to the SBA?
    • Or, when the SBA remits payment to the lender?

    The point in which the criteria for forgiveness are substantially met is not entirely clear, and there will probably be diversity in practice. For this reason, we believe few business entities will follow the NFP model to account for PPP loans.

  4. Gain Contingency. Another method a business entity may elect, if it expects the loan to be forgiven, is by analogy to the gain contingency recognition model presented in FASB ASC 450-30. Under this model, the loan proceeds are recorded as a deferred income liability. Grant income will not be recognized until the period when the grant proceeds are realized or realizable. This will probably not be until the lender approves the company’s application for loan forgiveness.

    We think few businesses will use this model. If management is inclined to wait until forgiveness to recognize the grant income, they will use the debt model instead.

Regardless of the approach taken to account for the PPP loan, all companies must adequately disclose its accounting policy and its implications to the financial statements.

The Good Liability?

The Upside Down

If you are a fan of the popular Netflix science fiction horror series Stranger Things, then you are familiar with The Upside Down. For those who are not acquainted with the series, The Upside Down could be described as an alternate parallel dimension that is not too human friendly, to say the least.

The world of construction accounting is viewed by many as somewhat of an upside-down, with a strange language consisting of such terms as POC, under billings, overbillings, ASC 606, phase codes, related parties and, worst of all, though certainly not unfamiliar, income tax.

The first U.S. income tax was passed in 1861 and signed into law by Abraham Lincoln to fund the war against the southern states. It began as a flat tax of 3% on incomes above $800 and because the war lasted longer than expected by the Union, was later modified to a progressive tax structure. It was repealed in 1872. Our present income tax system was set in place in 1913 with the ratification of the 16th amendment to the U.S. Constitution.

The history of U.S. income taxation began with a national struggle, and to this day continues to be a struggle. The federal tax code and regulations are complicated and confusing. Convoluted by special interest lobbying, made difficult with programs to correct economic and social issues, replete with governmental spending disguised as tax cuts, and made more incomprehensible by well-meaning attempts to infuse fairness into the code, it has increasingly become not too human friendly.

However, when the fog lifts just a bit, one thing is clear: it is better to legally push the payment of income taxes as far as you can to the future. And then push it some more. The more distant the tax horizon, the better. There are exceptions, of course, but in most cases, you want to pay later, not now. Fortunately, construction contractors have several powerful tools available to defer income tax liabilities. The result of a skillful use of these tools creates a liability on your balance sheet called deferred income tax liability (“DTL”). A DTL is one of those rare “good liabilities”.

It is true that most privately-held construction companies elect to be taxed as a flow-through entity for federal income tax purposes. Therefore, income, expense, and credits will not be taxed to the company directly, but instead, will pass through and be taxed to the owners of the company. This includes companies organized as S-Corporations, partnerships, limited liability companies, and proprietorships. Many states also permit this flow-through treatment. Therefore, when we describe a DTL on the balance sheet, the liability may, instead, be at the owner level, not the company level. However, most construction companies will make tax distributions to the owners to fund their current income tax liability. Accordingly, income tax deferral strategies at the company level have a direct bearing on the size of the company’s tax distribution and its cash flow.

So, what tools are available to a construction contractor to defer income tax? You look for tools that create taxable temporary differences. Taxable temporary differences produce deferred tax liabilities for financial reporting, and that means you pay later, not now. Without getting too deep into the weeds, here are some of those tools available to contractors under the Internal Revenue Code (“IRC”):

  1. Method of accounting. Contractors can select more than one method of accounting under the IRC. Selecting the correct methods will make a significant difference in tax deferral. The contractor may have an overall method of accounting, such as the accrual method, and different methods specific to non-exempt and exempt contracts. (Non-exempt contracts are those required under IRC Section 460 to account for revenue recognition using tax cost-to-cost percentage of completion (“POC”) method – generally not to the taxpayer’s advantage. Exempt contracts are those exempted from tax POC under IRC Section 460, permitting the taxpayer to select more favorable income recognition methods). Methods of accounting include:

    • Cash method. This can be an overall method of accounting but is limited to certain eligible entities based on average annual gross receipts.
    • Accrual method. This can be an overall method of accounting, including any exempt construction contracts. This is generally the worst method for contractors because taxation of overbilling is accelerated.
    • Completed contract method. For qualifying contractors, this is often the best method to elect because it produces the greatest deferral of income.
    • Exempt-contract POC method. This method can be elected for contracts that are exempt from POC under IRC section 460 and permits the percentage of completion methods other than the Section 460 cost-to-cost method.

  2. Contracts potentially exempt from tax POC under IRC Section 460. Additional tax deferral opportunities exist for contractors with exempt contracts under IRC Section 460.

    • Ten percent method. This election excludes from tax any contract that is less than 10% complete at year end. In other words, revenue and cost from contracts less than 10% complete are deferred from taxation until the tax year its percentage of completion is greater than 10%.
    • Small contractors. Contracts of small contractors, as defined in the code, may be exempted from tax POC under IRC Section 460. Other methods may be elected. Under the Tax Cuts and Job Act, contracts entered into after December 31, 2017, meet the exception for small construction contracts if the contract is expected to be completed within two years and the taxpayer meets the $25 million gross receipts test for the year the contract is entered into.
    • Home construction contracts. If certain requirements are met, the primary one being that at least 80% of the estimated total contract cost is expected to pertain to the construction of four or fewer dwelling units in the building, then that contract may be exempt from POC treatment under IRC Section 460. Another method may be elected.
    • Percentage of completion / capitalized cost method. This method exempts 30% of the contract from tax POC treatment and applies to residential construction contracts with more than 4 dwelling units with an average stay of more than 30 days. The 30% exempted portion is accounted for under the company’s normal method as elected.

The tax code does provide benefits to the construction industry, mostly through tax deferrals. The deferred income tax liability is the result of those tax deferrals and is a sign of savvy tax planning. Consider discussing your DTL with your tax professional to see what elections have been made and how those elections benefit the company and its owners.

Is Your Company Strong enough for Bonding?

How to Determine if Your Company is Strong Enough for Bonding

If you are building a construction business, you will most likely want to bid on projects that require bonding. Public works projects especially require bonding to demonstrate your business is trustworthy and financially stable enough to take the project on, enough that a bonding company is willing to guarantee your performance. That presents a paradox for young businesses that lack the net worth and working capital to meet surety underwriting criteria. If they can’t meet the criteria, they can’t land profitable projects that require surety bonds. If they can’t land profitable projects, they can’t build the necessary net worth and working capital to qualify for surety bonds.

Contractors can break that vicious cycle by focusing on the key elements of their business that concern surety bond companies the most – working capital, equity, cash flow and work-in-process (WIP). Concentrate on improving those and you can effectively increase the bonding capacity of your company.

Working Capital and Equity

To sureties, your working capital is indicative of your company’s liquidity and its ability to fund its operations and service its debt obligations. The more working capital you can show on your balance sheet, the more bonding and licensing capacity you have. Equity is equally important as the surety typically factors in the lesser of the two when determining your bonding capacity. Licensing boards use these same criteria as well.

One way to quickly overcome the working capital and equity criteria is through an infusion of capital from management or an investor. A joint venture with a larger company could also help to increase your bonding capacity. In addition, restructuring debt could reduce the amount owed in the short-term and therefore increase working capital.

Cash Flow

Sureties know that one of the biggest cause of contractor job defaults is weak cash flow, specifically weak cash flow from operations. Maximizing cash flow is critical to increasing your bonding capacity. Central to that is your ability to effectively forecast cash flow and take steps to improving your company’s cash position through improved financial management and operational efficiency.

Work-in-Process

For a favorable review by a surety or a banker, your company must show a demonstrative track record of steady work that is accurately estimated and tracked. If your jobs consistently fade without reasonable explanations, the surety will assume that you do not know how to properly estimate job profit and therefore not give you fill credit for the working capital shown on your balance sheet. It is critically important to have the right systems and processes in place to accurately compute WIP, not just for the surety, but for your own information so that you can make decisions based on accurate reporting.

Have a CPA in Your Corner

Whether or not a surety requires that the financial statements be compiled by a CPA, having one that understands your industry and the specifics of project accounting can make a significant difference in how a surety views your business. Since most sureties require the financial statements to be audited, reviewed, or at least compiled by a CPA,choosing a CPA that understands the construction industry and its unique financial requirements is critical. The right CPA can help you create an overall financial picture for the surety.

Buying a Business?

What it Takes to Get to the Finish Line

Buying a business is one of the most complex transactions you will ever experience. The many and often varied steps leading up to the closing agreement are critical in determining which party walks away with the better end of the deal. From the time you decide on the business you want to buy, the process is a series of negotiations with both parties seeking the upper hand. You meet with the seller, make your opening bid and negotiate the key purchase terms. But that is all preliminary – simply the prelude to the real work of due diligence, submitting a formal offer, final negotiations, signing the purchase agreement and closing the deal. Not to diminish the effort that goes into the preliminary stage, because it can be very extensive, but nothing is real until a letter of intent is signed.

It Starts with the Letter of Intent

Once you and the seller agree to the broad terms of the deal, the next step is to have your attorney put it to writing in a letter of intent (LOI). A properly drafted LOI offers the buyer certain protections, such as restricting the seller’s ability to entertain other offers for a period of time. It should provide you with the time you need to thoroughly evaluate the company’s operations, financial statements, contracts, employee agreements, suppliers, pending litigation among other issues that could impact the purchase price. Although the purchase price is included in the LOI, it does allow for the buyer to question the assumptions and propose price adjustments and negotiate provisions based on changing assumptions or circumstances.

Getting to the Final Price

In most cases, the purchase price agreed to in the LOI is based on an EBITDA calculation of its earnings before interest, taxes, depreciation, and amortization. However, EBITDA is not a thorough measure of the business; rather, it is an acceptable starting point from which you can more thoroughly evaluate profitability and future returns. You can then apply various adjustments (add-backs and deducts) to arrive at “normalized earnings”. These adjustments are typically based on income or expense items currently included in the income statement that will not continue after the acquisition. Identifying these adjustments is vital to determining what you are likely to pay for the business. Typical adjustments include:

Owner salary and compensation: If the owner’s salary and benefits are deemed to be excessive when compared to market levels, an add-back for the excess would be appropriate. This could also include any family members receiving benefits who are not active in the business.
Owner-related expenses: Any non-essential items which the owner expensed through the business and are deemed excessive could be added back. These could include personal vehicles, travel, entertainment and memberships.
Unusual or non-recurring incentive compensation: The company’s income statement may be laced with large bonuses or other forms of incentive compensation that won’t be continued under the new owner. This could also include severance payments.
Management needs: Should the departure of the owner leave any gaps in the management team, requiring the new owner to fill the gaps, an adjustment should be made for the cost of hiring and compensating the new executives.
Rent expenses: If the seller owns the property housing the business as a separate entity, it may be charging above market rent. An adjustment should be made reflecting the true market rent. Conversely, if the company leases a building and pays under-market rent, and the lease is not assumable by the new owner, a similar adjustment can be made.

There are dozens of potential adjustments that could be made to EBITDA. It is vitally important not to miss items that could positively or negatively impact the purchase price. The normalized earnings calculation becomes the new starting point entering the final acquisition stage.

Your CPA Gets You to the Finish Line

Critical to the process of calculating normalized earnings is the buyer’s CPA firm. To conduct its part of due diligence, your CPA should have a minimum of three years of financial statements and tax returns, a copy of all material leases you expect to assume, a list of open receivables and payables, a list of all fixed assets you will be acquiring, payroll records and employee agreements.

Your CPA can evaluate all of these records in detail to evaluate their integrity and identify inconsistencies, improper record-keeping and mispriced assets. It is critically important to have any assets you expect to acquire to be confirmed. Are the company’s biggest assets actually owned by the company? Any significant assets that have been sold off in recent years could drop the purchase price. Some companies may try to misrepresent its asset register, listing assets that don’t actually exist or overstating their value. Your CPA will be able to challenge inventory value if it is outdated, damaged or otherwise unsalable.

In essence, your CPA puts you on the final glide path to successfully negotiating a fair price based on a clear and supportable evaluation while protecting your interests in the deal.

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