Daniel Massey

Ignoring GAAP or Tax Effects of Business Decisions

Small Business Series – Mistake 5:

Continuing our series of common mistakes that small businesses may make, I think how many things business owners or executives have to know. They have to know their product or service, their pricing strategy, their competition, their people, their customers, their vendors, their strategies, their long-term plans, their short-term plans, and much more. In focusing on all of those necessary aspects of the business, owners often neglect to consider financial statement and tax effects of decisions that they make.

Even the seemingly simplest transaction can have ramifications from a tax perspective or for financial statements presented under generally accepted accounting principles (GAAP). Having a general understanding of what types of transactions can cause financial statement or tax problems is a proactive way to avoid issues that may only come to light months later at year-end. At the very least, business owners and executives should be willing to ask a question of their CPA before entering into an uncommon transaction so that they can adequately plan for the ramifications or adjust their approach to the transaction.

Tax rules and GAAP rules are not getting simpler. Most people know the generalities of tax changes because they have wider affect and are often highlighted by many media channels, but there are also 15-20 accounting standards updates issued every year. So, even when businesspeople believe they have an understanding of the rules and laws, there are bound to be changes.

Transactions to Consider

Here is just a sampling of transactions that are hardly unusual but that occur outside the normal course of business, all of which, depending on how they are handled, could have dramatic effects on tax returns or financial statements:

• Choosing or switching an entity type
• Bringing new owners into the business
• Having existing owners leave the business
• Selling a segment of the business
• Buying a new business
• Investing in another business
• Creating a new entity to house a specific service or specific assets
• Building a new office
• Structuring leases
• Distributing profits at the end of the year

Tax Effects

The tax impact of these decisions is sometimes the ability to defer tax into another period, but at other times can avoid tax altogether. The avoidance of tax is optimal, but changing tax rates also allow for the opportunity to move tax from one period to another where there may be different rates.

Financial Statement Effects

The financial statement impacts can be much more diverse, including:

• Whether to consolidate variable interest entities
• How to handle entities invested in by the company
• Balance sheet composition
• Income statement composition

Financial Statement Users

The balance sheet and income statement composition come into play most often in regard to users of the financial statement. Many companies have loan covenants as part of their debt or lines of credit with a bank or other lender. Change to assets, debt, or equity will have a potentially dramatic effect on ratios that are the underlying metric used in covenant compliance. Construction companies also have bonding companies as financial statement users, who also look at various metrics, such as working capital, to determine the company’s bonding capacity.

Bottom Line

While business owners cannot possibly know all of the tax and GAAP laws, they need to be aware that there are consequences to transactions, and proactively seeking answers to these effects will better position the company internally and with its financial statement users.

See previous installments in the Small Business Mistakes Series:

By Dan Massey, CPA, Manager
This installment is brought to you by Dan Massey. Dan is a Partner in the firm’s Assurance Division. He performs audit services for clients in many industries, focusing on construction, entertainment production, and not-for-profit entities.
Dan is both a member of the American Institute of Certified Public Accountants (AICPA) and the Pennsylvania Institute of Certified Public Accountants (PICPA). He is also chairman of the C.O.R.E. Task Force for the Keystone Chapter of Associated Builders and Contractors.
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