How Accounting Methods & Entity Type Affect Financial Statement Recasting
There are several accounting methods that will be encountered when recasting financial statements of small businesses, as well as variations on these methods. This article provides an introduction to the various methods. The subject’s entity type can also affect the accounting method used for tax returns. This article also discusses the impact of entity type on tax returns and tax return recasting. In addition to the accounting methods discussed below, other accounting methods may encountered, including “income tax basis”, “modified cash basis”, or “hybrid basis”.
In income tax basis accounting, the financial statements are prepared primarily using financial information as it will appear on the income tax return. In modified cash basis accounting, long-term assets and liabilities are accrued, while short-term income and expenses are kept on the cash basis. Under a hybrid accounting method, companies will use the accrual accounting method to satisfy tax requirements and the cash basis method for all other financial transactions. Accounts receivable (A/R) and accounts payable (A/P) are the only items recorded using the accrual method; A/P transactions relate to inventory, as required by the IRS. Financial transaction like asset purchases, payroll or equity investments are recorded using the cash method, reflecting transactions where cash changes hands.
In this article financial statement recasting, with regard to the income statement, refers primarily to the analysis required to determine the client company’s Seller’s Discretionary Earnings (SDE). Where SDE is defined as:
“…..net income before the primary owner’s compensation, other discretionary, non-operating, or non-recurring income or expenses, depreciation, interest, and taxes” – ValuationResources.com
SDE = Earnings Before Tax + Add-backs
- Seller’s Discretionary Earnings are pre-tax
- Seller’s Discretionary Earnings are based on one owner
- Seller’s Discretionary Earnings must be verifiable
- Add-backs must be acceptable to Buyer and/or a Lender
If you are recasting financial statements for a client company, and you have questions regarding the details of the accounting method used, with the owner’s approval, meet with the client’s Accountant/CPA to make sure you understand the accounting method.
Accrual Basis Accounting
¨ Accrual Basis Accounting: Revenues are reported in the fiscal period in which they are earned, regardless of when received, and expenses are deducted in the fiscal period in which they are incurred, whether they are paid or not. In other words, using accrual basis accounting, you record both revenues and expenses when they occur.
Cash Basis Accounting
¨ Cash Basis Accounting: Revenues are recorded when cash is actually received and expenses are recorded when they are actually paid (no matter when they were invoiced).
- Cash basis balance sheets do not include accounts receivable, accounts payable, and accrued expenses
The accrual basis of accounting generally is preferred for income statement and balance sheet recasting because it more accurately matches revenue sources to the expenses incurred during the accounting period.
If the client company uses cash basis accounting, one can make a couple of simple cash-to-accrual adjustments to estimate the revenue and expense if the company had used accrual accounting.
The first adjustment is based on the increase/decrease in the subject’s accounts receivable from the beginning of the year to the end of the year. The amount that accounts receivable increased is added to the cash basis revenues to estimate the accrual basis revenue. If the accounts receivable balance decreased, the amount of the decrease is subtracted from the cash basis revenue to estimate the accrual basis revenue.
The second adjustment is based on the increase/decrease in the subject’s accounts payable from the beginning of the year to the end of the year. The amount that accounts payable increased is added to the cash basis cost of goods sold to estimate the accrual basis cost of goods sold. If the accounts payable balance decreased, the amount of the decrease is subtracted from the cash basis revenue to estimate the accrual basis revenue.
Construction-Related Accounting Methods
Construction-related accounting methods can be quite complicated. Therefore, a detailed discussion of these methods is outside the scope of this article. However, business brokers and other business consultants involved in pricing and/or selling such companies need to be familiar with these methods. The following discussion is intended to provide a cursory description of construction related accounting methods and the related terminology. It is recommended that business brokers / business consultants work closely with their clients and/or their client’s Accountants/CPAs when pricing such businesses to make sure that they correctly interpret the subject’s financial information.
Most construction businesses use two different methods, one for their long-term contracts and one overall method for everything else. A long-term contact being one that is not completed in the same year it is started. A short-term contract is one that is started and completed within one tax year.
Construction-related companies can use several different accounting methods, including:
¨ Cash Method
¨ Accrual Method
¨ Percentage of Completion Method
¨ Completed Contract Method
In the percentage of completion method, the contractor must allocate direct and indirect costs to contracts in a manner as to recognize revenues and gross profit in the applicable periods of construction, and not only in the period when the construction has been completed, as in the completed contract method. The degree of completion of the construction, i.e., the percentage-of-completion, is typically estimated by dividing the total construction costs incurred to date by the total estimated costs of the contract, or job.
The referenced IRS article, also discusses several variations to these methods. There are special IRS tax rules3 that determine which accounting method(s) and/or variations of methods must be used for construction companies. Factors that affect the allowed accounting method(s) include:
¨ The type of contracts the company has,
¨ The company’s contract completion status at the end of the tax year,
¨ The company’s average annual gross receipts
When the percentage of completion method is used, the accounting principle of full disclosure requires the presentation of a work-in-process schedule in the company’s financial statements. This schedule discloses the details of each contract stage of completion and profitability to date as well as in the current period of reporting. The work-in-process schedule will not show the backlog of contracted jobs that have not yet started.
Comparison of the subject’s backlog from year-to-year, including those contracts that have not been started, is important information when listing a business.
For more detailed information on accounting for construction contracts see the IRS article referenced above3.
Terms unique to construction industry accounting include:
¨ Retainage – An amount held back (retained) by the customer (or prime contractor if the subject is a subcontractor) from each draw request. Retainage is typically in the range of 5 to 10%.
¨ Costs and Estimated Earnings in Excess of Billings – The amount by which the contractor has under-billed the customer (or prime contractor if the subject is a subcontractor).
¨ Billings in Excess of Costs and Estimated Earnings – The amount by which the contractor has over-billed the customer (or prime contractor if the subject is a subcontractor).
Impact of Entity Type on Tax Returns
Some of the most common types of entities are listed in the following table along with the applicable IRS form(s) for income tax reporting.
|IRS Form 1120S|
|IRS Form 1120|
|IRS Form 1040, Schedule C|
|IRS Form 1065|
|Limited Liability Company (LLC)||
|Any of the Above|
The most common expenses considered in financial statement recasting, that are affected by the entity type and/or the tax return, are:
¨ Sec. 179 Deduction/Depreciation – Section 179 allows the taxpayer to expense rather than capitalize certain types of assets up to a given dollar amount each year. Depending on the type of entity, the Section 179 may be taken as a business deduction in which case it would be an add-back in financial statement recasting; or, as a personal deduction, in which case it would not be an add-back in the recasting.
¨ Charitable Donations – Charitable donations are also handled differently for different entities. They may be treated as either business deductions or as personal deductions on tax returns depending on the entity type.
¨ Health Insurance – Owner’s health insurance premiums are also handled differently for different business entities. They may be treated as business deductions, included in owner/officer compensation, or as personal deductions based on several factors including business entity, whether or not the company has a qualified retirement/pension plan that includes a health insurance program. Due to complexity, the manner in which each different entity handles health insurance / medical expense is not discussed in this article. Business brokers should be aware, however, that health insurance premiums may or may not be allowable deductions on tax returns.
The following paragraphs discuss how different entities handle the Sec. 179 deduction/depreciation, charitable donations, and health insurance. The discussion applies only to tax returns. Owner fringe benefits that are expensed on financial statements are potential add-backs even if they are not legitimate tax return business deductions.
¨ S-Corporation – The S-Corporation is a pass-thru entity, i.e., there are no income taxes at the corporate level. The profits of the corporation pass thru to shareholders who are taxed at their personal income tax levels. However, shareholders of S-Corporations have a tax liability on the profits of the company, regardless of whether or not these profits are distributed to the shareholders.
- Although the IRS frowns on this practice, owners of S-Corporations often take minimal salaries to avoid payment of payroll taxes.
- S-Corporation tax returns (IRS Form 1120S) treat the Sec. 179 deduction/depreciation and charitable donations as personal deductions (not business deductions). Therefore, neither of these items is an add-back in the financial statement recasting for S-Corporations. In the S-corporations tax return (IRS Form 1120S) these and other personal deductions, etc. are listed on Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc. As indicated by the name of Schedule K-1, deductions listed on this schedule are personal deductions not business expenses.
- S-Corporation tax returns typically include owner’s health insurance expense either in Compensation of Officers (Line 7 of Form 1120S), or it is included as a non-deductible expense on Schedule K-1. It is then treated as a personal expense on the owner’s individual tax return.
¨ C-Corporation – Unlike S-Corporations, C-Corporations pay income tax. After-tax profits are distributed to shareholders as dividends. Shareholders pay personal tax, currently 15%, on dividends from C-Corporations.
- In order to avoid double taxation, owners of C-Corporations often take large salaries to minimize profit and corporate income tax. C-Corporation shareholders do not have any tax liability on undistributed profits.
- C-Corporation tax returns (IRS Form 1120) treat Sec. 179 deductions/ depreciation as a corporate deduction combined with normal depreciation. Therefore for C-Corporations, Sec.179 depreciation is a potential add-back in income statement recasting. An exception may be companies that have high annual capital expense. Charitable donations can also be treated as corporate deductions (charitable contributions are limited for C-Corporations to 10% of Taxable Income on Line 28 of IRS Form 1120). Therefore, C-Corporation charitable donations on Line 19 of IRS Form 1120 are add-backs in the recasting analysis.
- C-Corporation tax returns also allow owner’s health insurance to be deducted as a business expense.
¨ Sole Proprietorship – Income from a Sole Proprietorship is reported Schedule C (IRS Form 1040) as part of the owner’s personal income tax return. The sole proprietorship is a pass-thru entity like the S-Corporation in that money made in the business flows through to the individual’s tax return. The Sole Proprietorship does not provide the liability protection of a corporation (e.g., S Corporation, C-Corporation). Generally all liability of the business is liability to the business owner. For a Sole Proprietorship, Section 179 Depreciation is treated as a business deduction included with normal depreciation. Charitable contributions are treated as personal deductions and are not included on Schedule C.
- For sole proprietorships, owner’s health insurance expenses are treated as personal expenses – not business expenses.
¨ Partnership – IRS Form 1065 is an information return a Partnership uses to report its income, deductions, gains, losses, etc. A Partnership does not pay tax on its income but “passes thru” any profits or losses to its partners. Partners must include partnership items on their tax returns.
- The partnership uses Schedule K-1 to report each partner’s share of the Partnership’s income, credits, deductions, etc. All Partnerships must complete Schedule K. Although the partnership generally is not subject to income tax, partners are liable for tax on their share of the partnership income, whether or not the partnership distributed the income.
- Like the sole proprietorship, the Partnership is usually a bad choice for a business entity. Generally all liabilities of a Partnership are liabilities of the partners. Individuals considering partnerships should look into the more formal entities (i.e., S-Corps., C-Corps., or LLC’s).
¨ Limited Liability Company (LLC) – The federal government does not recognize an LLC as a classification for federal tax purposes, such entities must decide how they want to file their federal returns. For Federal tax purposes, an LLC business entity must file as a corporation, partnership or sole proprietorship tax return.
There are several accounting methods, and variations of these methods, that may be encountered by business brokers and intermediaries when recasting financial statements. Recasting tax returns is also affected by the type of entity. Business brokers and intermediaries should be familiar with the various accounting methods and entity types. However, due to potential differences from company to company, anyone recasting financial statements should meet with their client’s Accountant/CPA to make sure they understand the details of the accounting method used by the client company.
One thing to remember, whether you are recasting financial statements or tax returns, if an item was not included as a business expense it can’t be added back.
 How to Prepare OCBOA (Other Comprehensive Basis of Accounting) Financial Statements, www.eHow.com
 Hybrid Accounting Methods,www.eHow.com
 Article on IRS website entitled Accounting for Construction Contracts – Construction Tax Tips, http://www.irs.gov/businesses/small/industries/article/0,,id=97986,00.html