You Won't Retire in Paradise on Social Security

Tax Protection

A dollar saved by avoiding taxes is even better than a dollar earned, mostly because you would have had to pay on that dollar earned, anyway! Plus, it always brings a smile to my face when I am able to keep a few of my hard earned bucks out of Uncle Sam’s greedy grasp.
The advantages of investing through a tax deferred plan aren’t just spiritual, however, and they go beyond the immediate tax deferment of income.

• Opens up different kinds of investments that might not make sense if they were not tax advantaged. For example, while your assets are inside their tax protected shell all earnings and capital gains on them have no immediate tax effect; which is not the case for investments held outside a retirement plan. Therefore I can invest in assets without having a tax bite every time I buy or sell. If you’re interested in trading or even if you’re only rebalancing your portfolio, which you ought to do anyway, there will be no tax to pay as long as you keep those assets inside the plan. My wife and I have assets both inside and outside our retirement plans and our money outside is for more long-term investments while we like to look for deals and growth with our money inside the plans.
• Allows faster accrual of income. Look, you don’t have to have a MBA in finance to understand that if you have to pay taxes on gains every time you sell an investment or receive a dividend then your money will grow more slowly than if you were able to do the same transaction tax free. This is the unappreciated benefit of a retirement plan contribution as people fixate on the immediate tax savings instead of the long term savings.

Bankruptcy Protection

Owning your own business is risky business. You get sued, the economy tanks and takes your business with it, your supplier steals your designs or your partner goes bankrupt and leaves you with a big bill. One day your on top of the world and the next day you’re on the breadline and its happened to many smart entrepreneurs with much more experience than yourself; Donald Trump, Henry Ford, and George Foreman have taken the walk of shame only to come back bigger and badder than ever. Most retirement plans, done right and not abused, can shelter assets from bankruptcy and provide a nice, soft cushion to fall upon before building your next business.

Diversification

There is stereotype of the entrepreneur as a hyper-testosteroned type A guy that bets everything on his business, including the family farm and his first born. As you learn the ropes, you quickly find out that this is absolute nonsense. Obviously, many successful entrepreneurs are female and virtually 100% of entrepreneurs that have been in the game for any amount of time carefully diversify their money across various business and investment opportunities.
Every entrepreneur that I have had the honor to work with and learn from has had a passion for their business and laser intense focus on making it successful. It is because of the focus and attention to detail that they should be stuffing every dime that they are able to or are allowed to into a retirement plan. Most retirement plans can be set up to be very low maintenance. Just make the maximum contribution allowable into one or more index funds and forget about it. This is what makes it so special to the entrepreneur, no sweat, no hassle, no losing focus on their most important investment, their business. Keep the current economic crisis in your mind and remember that businesses really can be floating in a sea of cash one day and then high and dry the next.

You Are Not Immortal

When your mother gave birth to you she simultaneously condemned you to your death. We will all die and most of us will grow old or become ill before we finally kick the bucket. When you’re a new entrepreneur everything is exciting and the sky is the limit and you don’t really think about that, but it’s there, hovering over everything that you do. The fact is that your enthusiasm for business and entrepreneurship will fade and you will tire and wish to devote time to other pursuits, whether its spending more time with your family or traveling the world or running away with the circus. An industrious and fortunate few of us will cash out Paul Allen style and the chicken feed that we have saved through our retirement plan will almost be an afterthought, a little gas money for the yacht. Savor that thought for a moment. Now, 95% of entrepreneurs I know, and I’m including people with successful, multi-million dollar businesses, use their retirement plans to at least supplement their incomes when they choose to slow the pace down a little (few actually totally retire). Also, should you lose the longevity lottery and slip into the deep sleep prematurely, then those retirement funds could help sustain the loved ones that you leave behind.

If you don’t max out your retirement plan contribution, or at least give until it bleeds, 2010 is the time to really make this a priority. Even if you are in the start-up stage and cash is hard to come by you need to “pay yourself first” and not neglect this important tax and finance tool.

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The Old Bath + Bottle + Story = Sleep!

How My Two Year Old Can Help You Kick More Ass

There is no greater lesson on the importance of communication and what works in motivating people and modifying their behavior than the one you get as the parent of a small child. I mean, you can have long-winded meetings at work and hope to motivate employees through entreaties to their professionalism and the possibility of career advancement but that absolutely will not cut it with Little Susie Q, your adorable but emotionally erratic two year old. If you want to reward her for doing something (or bribe her to do it) then the gratification has to be instant and when you need to punish her (and you will need to punish her) then the punishment has to be swift, fair, and consistent.

New parents quickly figure out that their children actually crave routine and order, even as they rebel against it, and they put this to use in their war battle loving effort to get the damn thing to fall asleep and sleep through the night! How many of you have used some variation of the nighttime formula: bath + bottle + book + crib = good night’s sleep? And by good night’s sleep I mean yours, not the child’s. Well, what you are doing is establishing routine and order in the otherwise chaotic life of your infant. Like Pavlov’s dog, over time the infant internalizes the sequence of events and the sleep becomes natural to them. Good parents recognize a good thing when they see it and use similar tricks for potty training, teaching manners, and teaching sharing.

Well, it’s not just small children that crave order, the very same technique can work to make us more productive, healthy, and happy. Think of any great habit that you wanted to develop and how hard it was to stick to it. By creating a routine, a ritual even, leading up to the successful practice of that habit you can vastly improve your probability of success.

I’ll give you a for instance. Every night, after I put my two year old to bed, I sit down to write. Well, I don’t sit right down, first I go through my ritual. First I make myself a cup of tea and then I spend five minutes thinking about my goals and why I sit down to write every night, no matter what, instead of watching t.v. or surfing the Internet. Then, at the end of the five minutes I take a brief minute to plan my attack on the night and I get down to work. In the past I have tried to just get right to work but ever since my son taught me the value of ritual I have followed this and IT WORKS! Not just in making me more productive, although I certainly have noticed that, but it makes the task so much more fun and therefore I am much less likely to skip it.

The key to developing a real kick-ass and effective ritual is consistent, dedicated application toward a worthwhile goal. This is where the word ritual comes into play because you have to be religious, almost fanatical, in your practice; at least at first. You’ll know that you’re starting to get the hang of it you start to do it automatically, without even thinking about it as an option. When it gets to the point that you would feel odd and disconcerted if you didn’t go through with it then you’ll know that you are really getting it down right.

Beware of Bad Rituals!

Just as rituals can be used to learn and grow good habits, they can also cut the other way. Think of the incredible number of people out there that get home from work, eat dinner, and then veg in front of the idiot box until they realize that it is bedtime. I know people that can’t walk into a room without turning on the television; notwithstanding the presence of company or having some other task to accomplish. The television is normal, and its absence makes them uncomfortable.

Don’t Believe Me? Then Ask Landon Donovan

Have you ever seen Landon Donovan take a penalty kick? What about Tiger Woods tee off, Peyton Manning take a snap or Lebron James take a free throw? Before Landon takes a penalty he goes through a routine that involves his crossing his fingers and kissing them several times before he starts the approach to the ball. He’s gotten a lot of slack for that, but he’s also made a ton of penalty kicks. Never missed for the United States, as a fact.

Rituals for preparing for and performing in sports are both ubiquitous across all sports and legendary. Some athletes will continue to wear the same clothes when they have a hot streak, some will shave their heads to start one and some won’t shave while they are winning. To prepare for games, some players will listen to aggressive, high-intensity music like some rock or rap while others will choose music that makes them mellow. During games some players will cross themselves, mutter to themselves, bounce the ball a certain number of times or approach the plate a certain way.

While sports are especially notorious for the use of rituals to put the athletes “in the zone” and to promote concentration and performance, highly effective people in other professions such as actors, public speakers, and sales people have also tapped into the power of routine and ritual. I’ve spoken with sales people who use methods to hype themselves up and with surgeons who use yoga and soothing music to calm themselves down. Writers will use tricks to bring focus and artists to encourage creativity.

So What Do the Experts Say?

So what do the professional psychologists, men and women of science who have devoted years of study to the subject, think of the use of ritual to enhance performance? Surely they frown upon it, or at least turn a blind eye. I remember an episode of Frazier when Miles Crane took on a basketball player who was in a slump as a client. The upshot is that Miles encouraged the use of positive thinking and visualization while the player fell back upon good old superstition. Either way, the slump was rectified and both parties were happy. Real sports psychologists, who get paid big bucks to advise clients, often actually encourage the use of routines and consistency in their clients, and there are even clinical studies that lend evidence that it actually is effective in enhancing performance.

What’s Harry Potter Got to Do With This?

Some Harry Potter fans will remember in Harry Potter and the Half-Blood Prince when the potions master, Horace Slughorn, gives Harry a flask of the elixir Felix Felicis, also known as liquid luck. Slughorn claimed to have used it twice, each time resulting in a “perfect day.” Under the influence of Felix the feels confident, self-assured, ready for anything that may come. So suggestive is its power that Harry pretends to give some to his best mate Ron before a Quidditch match; with the result that Ron, who is duped into believing that he has taken the medicine, performs brilliantly because that is what he believes he is destined to do.

The Recipe for Felix Felicis

Alright, Old Slughorn didn’t really give me the recipe (I was a crap potions student) but between my son, Landon Donovan, and Harry Potter I think the path has been blazed and the answer is evident. Feeling good about yourself (having the “perfect day”) comes about from kicking ass and getting things done, while kicking ass and getting things done comes about as a result of consistent and relentless effort. Indeed, I’ll bet Landon Donovan wasn’t always an automatic goal at the penalty kick and my son certainly didn’t fall asleep the first time we tried the old bath + bottle + book + crib trick. However, through countless repetition, and that old Jedi mind trick of using ritual as a psychological trigger, they have developed the confidence to do so. The ritual triggers the action, and the action becomes automatic.  Now is your chance to tap into the power!

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How much did I really make?  Learn the secret of calculating your business’s net income!

Everyone wants more income, but way too many business owners and managers don’t really fully understand the concept of net income and what it means to their business.  Learn the simple trick to fully understanding and preparing your income statement.

Money Makin' Inc.

Other Names:

The Income Statement is also often called a Profit and Loss Statement, and, less commonly, a Statement of Operations, an Earnings Statement, or an Operating Statement, depending upon the industry or geographic area that you operate in.  For our purposes, they are all one and the same.

What It Is

“C’mon Tyler, this is a waste of time; everyone knows what an income statement is!”  I can hear your argument now.  Well, knowing what it is and understanding are two different things, so have a little patience.  Let’s start by looking at Wikipedia’s definition of the income statement as

“a company’s financial statement that indicates how the revenue (money received from the sale of products and services before expenses are taken out, also known as the “top line”) is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as the “bottom line”). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g.,depreciation and amortization of various assets) and taxes.”

Clear as mud?  Here is another way to look at it.  If you remember from our lesson on the balance sheet and on retained earnings, the balance sheet represents, at one given moment in time, a company’s assets (everything it owns that has value) less its liabilities (everything it owes or that will cost it money in the future) to get at its equity (the net value of the company).  What the income statement does, together with the statement of owner’s equity, is to tell the story of the change in a balance sheet over a period of time.
Let’s boil this down to the simplest level, and ignore everyone out there who is screaming out exceptions that really don’t apply to most of you as entrepreneurs and owners of small businesses.  Your Net Income (the bottom line of your income statement) must be equal to the increase (or minus the decrease) in your assets over the year minus the increase (or plus the decrease) in your liabilities plus any cash paid out to the owner.

Now think about this, increased assets make you feel happy, right?  After all, they represent items that have value to the business and that should, in the future, bring you money.  Increased liabilities should make you a little uneasy.  Your liabilities are money that you will have to pay out someday, which will make you unhappy.  I hate paying money, but I sure love getting it!  Maybe that’s why my wife calls me a cheap sonofabitch.  Now, your distributions are money that you have already taken out; and so they gave you happiness at some point in the past.  So really, net income is your overall increase in future happiness, less the increase in future unhappiness and plus the amount you have already taken out in past happiness!

Why important

The income statement is the single most important vital sign of the health of your business.  If income is good, then more assets can be put to use for the business and more money can be distributed to the owners.  The flip side is that when income is negative, which means that you have a loss, then you will have less money to take out of your business as distributions and you will have to support your operations by either selling off assets or by increasing liabilities.

What It Looks Like

If you have accounting software, like QuickBooks, then you will get a basic presentation as part of the package.  In virtually all businesses, the income statement starts with sales and ends with expenses.  If your enterprise is either manufacturing or retail related, then the basic presentation is Sales – Cost of Sales (also called Cost of Goods Sold) = Gross Income – Sales Expense, Operating Expense, and all other expenses + income not from ordinary operations (such as the gains on the sales of assets besides inventory or interest income) – expenses not from ordinary operations (including taxes, although I would consider taxes pretty ordinary) = Net Income.

Oh my God!  I’ve just totally turned geeky-accountant super-nerd on you guys!   Look, presentations vary wildly from industry to industry and from one set of accounting standards to the next.  If you need to present the statements to others then you’ll probably end up getting an accountant to put them together, anyway.  So just put them together in the way that makes sense for you and helps you find the information that you need.

What is Revenue

Now that we know what the net income must be, let’s take a peek under the hood to see some of the gory details.  The basic income statement is divided between items that have made you money or will make you money in the future, income or revenue, and items which have cost you money or will cost you money, expenses.  As you may imagine, we want to keep close tabs on those warm, fuzzy revenues so that we can nurture them and make them grow and thrive.  Therefore, we group the revenues together and lump them at the top of the page.  Your revenues can further be divided by important products or divisions to provide the readers of the income statement with more information.  Finally, some items are always segregated from the general revenue items due to their unusual nature, including unrealized gain or loss on assets, realized gains or losses on assets, interest income, and other items.

What is an Expense

Expenses are the Devil, prying money from your pockets either now or in the future.  Every business has to deal with the Devil in order to operate, but we want to keep track of these deals so that we know how much of our soul we still have left!  As you may imagine, we further segregate expenses into sub-categories.  Cost of Goods Sold (also called Cost of Sales) is the money you spend to purchase or make the product that you sell.  General and Administrative Expenses are more peripheral items that pop up in the course of running a business.  Your accounting software, wages paid to the janitor or the secretary, Internet service for the office, basically anything that can’t be directly attributed to the purchase or manufacture of your product.

How to Prepare Your First Income Statement

If you are using QuickBooks or another accounting program then it is seemingly easy to put the income statement together.  The problem with most of those programs is that they can’t tell you when you put garbage in them.  So you will want test your income statement by following the steps below.
Step One: Make sure your balance sheet is up-to-date and accurate.
At the end of the year I go down my balance sheet line by line and make sure every amount makes sense to me.  In fact, that is the first step of an auditor if you get your statements audited.  I like looking at at least two periods side by side, since inconsistencies are more apparent that way.  Make any adjustments that you need and move on to Step Two.
Step Two:  Calculate Your Retained Earnings
I’ve already written about this in detail in another article, but basically your retained earnings are the bridge between your balance sheets for the current and prior periods.  Any change must be reflected in retained earnings, which is in return the product of your income plus any contributions in capital and less any distributions of capital.  So if you can get the correct number for any capital that you took out (other than wages, which will go onto the income statement and for which you will pay payroll taxes) or put into the business then you can isolate the effect of net income.  Can you figure those out?  Good, then any remaining change in net assets must be due to net income.  Now you have your net income and, if you are using an accounting software, you should check your number for net income with the number that you just calculated.  If they don’t match, well, you’re screwed and I can’t help you anymore.  No, just kidding, you’ll have to adjust your income on the income statement to match.
Step Three: Fill In the Blanks
Now plug the number that number into the bottom line of your income statement and start filling in the details.  When you have everything in but it doesn’t total up then just plug the difference, if it is minor enough, into some sort of Miscellaneous Expense or Miscellaneous Income account.  Don’t worry your accountant does that all the time!

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler Wells, C.P.A.

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It didn't have to come to this

If I am filing bankruptcy, can I also discharge any taxes I owe? I get this question way too much these days and it is never pleasant. Neither, unfortunately, is the answer, “maybe.” Like anything that has to do with our government, the rules and limitations for discharging your tax debt through bankruptcy are complicated and are most likely to benefit you if you carefully examine your options, plan ahead, and hire some professional help.

Income Tax Rule

In order to eliminate your tax liability through bankruptcy, it has to clear the following hurdles:
Be more than three years old – the three year clock starts ticking on the date the tax return for the year in question was due; so April 15, 2010 for 2009 taxes. Note that this is the minimum time in which you can include taxes in your bankruptcy and that certain circumstances could extend this even further.

• Be filed at least two years ago – the date that you file the bankruptcy petition must be at least two years after the date that the tax return was filed. This is relevant if you filed an extension, were late to file, or just plain failed to file a return. The motivation here is plain, get those damn things filed! Even if you don’t have enough money to pay the taxes due it is almost always better to file without paying then not file at all.
• Have not received an assessment from audit adjustments or amended returns in at least 240 days. This could be extended by an Offer in Compromise (see below). Basically, this means that your return was amended, either by yourself or by the IRS, and additional tax was assessed because the original return was incorrect.
• No fraud or evasion – as you may have guessed, your rich Uncle Sam gets pissed off when people try to deceive him, and so fraudulent returns or tax evasion can mean that your debt is not dischargeable in bankruptcy.

Two Bankruptcy Options

Chapter 7 – “The Full Monty,” and what people usually mean when they say
bankruptcy, Chapter 7 is when everything except certain exempt assets are sold and then the money is divided up between your creditors.
Chapter 13 (11 for businesses) – or “reorganization,” is when a plan is made for you to repay your debts under court supervision. Essentially, Chapter 13 allows you to put together a plan with all debtors and then set up a system of repayment. As part of the bankruptcy some of the amounts due can be reduced or new terms can be established.

Limitations of Bankruptcy

Taxpayer Beware: the above rules only pertain to federal income tax due. State
taxes are a whole different ballgame and will have to be resolved on a state by state basis. In addition, the following taxes cannot be eliminated in a bankruptcy:

• Self-Employment Taxes – this one can be particularly tricky because so many
• entrepreneurs just get their self-employment taxes lumped in with the rest on their 1040s and don’t really think about them. However, you’ll have to separate these if you are considering filing bankruptcy to see how much of your tax is really potentially dischargeable.
• Payroll Tax Withholding - Like self-employment taxes, you can’t discharge your payroll tax withholding in a bankruptcy.
• State Sales Taxes – ditto
• Various Other Taxes That I Have Forgotten to Include – No, those are not dischargeable either.

Options to Bankruptcy

Most taxpayers who owe federal taxes will at least consider the alternatives
to bankruptcy, if only because there is no way in Hell the IRS will let you get by three years before assessing you for taxes due.

• Installment Agreement - like any other creditor, the IRS can, at its discretion, put taxpayers on payment plans to help them settle their debts. Note, however, that interest and penalties will still apply and so it is in your best interest to pay the amount due as quickly as possible.
• Collection Due Process - a CDP can be filed with the IRS to protect your right to go to court and is filed after you have received a Federal Tax Lein or an Intent to Levy. Basically, with a CDP you are signaling your intent to dispute the assessment. File to protect your right to go to court.
• Offer In Compromise – Make a deal with the Devil and ask the IRS to reduce your burden by accepting partial payment. The IRS may decide to accept an Offer in Compromise if there is some doubt about the legitimacy of the amount you are purported to owe, if there is no doubt as to the legitimacy of the payment but there is no way you have the ability to cover the payment, or if you have the assets to cover the payment but there are some remarkable extenuating circumstances that convince the IRS to have mercy on your soul, like you’re abducted by aliens and have to pay the ransom.

What does this mean if I am behind on my taxes and I owe the IRS money?

In theory, people in economic trouble shouldn’t really owe taxes because they don’t have much income. However, as with just about everything in life, there are 5,001 potential outcomes that could result in your owing taxes and not having the cash to come up with the payment.

1. Step One: File all returns. Remember that you will have to have filed at least two years before filing for bankruptcy if you hope to have your taxes discharged, so make sure that you are up to date.
2. Step Two: Protect your spouse. If the tax burden, and accompanying inability to pay, is the result of the activities of one spouse then consider filing married filing separate to protect the other spouse.  This usually happens when one spouse is an aspiring Donald Trump or Oprah Winfrey while the other is a mild-mannered librarian.
3. Step Three: Is the inability to pay due to a permanent or temporary change in fortune? If your business was wiped out and folded sometime between the beginning of the year and when your taxes are due then you are a prime candidate for some sort of deal with the IRS. On the other hand, if you can’t pay your tax bill because you already spent the money without budgeting enough for taxes then you are most likely a candidate to get on some sort of payment plan.
4. Step Four: Pull the trigger. Either way, don’t duck the issue and hope that it will go away. Take the bull by the horns, get your returns filed, and then seek some professional council on how you can get the situation resolved.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

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Don't Get Burned by a Boring Business Idea!

When it comes to starting a new business too many hopeful entrepreneurs display a shocking lack of creativity, thinking only of expensive and time-intensive business, like bars, restaurants, and boutique stores, and therefore absolutely miss the best businesses for new entrepreneurs.  If your just starting out and want to make some money as you learn the ropes as an entrepreneur, firmly say “no thanks” to these boring businesses with their high start-up costs and even higher risk of failure and instead sell something much sexier and potentially exponentially more profitable, your own ingenuity and hustle.  To learn more and for some great ideas on starting up your own home business, see my guest post at Entrepreneur and Small Business Journal.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler Wells, C.P.A.

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I absolutely love the material put out by the Kauffman Foundation, which exists to help instill entrepreneurialism in America and around the world.  Now they are bringing entrepreneurs together to commit ourselves to the countries future because, in the words of the Kauffman Foundation’s executive, Carl Schramm, “entrepreneurs continue to be the key to our country’s economic recovery because they are the primary source of new job creation. Introducing the Pledge only enhances the Entrepreneurs’ Movement, which is aimed at giving entrepreneurs a platform to share their stories and amplify their voice.”  So check out the pledge below, and then go over to the Kauffman Foundation to sign the pledge.

The Entrepreneur’s Pledge:

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Purpose of a Balance Sheet

The balance sheet boldly declares where a business stands at a given moment in time.  From the balance sheet, a financially sophisticated reader can learn an immense amount of valuable information about a business and its viability.  That is why potential investors and lenders will almost always ask you for a copy of your financial statements, including the balance sheet, income statement, statement of retained earnings, and statement of cash flows.  This is also why you, as a savvy entrepreneur, need to understand the information presented on them.

Why It Is Important

The principal reason your business’s balance sheet is so important to you and to any potential investors or lenders is that it is like a photograph of your business.  It tells how the business is put together, what its principal resources are and where any potential dangers lie.  Like any portrait it is incomplete, in that it only shows one fleeting moment in time, and therefore is most useful in conjunction with the income statement and by comparing several balance sheets over a period of time.  Ahh, this is where the real story begins to unfold!  The clever entrepreneur becomes the Sherlock Holmes of the balance sheet and astutely looks for trends over time and checks ratios and balances to see which direction the company is headed in and to look for any potential to cut costs or perform more efficiently.

Why Small Businesses Are Different

If you are a small business owner or entrepreneur then you need to be able to read and understand your balance sheet because, first, it is through your financial statements and other numerical data that you collect that you really get to know your business.  Michael Gerber, the best selling author of the E-Myth Revisited, says it much better than I ever could as “because without the numbers you can’t possibly know where you are, let alone where you’re going. With the numbers, your business will take on a totally new meaning. It will come alive with possibility.”  The very first step you will ever take down that road to really knowing your business is through examining and understanding your own balance sheet.

Second, your balance sheet is how anyone that you will ever want to do business with will understand your business.  Think about getting a loan, the first thing your banker wants to see are your financial statements and the first page of your financial statements is your balance sheet.  Why is it first?  Perhaps because it is the most important.  Now think about your situation; you’re applying for a loan or a grant or you want to do business with the federal government or an investor is thinking about either coming on board or buying you out and you present your financial statements to them.  They open them up, turn to page one, and there is your company laid bare, open to them.  And they ask you questions; “why is this line a negative number, how did you arrive at the valuation of that line, what are the terms of this liability.”  Don’t you want to be able to confidently look them in the eye and answer those questions?

What Makes Up a Balance Sheet

Hopefully, you have been exposed to some basic accounting and understand the concepts that some numbers in accounting are recorded as debits and some numbers as credits.  These numbers are often represented as positive and negative numbers and the balance sheet, as its name suggests, must balance, i.e. the negative and the positive numbers must total zero.  In addition, the basic formula for accounting is Assets = Liabilities + Equity, and any US balance sheet will be organized into exactly three sections with at least two subtotals, for assets and for liabilities and equity.  Using the basic algebra that we learned in Ms. Arithmatic’s 6th grade class, we can shrewdly deduce that the two subtotals must be exactly equal.  So far no problem, because if your balance sheet doesn’t balance then you have much bigger problems then simply worrying about understanding your financial records.

How Assets Are Valued

Great! you’re thinking, let’s start with the assets!  Well, I love an enthusiastic learner and so I will oblige.  To put it very briefly, assets are the total of everything your business has that has some sort of value to the business.  This could be cash or real estate or stocks and bonds or machinery and equipment or accounts receivable or other moneys due to you.  It could also include inventory, which is product that you have produced but not yet sold.  So to summarize assets are usually either cash, something that you have bought, something that you have made and that you expect to sell, or something that is owed to you.

Clearly then, if you want to make your balance sheet you must have a list of your assets and how much each is worth.  The rub lies in the worth, or valuation of the assets.  “Hmm, you think, I bought this asset ten years ago at 10 grand, I added 5 grand in improvements to it, it would cost me 20 grand to replace it and I could get about 18 grand on the open market for it, so what value should I put down for it?”  Clever question, my dear reader!  Well, as you may have assumed, we accountants have put a great deal of thought into these issues and we continue to think about and tweak the ways we value things to this very day.  If you want the exact answer to just about every accounting question then it is there for you, for free but in techno-accountant babble, at http://asc.fasb.org/.  However, most of you don’t want to do all that work, you want a quick and easy rule of thumb that works 90% of the time without you having to leave this article, and that is exactly what you will get.  The key here is conservatism, we are much more worried about overvaluing an asset then we are at undervaluing.  Therefore, the rule of thumb is that assets are valued at the lessor of cost (what you paid for it) or fair market value (what you could get if you sold it right now).  Now, there are additional considerations, like depreciation for buildings, machinery, and equipment, and the value of receivables and other moneys owed to you, but that is the general rule.

How Liabilities Are Valued

The next step is to make a list of items that your business owes or obligations that it has.  This could be money that you owe to your suppliers for products and services or money that you owe to your employees for services performed or money that you owe to the government for taxes or or money that you owe to the bank or another lender.  It could even be money that the business owes to you, as an owner.
Remember what I said before about conservatism?  Well, this counts for liabilities as well, only in this case the concern is that liabilities are undervalued or, even worse, unrecognized and unrecorded.  The general rule of liabilities is that they are included at amortized cost which should be equal to the amount owed on them at that moment in time.  This usually presents less of a challenge than the valuation of assets because most long term assets, like loans, have explicit terms that spell out exactly how much you owe on them at any given moment in time.

How Equity Is Valued

Depending upon the type on entity (Corporation, S-Corp, LLC. etc.) that you use the equity portion of the balance sheet can use different terms, but really there are two kinds of equity: capital that you put into the company (stock, contributed capital, etc.) and the earnings of the company (retained earnings).  The capital that you contribute is usually pretty straightforward.  If you contributed something other than cash, such as real estate, machinery, or your interest in another business then use the rules for the valuation of assets, the lessor of cost or fair market value.

Retained earnings is a whole different ball game.  Remember what I said back in the beginning about the formula for the balance sheet?  That Assets = Liabilites + Equity?  Well, if you’ve filled everything else out you only have retained earnings left, and, using a little bit of algebra and adding some detail to the preceding formula, retained earnings absolutely must equal Assets – Liabilities – Contributed Capital.

Now, it’s fine to do the math and plug the number to get started, but as you go forward your retained earnings will develop a new relationship, with the income statement (also commonly called the profit and loss statement).  Basically, the relationship is net income + any contributions to capital – any distributions of capital (dividends) = the change in retained earnings for the period.  So retained earnings becomes the bridge between the balance sheet over two consecutive time periods (usually a year).  For more information on calculating retained earnings see the link to my blog post on retained earnings.

What the CPA or Auditor Does

You’ve done a fantastic job getting your balance sheet set up and keeping it going, but at some point you’re going to show it to someone, a banker, a supplier, a potential business partner, and they are going to take one look at the work that you have so proudly and lovingly put your heart into and they will say, “what the Hell is this crap?”  Don’t take it personally (you need their money, after all) just understand that there are standard ways to present present financial statements and set rules to follow.  In order to make your statements comply with these rules and to give them an air of authority you will have to hire a Certified Public Accountant, or C.P.A., and have them compile, review, or audit your financial statements.  What this means is that the C.P.A. takes your statements and then makes some cosmetic changes in order to present them in the form proscribed by US Generally Accepted Accounting Principles or, if appropriate, one of a number of alternate forms, and then issues an opinion on them.  The opinion will vary depending upon the type of engagement you hired them to do.  The standard opinion for a compilation is “we took this pile of crap and made it pretty, but we’re not saying that it makes any sense” while the standard opinion for an audit is “sure, we took a look and everything seems OK, but please don’t sue us if we’re wrong!” while a review falls between the two.

Shenanigans

If you’ve watched the news at all over the past five years then you are aware that not all balance sheets are what they are painted to be.  Enron and WorldCom are the biggest examples of out-and-out fraud, but more recently the big Wall Street firms, like Lehman Brothers, have come under fire for inadequate or questionable accounting practices.  How does this all happen?  Well, let’s go back and revisit the assets and liabilities sections of this article and rethink what I said about conservatism.  If assets are valued at higher than they should be, or liabilities lower, the difference must come through retained earnings in the form of income.  So, most accounting frauds are a resulting of overstating assets, usually inventory for industrial firms or investments for banking and Wall Street firms, or by not including certain liabilities on the balance sheet.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

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Foreign Investments and Bank Accounts

The amnesty period for holders of foreign bank accounts to come forward and pay back taxes due to avoid prosecution and penalties has expired and now the IRS seems serious about rooting out potential tax evaders.  First UBS was coerced into coughing up an estimated 4,000 names and now HSBC seems under the gun.  In addition to the rules over foreign bank accounts, don’t forget your requirements to disclose certain investments in foreign corporations.  Expect this to be a hot area of compliance for some time.  Unfortunately, the statutory penalty for failure to file IRS Forms 5471, 8858, or 8865 with the IRS is $10,000 per return, per year, per taxpayer for each year in which the required returns are not filed.  Keep in mind that the penalty is for failing to disclose and has nothing to do with rather or not any additional tax would have been due.

Contract Workers and 1099s

Another bee up the IRS’s bonnet is the improper classification of employees as contract workers, thus depriving the Treasury of the employer’s portion of FICA and of federal unemployment.  A reclassification by the IRS can be hideously expensive, so cover your ass by making sure that you get it right.  One way to do so is by making sure you treat all workers consistently, making sure that your classification is reasonable, and giving everyone a 1099.  If you clear those three hurdles the IRS cannot retroactively declare them employees and demand the FICA and employment insurance payments from you.  However, if you fail to give the workers a 1099 and the IRS audits and reclassifies them as employees, you’re left holding a potentially very expensive bag.

Deduct Your Health Insurance on Your Schedule C to Lower SECA

In what will be a sweet deal for many of my clients self-employed persons will be able to deduct their medical insurance right on Schedule C for 2010.  A sweet deal, if very brief because right now that will only be a one-off for 2010.  This could be great for you because it should lower your Schedule C income and therefore lower your self-employment taxes.

Save Your Kids Taxes By Dying in 2010

If you have assets in excess of $3.5 million then this might still be a great year to die, just ask George Steinbrenner.  Ridiculously, Congress has still yet to act to close the loop in the inheritance tax law that could, in the absence of a new law, allow George Steinbrenner’s kids to inherit the Yankees without owing any estate tax.  Back in January everyone was sure that a new law would be passed before the year’s end that would include 2010 but so far there has been no action.  If things keep going like this the Mrs. and I might consider a vacation to the West Bank come December.  Of course, we would need to come up with another $3.4 million to make it worth Junior’s while.

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I don’t know about you but every once in a while I need a real kick in the ass; something that shocks me out of complacency and moves me to reach for something more and to leave my comfort zone in order to venture out into the unknown. Well, this week the William Kamkwamba story provided just that shock to the system.

William grew up in rural Malawi, Africa, and had to leave school to help provide for his family of 20. In William’s village there was no electricity but lots of wind, and so, sick of sitting in the dark, William decided to make a windmill. His only book as a guide just had photos and the basics of what a windmill was and was definitely not a guide on how to make them. Not the quitting type, William says “Yeah, I figured it out on my own.”

But don’t just listen to me wax on about it, invest 6 minutes of your time to take a look at William’s story.

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Ty's Offshore Telecommute

No Graphics or Photos

Look, with amazing and breathtaking photos available for free on flicker.com (don’t forget to give credit to the photographer) and inexpensive photos and graphics at iStockphoto.com there is absolutely no reason not to include some images that can bring some life into your book.  I may turn an exquisite phrase, but the perfect photo can frame and enhance my prose to make it truly a masterpiece.  Or at least readable.

No Table of Contents

Nothing screams amateur like the lack of a detailed table of contents with hyperlinked indexes.  The first page I read, or at least review, in any book is the index.  It helps me organize my reading and serves as a reference when I’m done.  God knows I could use a little more organization in my life.

No Section About the Author

It's OK, He Takes After His Mother

No Personality in Writing

I once had an accounting professor who literally wrote the book on corporate income tax.  As you can imagine, the book was your typical, dry college textbook; except he still managed to put some personality in it.  In the examples, instead of saying Mr. Jones, Chief Financial Officer of ABC Corp he would use something like Guido McGoodfella, CFO of Concrete Shoes , Inc.  Also, the guy had kids that played soccer and was a bit of a soccer nut, this was during the 2002 World Cup, and managed to bring in soccer references in his material.  Now when I write I think of that guy and think that if he can put personality into an accounting textbook then really none of us has an excuse not to season our material with our own personalities.

No Updates if Material is Technical or Timely in Nature

The world changes and, unless your eBook is on using the ancient Greek method of fermentation to make wine in your basement, your eBook needs to change too.  Open any book cover at Borders and you’ll see multiple published dates, especially if the book is informative or at least somewhat technical in nature.  The subsequent dates are often revisions in which the book was revised to keep up with changes in the material.  Your eBook, if you continue to sell it, must be kept up to date as well and the reader should be informed of any revisions.

No Follow Through or Use of Social Media

Once you’ve drawn the reader in and dazzled them with your wit and personality then don’t just let them walk quietly away into the darkness but rather give your new friend (the reader) the chance to maintain and even enforce the connection that you have established.  Provide links to your blog or Facebook fan page, let them follow you on Twitter, and lead them to other products you have been involved in.  This isn’t just good business, this is a service to your client.  After all, they’ve just been educated and entertained and are starving for more.  So don’t leave them hanging, throw them a bone.

How to do it Write Right

Besides not doing any of the above, you should look to the experts.  Pat at the Smart Passive Income blog has a brilliant eBook available that is a guide to writing and promoting better  eBooks!  Better still, all it costs you is your name and email address.  I have used it for my own eBook and I absolutely love it.  Note, I get absolutely nothing from Pat, not even a thanks, for recommending this to you.  Besides Pat’s book there are a number of books and blogs out there that can help.  In addition, if you are going to market through another website then see if anyone will edit your book.  Having a pair of experienced eyes read and edit your book adds tremendous value.

Please leave your questions or offer your solutions below. As the WebCPA and the author of WebBizFinance.com, my job is to help you grow your business and solve your business finance and accounting problems!

Tyler

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