Owners’ equity is the difference between the assets and liabilities reported on your company’s balance sheet. It’s generally composed of two pieces: capital contributions and retained earnings. The former represents the amounts owners have paid into the business and stock repurchases, but the latter may be less familiar. Here’s an overview of what’s recorded in this account.

Statement of retained earnings

Each accounting period, the revenue and expenses reported on the income statement are “closed out” to retained earnings. This allows your business to start recording income statement transactions anew for each period.

Retained earnings represent the cumulative sum of your company’s net income from all previous periods, less all dividends (or distributions) paid to shareholders. The basic formula is:

Retained earnings = Beginning retained earnings + net income − dividends

Typically, financial statements include a statement of retained earnings that sums up how this account has changed in the current period. Net income (when revenue exceeds expenses) increases retained earnings. Conversely, dividends and net losses (when expenses exceed revenue) reduce retained earnings.

Significance of retained earnings

Lenders, investors, and other stakeholders monitor retained earnings over time. They’re an indicator of a company’s profitability and overall financial health. Moreover, retained earnings are part of owners’ equity, which is used to compute certain financial metrics. Examples include:

• Return on equity (net income/owners’ equity),
• Debt-to-equity ratio (total liabilities/owners’ equity), and
• Retention ratio (retained earnings / net income).

A business borrower may be subject to loan covenants based on these ratios. Care must be taken to stay in compliance with these agreements. Unless a lender waives a ratio-based covenant violation, it can result in penalties, higher interest rates, or even default.

Retained earnings management

Profitable businesses face tough choices about allocating retained earnings. For example, management might decide to build up a cash reserve, repay debt, fund strategic investment projects, or pay dividends to shareholders. A company with consistently mounting retained earnings signals that it’s profitable and reinvesting in the business. Conversely, consistent decreases in retained earnings may indicate mounting losses or excessive payouts to owners.

Managing retained earnings depends on many factors, including management’s plans for the business, shareholder expectations, the business stage, and expectations about future market conditions. For example, a strong retained earnings track record can attract investment capital or potential buyers if you intend to sell your business.

Warning: Excessive accumulated earnings can lead to tax issues, particularly for C corporations. Federal tax law contains provisions to prevent corporations from accumulating retained earnings beyond what’s reasonable for business needs. We can prepare detailed business plans to justify an accumulated balance and provide guidance on reasonable dividends to avoid IRS scrutiny.

For more information

Many companies consider dividend payouts and plan investment strategies at year-end. We can help determine what’s appropriate for your situation and answer any lingering questions you might have about your business’s statement of retained earnings.

A chart of accounts is the foundation of accurate financial reporting, so it needs to be set up correctly. A disorganized chart or one that lumps transactions into broad, undefined “buckets” of data can make it difficult for management to evaluate financial performance and identify unmet customer needs — or open the door to accounting errors and fraud. Here’s some guidance on how to create a robust chart that’s right for your situation.

Why it matters

A chart of accounts is a structured list of general ledger accounts that are used to record and organize financial transactions. An organized chart simplifies the preparation of tax returns and financial statements that comply with formal accounting standards, such as U.S. Generally Accepted Accounting Principles.
Additionally, a detailed chart provides insight into profitability and asset management. It can help you identify financial and operational areas in need of improvement and make better-informed strategic decisions.

In turn, these insights can help you communicate with stakeholders, such as lenders and potential investors, about your business’s financial performance. This can be useful, for example, when applying for new loans, seeking additional capital contributions, or selling your business.

Numbering and naming conventions

Essentially, the chart of accounts mirrors the financial statements; it includes major balance sheet and income statement accounts. Each account is assigned a unique identification number and an account name.

The following sequence is customarily used for account numbering:

• 1000-1999 for assets, such as cash on hand, undeposited funds, accounts receivable, equipment, machinery, vehicles, real estate and inventory,
• 2000-2999 for liabilities, including accounts payable, accrued expenses and outstanding loans,
• 3000-3999 for equity, for example, retained earnings and capital accounts,
• 4000-4999 for revenue, such as contract revenue, change order revenue, reimbursements and retainage, and
• 5000-5999 for expenses, for instance, materials, labor, payroll and benefits, rent, utilities, equipment leasing, marketing, insurance, depreciation, and administrative costs.

Subcategories are generally created for key accounts within each main category. For example, current assets could start at 1100, fixed assets at 1200, and other assets at 1300. As your business grows or its reporting needs change, you might add more accounts within a range.

Following best practices

There’s no one-size-fits-all format for the chart of accounts. The appropriate structure will depend on the number, nature, and complexity of your company’s financial transactions. Most companies start with industry-specific templates provided by their accounting software packages. Then, they customize those templates to fit the company’s needs.

When setting up your chart, consider these best practices:

•  Leave space between account numbers to accommodate business growth,
• Use simple, easy-to-understand naming conventions,
• Add a description for each account to help accounting personnel enter transactions into the correct general ledger account,
• Select the correct account type (asset, liability, etc.) to facilitate financial statement and tax return preparation, and
• Review the chart at year-end and make any necessary adjustments.

A simple chart of accounts might work initially, but more complexity may be needed as your company evolves. For example, management might want to track results by department, project, or region. This may require additional account segments or layers to allow for segmentation in reporting. A new business line might also require changes to an existing chart. More complex charts are common in certain industries, such as health care or construction.

For more information

Setting up a chart of accounts isn’t a one-off task that produces a template you can use forever. Contact us for help setting up a new chart of accounts or reviewing an existing one. Our experienced accounting and bookkeeping professionals can help you capture the relevant information your business needs to succeed.

The pretax (accounting) profit that’s reported on your company’s income statement is an important metric. Lenders, investors, and other stakeholders rely on pretax profits to evaluate a company’s financial performance. However, business owners also need to keep their eyes on taxable income to optimize tax outcomes and manage cash flow effectively. Here’s an overview of how these profitability metrics differ.

Crunching the numbers

Under U.S. Generally Accepted Accounting Principles (GAAP), pretax profit includes all revenue and expenses (except income taxes) for the accounting period. Accrual-basis accounting rules require revenues earned during the period to be “matched” with the expenses that were incurred to generate them. Reporting higher profits on the financial statements is generally preferable because it’s equated with more robust financial performance.

In contrast, taxable income is reported to tax authorities using applicable tax laws. Higher taxable income leads to higher tax obligations. Accounting professionals can help companies implement legitimate tax planning strategies to reduce taxable income.

The tax rules and accounting standards may differ for certain items (such as depreciation methods, expenses, and deductions). This may lead to differences in timing and amounts between the two metrics.

Understanding common differences

To illustrate, consider the following calculations: A hypothetical calendar-year C corporation earns $10 million of revenue and incurs $4 million of general operating expenses for book and tax purposes in 2024. Under GAAP, the company’s income statement also reports the following items for 2024:

• $1 million of depreciation using the straight-line depreciation method,
• $500,000 of bad debt expense based on management’s estimated allowance,
• $600,000 of accrued bonuses, and
• $700,000 of regulatory fines to the Environmental Protection Agency (EPA).

So, the company’s pretax profit is $3.2 million ($10 million − $4 million − $1 million − $500,000 − $600,000 − $700,000).
On the other hand, the company’s Form 1120 reports the following for 2024:

• $1.6 million of depreciation using the accelerated depreciation methods, and
• $300,000 of bad debt expenses based on actual write-offs.

Under federal tax law, accrued bonuses are generally deductible in the year employees earn them, but only if they’re paid within 2.5 months of the year end. This company routinely pays year-end bonuses on April 30 of the following year. So, it can’t deduct its 2024 accrued bonuses until 2025. In addition, fines and penalties paid to a governmental agency aren’t deductible under current tax law. As a result, the company’s taxable income is $4.1 million for 2024 ($10 million − $4 million − $1.6 million − $300,000).

Most differences — such as those related to depreciation methods, accrued expenses, or bad debt deductions — are temporary and will reverse over time. But permanent differences, including nondeductible EPA fines, don’t reverse. It’s also important to note that state tax rules may differ from federal rules, adding complexity.

Why it matters

Had the business owners in this hypothetical scenario paid estimated taxes using only pretax profit estimates, they likely would have underpaid tax for 2024. This could result in a surprise tax bill, which also might include an underpayment penalty. Coming up with funds on Tax Day could be challenging.

Anticipating differences between pretax profits and taxable income is essential for tax planning and cash flow management. For instance, the company could reduce taxable income for 2024 by paying year-end bonuses by March 15, 2025. The owners also could adjust estimated tax payments or set up a tax reserve to avoid a shortfall when filing the company’s return.

We can help

Our experienced accounting professionals can help you understand how pretax profits and taxable income may differ based on your company’s situation and plan accordingly. Contact us for more information.

 

It’s critical for business owners and managers to understand how to present contingent liabilities accurately in the financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), some contingent losses may be reported on the balance sheet and income statement, while others are only disclosed in the footnotes. Here’s an overview of the rules for properly identifying, measuring, and reporting contingencies to provide a fair and complete picture of your company’s financial position.

Likelihood vs. measurability

Under GAAP, contingent liabilities are governed by Accounting Standards Codification (ASC) Topic 450, Contingencies. It requires companies to recognize liabilities for contingencies when two conditions are met:

1. The contingent event is probable, and
2. The amount can be reasonably estimated.

If these criteria aren’t met but the event is reasonably possible, companies must disclose the nature of the contingency and the potential amount (or range of amounts). If the likelihood is remote, no disclosure is generally required unless required under another ASC topic. However, if a remote contingency is significant enough to potentially mislead financial statement users, the company may voluntarily disclose it.

Common examples

For instance, a company must estimate a contingent liability for pending litigation if the outcome is probable and the loss can be reasonably estimated. In such cases, the company must recognize a liability on the balance sheet and record an expense in the income statement. If the loss is reasonably possible but not probable, the company must disclose the nature of the litigation and the potential loss range. However, when disclosing contingencies related to pending litigation, it’s important to avoid revealing the company’s legal strategies. If the outcome is remote, no accrual or disclosure is required.

Other common types of contingent liabilities include:

Product warranties. If the company can reasonably estimate the cost of warranty claims based on historical data, it should record a warranty liability. Otherwise, it should disclose potential warranty obligations.

Environmental claims. Some businesses may face environmental obligations, particularly in the manufacturing, energy, and mining sectors. If cleanup is probable and measurable, a liability should be recorded. If the obligation is uncertain, the business should disclose it, describing the nature and extent of the potential liability.

 

Tax disputes. If a company is involved in a dispute with the IRS or state tax agency, it should assess whether it is likely to result in a payment and whether the amount can be estimated.

Under GAAP, companies are generally prohibited from recognizing gain contingencies in financial statements until they’re realized. These may involve potential benefits, such as the favorable outcome of a lawsuit or a tax rebate.

Transparency is essential in financial reporting. However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.

Best practices

To help ensure transparency when reporting contingencies, companies must maintain thorough records of all contingencies. Proper documentation may include contracts, legal filings, and communications with attorneys and regulatory bodies. Legal and financial advisors can provide insights into the likelihood of contingencies and help estimate potential losses.

As new information becomes available, management may need to reassess contingencies. For instance, if new evidence in a lawsuit makes a favorable outcome more likely, the financial statements may need to be updated in future accounting periods.

We can help

In today’s uncertain marketplace, accurate, timely reporting of contingencies helps business owners and other stakeholders manage potential risks and make informed financial decisions. Contact us for help categorizing contingencies based on likelihood and measurability and disclosing relevant information in a clear, concise manner.