Jacob Courtright, Author at Whalen & Company, CPAs

Why can’t my profitable business pay its bills?

Jacob Courtright on June 19, 2023

If your profitable business has trouble making ends meet, it’s not alone. Many business owners mistakenly equate profits with cash flow, leading to shortfalls in the checking account. The truth is that there are many reasons these numbers might differ.

Fluctuations in working capital

Profits (or pretax earnings) are closely related to taxable income. Reported at the bottom of your company’s income statement, they’re essentially the result of revenue earned minus operating expenses incurred in the accounting period. Under U.S. Generally Accepted Accounting Principles (GAAP), companies must “match” costs and expenses to the period in which the related revenue is earned. It doesn’t necessarily matter when you pay for a product or service.

So, inventory items that are in progress or are completed but haven’t yet been sold can’t be deducted — even if they’ve been long paid for (or financed). The cost hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.

Other working capital accounts — such as receivables, accrued expenses, and payables — also represent a difference between the timing of cash outflows and the matching of expenses to sales. As businesses grow and prepare for increasing future sales, they need to invest more in working capital, which temporarily depletes cash.

Capital expenditures and financing transactions

Working capital tells only part of the story, however. Your income statement also includes depreciation and amortization, which are noncash expenses. And it excludes capital expenditures and financing, which both affect your cash on hand.

To illustrate, suppose your company purchased a new piece of equipment in 2022. Expanded bonus depreciation and Section 179 allowances permitted your company to immediately deduct the purchase price of the equipment, which lowered its taxable income for 2022. After making a modest down payment, the remaining amount of the purchase was financed with debt, so actual cash outflows from the investment were minimal in 2022. Throughout 2023, your company has been making loan payments, and the principal repayment portion of these payments reduced the company’s checking account balance but not its profits.

Capital contributions, dividends and stock repurchases

You also can link discrepancies between profits and cash flow to owners’ equity accounts. For example, owners might pay out dividends based on their personal financial needs, regardless of whether the business is profitable.

Dividends (or distributions) paid to owners lower cash on hand, but they have no effect on the profits reported on the company’s income statement. Likewise, additional capital contributions and stock repurchases will hit the company’s checking account without affecting profits.

Efficient cash flow management

It’s important for business owners to understand the key differences between profits and cash flow. Some growing, profitable companies will experience cash shortages. And some mature “cash cows” will have ample cash on hand, despite lackluster revenue growth. If your business is facing a cash crunch, contact us for help devising strategies to improve cash flow. We can help your business pay its bills on time and find resources to seize value-building opportunities.

How to leverage AI in your accounting department

Jacob Courtright on June 2, 2023

Many people speculate that artificial intelligence (AI) will replace humans for certain work-related tasks in the future. But accounting and finance jobs may be safe — at least for now.

Recent study

Brigham Young University recently put AI to the test. Academic researchers administered an accounting exam covering such topics as accounting information systems, auditing, financial accounting, managerial accounting, and tax. The results? Undergraduate students scored an average of 76.7%, compared to only 47.4% by AI-powered ChatGPT. In particular, the study found that humans outperformed AI in several key areas, including tax, financial, and managerial assessments.
AI may not yet be advanced enough to handle complex, managerial-level accounting and finance tasks. But it can be leveraged to automate certain lower-level accounting duties. Examples of tasks where you can eliminate manual (human) intervention include journal entries, bank reconciliations, and some aspects of the budgeting and forecasting process.

Getting started

To begin automating these accounting processes, consider taking the following five steps:

1. Inventory manual processes. Prepare a list of manual processes and rank them by complexity and the number of hours to administer them. This provides a prioritized list of automation candidates. Select the most straightforward process to convert first.

2. Standardize processes. Automation works best with standardized tasks and processes. So, you’ll need to apply a standard approach to all transactions. Identify exceptions and scrutinize why they exist and how they can be eliminated.

3. Focus on the source data. Accounting data often exists in different formats and locations, which doesn’t facilitate automation. So, you’ll need to centralize your accounting data using a consistent structure and format.

4. Document requirements. Many types of AI software solutions exist. Identify the functionality and capabilities you’ll need and use this list to screen potential providers.

5. Conduct robust testing. Before relying on the output generated by AI software, test the output to make sure it’s accurate and reliable. Such testing should use statistically valid sampling techniques. You’ll also need to consider judgmental sampling procedures, which allow team members to select transactions based on their training and experience.

Putting AI to the test

In general, the use of AI software can minimize data entry errors, reduce processing time and lower costs. However, getting it to work in the accounting department of a business takes some initial legwork and a fresh mindset. It also may affect the procedures a CPA performs when preparing your financial statements. Contact us for more information.

Keep these DOs and DON’Ts in mind when deducting business meal and vehicle expenses

Jacob Courtright on May 31, 2023

If you’re claiming deductions for business meals or auto expenses, expect the IRS to closely review them. In some cases, taxpayers have incomplete documentation or try to create records months (or years) later. In doing so, they fail to meet the strict substantiation requirements set forth under tax law. Tax auditors are adept at rooting out inconsistencies, omissions, and errors in taxpayers’ records, as illustrated by one recent U.S. Tax Court case.

Facts of the case

In the case, a married couple claimed $13,596 in car and truck expenses, supported only by mileage logs that weren’t kept contemporaneously and were made using estimates rather than odometer readings. The court disallowed the entire deduction, stating that “subsequently prepared mileage records do not have the same high degree of credibility as those made at or near the time the vehicle was used and supported by documentary evidence.”

The court noted that it appeared the taxpayers attempted to deduct their commuting costs. However, it stated that “expenses a taxpayer incurs traveling between his or her home and place of business generally constitute commuting expenses, which … are nondeductible.”

A taxpayer isn’t relieved of the obligation to substantiate business mileage, even if he or she opts to use the standard mileage rate (65.5 cents per business mile in 2023), rather than keep track of actual expenses.

The court also ruled the couple wasn’t entitled to deduct $5,233 of travel, meal, and entertainment expenses because they didn’t meet the strict substantiation requirements of the tax code. (TC Memo 2022-113)

Stay on the right track

This case is an example of why it’s critical to maintain meticulous records to support business expenses for vehicle and meal deductions. Here’s a list of “DOs and DON’Ts” to help meet the strict IRS and tax law substantiation requirements for these items:

DO keep detailed, accurate records. For each expense, record the amount, the time and place, the business purpose, and the business relationship of any person to whom you provided a meal. If you have employees who you reimburse for meals and auto expenses, make sure they’re complying with all the rules.

DON’T reconstruct expense logs at year-end or wait until you receive a notice from the IRS. Take a moment to record the details in a log or diary or on a receipt at the time of the event or soon after. Require employees to submit monthly expense reports.

DO respect the fine line between personal and business expenses. Be careful about combining business and pleasure. Your business checking account shouldn’t be used for personal expenses.

DON’T be surprised if the IRS asks you to prove your deductions. Vehicle and meal expenses are a magnet for attention. Be prepared for a challenge.

With organization and guidance from us, your tax records can stand up to inspection from the IRS. There may be ways to substantiate your deductions that you haven’t thought of, and there may be a way to estimate certain deductions (called “the Cohan rule”), if your records are lost due to a fire, theft, flood, or other disaster. Contact us now to understand your options.

Cybersecurity: as much about technology as it is about training and awareness

Jacob Courtright on May 10, 2023

Cybersecurity is essential in the workplace because it helps to protect the company’s data, networks, and systems from unauthorized access, theft, and damage. The reality is we cannot hide from the fact that there are people who want to infiltrate our computer system to obtain private information or to hold our data hostage. Cybercriminals have no scruples. Driven by financial, political, corporate espionage, and “FIG” (Fun, Ideology, and Grudge) motives, they have no concern for who or how they harm companies or individuals. It is crucial, with the increased sophistication and frequency of cyber-attacks, that companies implement robust security measures.

A cyberattack can have a devastating effect on your business:

• Data loss and manipulation
• Unexpected ransom payment
• The cost associated with response and recovery
• Cost of investigation
• Regulatory breach reporting and legal consequences
• Potential fines and damage payments
• Operational disruption and decreased productivity
• Reputation damage and compromised trust
• Loss of customers/clients
• Threat to ongoing business operations

As business owners, we have many safeguards in place to protect our computers and networks. We have purchased firewalls, website blockers, antispam filters, EDR systems, antivirus protection, multi-factor authentication, data encryption methods, and backup systems. However, cybersecurity is as much about technology as it is about training and awareness.

Proper cybersecurity training is crucial in the workplace. Employees are often the weakest link in the security chain, and they can unwittingly expose the company to cyber threats through simple actions such as clicking on malicious links or using weak passwords. Therefore, it is advantageous for companies to train staff members about cybersecurity policies and best practices to aid them in identifying possible threats, taking appropriate action, and avoiding security lapses.

We must be diligent and intentional in protecting our data and computer systems.

Consider the following areas of cybersecurity training in the workplace:

Password management: Employees should be trained on how to create strong and work-specific passwords.
- Internal passwords should not be the same as personal ones, and do not use personal information in passwords.
- Remove lists of passwords from the network.
- Utilize password management software.
Data protection: Employees should be trained to handle and send sensitive information, such as customer data and financial records, to others.
- Encryption is key – purchase and require the utilization of encryption software.
- Do not use public Wi-Fi.
- Do not use flash drives.
- Create separate users for bank accounts and use two-factor authentication.
Phishing awareness: Employees should be educated on how to identify and report suspicious emails and links that may be part of a phishing attack.
- Never click links, open attachments, send money, or provide information if you don’t know the sender. (Note: Unsubscribe links are dangerous)
- Narrow the attack surface: Don’t shop online or surf the web while at work. These activities open you up to more phishing assaults.
- Block news channels
- Phones are easily hackable – do not plug phones or other devices into your computer to charge.

Cybersecurity awareness and training are crucial in the workplace to safeguard the company’s assets, reduce the danger of data breaches and cyberattacks, and uphold stakeholder and customer trust. It is your business to protect and preserve, and it is your business to lose if you don’t. Stay ahead of the next cyberattack. Start today and schedule a training session with your users to heighten awareness.

Linda L. Nay

Vice President, Administration

Beware of the gray areas in accounting

Jacob Courtright on April 21, 2023

Accounting and auditing standards have come under scrutiny in the wake of recent high-profile bank failures. Investigations are currently underway about what went wrong with Silicon Valley Bank and Signature Bank. But it’s likely that some “gray areas” in the accounting rules were exploited to make these organizations appear more economically secure in their year-end financial statements than they truly were.

Lessons from Enron

Andrew Fastow often speaks publicly about the issue of financial misstatement. As a convicted felon, Fastow has a unique perspective on fraud: He was the CFO of Enron in October 2001 — when it became the largest U.S. bankruptcy of its time. In March 2023, Fastow presented to the Public Company Accounting Oversight Board (PCAOB), which was created by the Sarbanes-Oxley Act of 2002 to prevent another Enron-like scandal. He advised the PCAOB to consider amending the accounting and auditing rules to help prevent corporate fraud.

Instead of focusing on finding the intentional fraudulent entry, Fastow said the PCAOB should concentrate on “fraud that occurs by exploiting loopholes for the ambiguity and complexity in the rules.” The latter is more the Enron story than recording the wrong number purposely, according to Fastow.

Compliance vs. reality

To elaborate, he gave a simple example of how financial statements, while perfectly in compliance with the rules, could be divorced from economic reality: In 2014, the average price of oil was $95 per barrel. For most of the year, the price was $110, but it dropped to $50 at year-end. Under the accounting rules at that time, companies were supposed to take the price of oil on the first day of each of the 12 preceding months and average it. The result of this calculation was $95, but the market price was $50 when oil and gas companies released their financial statements.

Fastow said that every oil and gas company followed the rule and used $95 per barrel to report their reserves — even though the market price was $50 at year-end. “All of them massively overstated their economically recoverable reserves, which is perhaps the most important metric that Wall Street looks at when they evaluate independent oil and gas companies. The mindset among people is so long as you’re following the rules, it doesn’t matter if the financial statements are misleading,” concluded Fastow.

Complex problem

Charles Niemeier, the former founding member of the PCAOB, said solving the issue of financial reporting fraud is bigger than just revamping the auditing standards. And the challenge is greater for financial reporting matters that rely on subjective judgment calls.

For instance, accounting estimates may be based on subjective or objective information (or both) and involve some level of measurement uncertainty. Examples of accounting estimates include allowances for doubtful accounts, impairments of long-lived assets, and valuations of financial and nonfinancial assets. Some estimates may be easily determinable, but many are inherently subjective or complex.

Another matter that may be susceptible to manipulation is the going concern assessment, which underlies all financial reporting under U.S. Generally Accepted Accounting Principles. The accounting rules give a company’s management the final responsibility to decide whether there’s substantial doubt about the company’s ability to continue as a going concern and to provide related footnote disclosures. The standard provides guidance to management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that companies commonly provide in their footnotes.

We can help

Financial misstatement can happen when managers use the gray areas in financial reporting to their advantage, especially as the rules have moved from historic cost in favor of fair value estimates. When making subjective estimates and evaluating the going concern assumption, it’s important to step back and ask whether your company’s financial statements, while in compliance with the rules, could potentially mislead investors. Contact us to address questions you may have about these complex matters. We can help you understand the rules and assess current market conditions.

Author: Jacob Courtright

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