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Preface: Statements of cash flow are a keystone statement to accountants. Statements of cash flow always tell the truth. Are operating cash flows positive and robust? What are the cash sources and uses? This blog helps readers understand the value of cash flow analysis. 

Control Cash Flight with Statements of Cash Flow

Credit: Jake M. Dietz, CPA

“For riches certainly make themselves wings; they fly away as an eagle toward heaven,” according to Proverbs. Entrepreneurs sometimes painfully experience the flight of cash from the business. Sometimes cash flies away and nothing can keep it. Maybe the economy or a disaster destroys it. Other times, however, a wise entrepreneur can take steps to avoid the problem of no cash.   The statement of cash flows is a tool that business owners can use to study historical cash changes as they prepare for the future. If an entrepreneur understands past cash flows then they may be able to predict and prepare for future changes in cash.

The statement of cash flows shows what happened to your cash over time. A statement of cash flows can be generated from certain accounting software, although it may need some classification to be useful. If a bookkeeper or accountant prepares your financial statements, consider asking them for a statement of cash flows. Perhaps your profit and loss is showing a profit, but your cash is down.

Where did the cash go? This question can vex business owners, but a properly prepared statement of cash flows can help answer that question. If accounts receivable has gone up, then the statement of cash flows will reveal that you have more uncollected accounts receivable. Those accounts receivable are showing up on the profit and loss statement as sales, but the cash is nowhere to be seen.

If your company is ramping up inventory for a busy time, then the correct way to account for those expenditures is as inventory, which keeps it off the profit and loss statement until sold. You may notice a cash crunch, even if the inventory is not affecting profitability because it was not deducted yet.

Why bother studying the statement of cash flows? Why not just look at the bank account and see if there is money there? Understanding what happened in the past can be satisfying, but more importantly it can help business owners and managers prepare for the future. If cash is tight now, it might be tight again in the future. If the causes of a shortage are understood, then a company may be able to minimize the shortage in the future.

If the cash crunch is from not collecting accounts receivable fast enough, then considering taking measures to change that. Below are some possible action items.

• Ask customers for a deposit
• If customers already give a deposit, consider asking for a larger deposit percentage
• Consider sending the initial invoice sooner, or emailing/faxing it so it gets to the customer sooner
• Consider calling customers that are behind on their payments and sending them statements

If the cause of the cash crunch is from increased inventory, consider taking some of these steps to address it.

1. Reduce amounts of inventory, perhaps by implementing lean procedures
2. Ask the vendor if they would store the inventory on your site or nearby, allowing you to wait to buy it but still having it quickly available.
3. Set aside some cash when it is available to fund inventory increases when they are necessary
4. Considering negotiating longer payment terms with creditors
5. Consider obtaining a line of credit from the bank

Although the tendency of cash may be to fly away, use the statement of cash flows to understand the flight patterns of your cash. If the flight patterns of cash are understood, then you may find it easier to plan to have cash on hand. If you are not currently viewing your statement of cash flows periodically, consider starting to look at this informative statement. If it is confusing or inaccurate, ask an accounting professional for help.

Preface: This blog out lines the proposed changes in the tax laws from the Tax Cuts and Job Acts introduced by the House on November 2.

Summary of Proposed Tax Legislation for Individuals and Businesses

Credit: Donald J. Sauder

The House introduced a tax revision to individual and business tax codes on November 2, 2017. The 400+ pages of the introduced tax plan, propose lower tax rates for both business and individual taxpayers. In addition a change to numerous tax credits, and other tax provisions in the plan are for individual taxpayers relevant to say itemized deductions and exemption modifications.

While the tax bill has additional hurdles to clear before passage to law, we think it relevant to keep you apprised of tax code revisions pertinent to your tax filings looking towards 2018.

Individual Highlights

Firstly, individual tax rates are proposed to be simplified to four rates in 2018, e.g. 12, 25, 35, and 39.6 percent. Individual tax payers would be in a 12% effective rate up to $90,000 MJF income or $45,000 filing individually. The 25% bracket would be from $90,000 – $260,000 for MFJ filers, and $45,000 – $200,000 for individual filers; over a $1m would be taxed at 39.6% for MFJ filers. The child tax credit would increase, with a $300 credit for non-child dependents. The proposed plan does not change taxation of qualified dividends or capital gains, nor the Affordable Care Act (ACA) net investment tax or additional Medicare taxes. A joint proposal was filed on November 1, to repeal the employer shared responsibility and individual responsibility required form the ACA.

Standard deductions with the plan are proposed to increase 100% to $24,200 for MFJ filers and $12,200 for individual filers. This is designed to result in fewer itemized deductions. With the increased itemized deduction, it is believed that charitable contributions will decline to non-profit organizations, with less encouragement on the tax benefits for 20%+ of taxpayers who will not benefit from itemized taxes, i.e. simplified tax code. Secondly, with a higher itemized deduction, it is thought to likely have an impact on real estate prices from lower incentive for home mortgage deductions on itemization. The real estate tax deduction would be limited to $10,000.

Federal estate taxes are proposed to be repealed after 2023, with an increased estate exemption increased to $11.2m per person, or $22.4m for couples, for the 2018 tax year. AMT taxes would be erased with the proposed tax provisions beginning in 2018.

Business Highlights

The proposed House Bill sets a 20% corporate tax rate; with a current maximum of 35%, it provides relief for corporations taxed at towering tax costs, and provides incentive to keep businesses from shifting activity out-side borders. In addition, qualified property could be deducted 100% in the current year of purchase, for five-year property, placed in service after October 1, 2017. The Bill would also temporarily increase Section 179 expensing limits to $5m, with a phase-out at $20m for tax years before 2023. This increase would benefit capital expenditure intensive businesses, e.g. transportation and agricultural.

The Code Section 199 domestic production activities deduction, and non-real property like kind exchanges would be eliminated entirely. Those repealed current tax benefits would result in higher taxable income, albeit, at a lower rate for some businesses. The Bill keeps the research and development credit intact. Companies with higher interest costs would have a cap at 30% of adjusted taxable income on interest expenses, with exceptions for some entrepreneurial businesses.

Partnerships, S-Corporations and sole proprietorships paying tax at the pass-through rates currently in place for 2017, would see a top tax rate of 25% for 2018. The Bill proposes a tax fence for services provides, e.g. doctors or lawyers, to prevent the converting of service compensation to business income at the flat 25% rate.

Although there are numerous benefits to the proposed Bill, as with all tax changes, this proposed plan has both rewards and costs relevant to specific taxable circumstances.

This is not to be construed to be tax advice, and is for informational purposes only. Please consult with your tax advisor for specific tax advice and/or before making any tax decisions.

Preface: Construction contract accounting can get complicated, and the IRS allows taxpayers various methods to account for it. This blog will look at the completed contract method of accounting. The completed contract method is a method of accounting for long-term contracts; this blog assesses both advantages and disadvantages of the accounting method.

Construction Finance with Completed Contract Accounting

Credit: Jacob M. Dietz, CPA

How does it work?

The completed contract method of accounting records the income and related costs of a contract in the accounting period in which it is completed. For example, suppose ABC Construction, LLC begins building a house addition on 9/1/17. ABC completes the job on 2/1/18. The total contract price is $200,000, and the total contract costs are $190,000. The taxpayer would wait until 2018 to include the $200,000 in income, and to deduct the $190,000.

What are some disadvantages?

A disadvantage of this method is that income can potentially be grouped into one year, which could throw the taxpayer into a higher bracket and phase them out of deductions and credits. For example, if a big job was started in July of 2016, and finished in January of 2017, then potentially 1 ½ years of revenue could be reported in 2017. 2016 would have less income. Specific tax circumstances vary, but these swings could hurt the taxpayer.

Furthermore, some lenders may request tax returns to grant credit. If the most recent year happens to have low income because a large contract was not completed, then the lender may be less likely to grant credit.

The taxpayer must track the revenue and contract costs per contract for this method to work. Contractors should track this anyway for financial management purposes, but it does take time. It would likely take more time to adjust the books appropriately for the completed contract method than for accrual or cash basis methods.

What are some advantages?

So why would anyone want to use the completed contract method? Perhaps the number one reason is tax deferral. Using the earlier example, suppose ABC Construction, LLC has a $200,000 project started in 2017 but not finished until 2017, the company expects to earn a profit. The completed contract method allows the taxpayer to defer that income until the next year.

Although the completed contract method naturally causes swings in revenue based on when jobs are completed, this method reports the cost of the contract in the same period as the revenue. If applied appropriately, the taxpayer’s gross profit may swing, but the gross profit percentage should not experience the wild swings that can come from getting contract costs in a different period than contract revenue. Also, the taxpayer doesn’t need to worry if billings don’t match the costs for financial management purposes. Both the billings and costs of the contract will be deferred until the contract is finished. If using the accrual or cash method, and if the billings are not in line with the costs, then income skews. The skewed numbers make it harder to understand the company’s profitability.

The taxpayer doesn’t even need to track the percentage of completion for financial reporting purposes, except possibly towards the end. (If it is 95% done, and the owner starts using the building, then it can be considered completed.) Avoiding the percentage of completion calculation simplifies the accounting and potentially reduces the risk of errors. The taxpayer doesn’t need to worry about entering the correct estimated cost to complete, or if change orders increased anything. The taxpayer, however, still needs to track the contract costs and billings related to the project to keep them off the profit and loss statement until completion.

As you read down the blog, did any of the advantages or disadvantages stick out to you? If you meet the IRS qualifications, various contract accounting methods are available for you. There may not be one right answer. Consider both the pros and cons, and discuss with your accountant which method makes the most sense for your business.

 

Preface: Assurance services with regards to sales tax are advised for entrepreneurial business’s, because charges from tax audits can be expensive. Appropriate sales and use tax compliance costs can repay your business with greater confidence of lower audit risk, to happier customers from reductions in unnecessary charges.

Sales and Use Tax Compliance and Assurance is Advised Before an Audit

Credit: Donald J. Sauder, CPA

Sales tax is an increasingly important tax compliance area for many businesses. Sales tax can be charged at more than just the state level. Forty-five states impose sales and use tax on purchases of tangible goods, and 4,696 cities and 1,602 counties also impose sales tax. If you’re conducting business across state lines, you should assess your nexus for jurisdictional sales and use tax compliance risks. More importantly for your customers, these sales tax deductions continue to be an itemized deduction on Schedule A with the passage of 2015 “tax extenders” bill, called Protecting Americans Tax Hikes (PATH).

Sales tax is often assessed on the retail level for sales of inventory or services, or transfers and exchanges of taxable inventory or services. All sales are presumed taxable at the retail level unless proven otherwise. Sales tax is added to the price of the product or service and remitted to the state by the seller who charges and collects the tax. Your business purchases a new snow blower from Your Hardware Superstore, sales tax is charged on the sale, and the seller, Your Hardware Superstore, remits that sales tax to the state. The complexity begins with special sales tax rules state-to-state specific on inventory items or services. Investing in sales tax compliance assurance is advised for every business.

Use tax, on the other hand, is a tax on the use or consumption of a taxable item or service when no sales has been charged or paid. The tax often applies to purchases made outside the state and used in the state, such as when you live in Pennsylvania and purchase a snow blower in Delaware from Snowblower Central. Then you need to pay use tax on the purchase. Use tax also applies to goods initially bought exempt from sales tax, but used for a non-exempt purpose. Use tax can be self-assessed and paid to the state, or collected from the customer from an out-of-state vendor registered with the purchaser’s state. Investing in use tax compliance assurance is advised for every business.

Use tax rates are the same as sales tax rates. Use tax levels the playing field for in-state vendors to keep them from pricing advantages of purchasing in sales-tax-free zones. States with budget concerns are now placing more scrutiny on sales tax with expanded jurisdiction on out-of-state vendors, increasing audit aggressiveness, expanding the tax base to include more inventory items and services, and sometimes increasing the tax rates.

The seller is primarily responsible and liable for collecting and paying the sales tax, whether they have collected the tax or not on the sale. Most often, a vendor must collect tax with respect to taxable sales unless the customer or client shows a valid exemption certificate. If the seller fails to assess sales tax, the state can collect that tax from either the seller or purchaser. Yet, often the vendor pays the tax as an additional expense in instances where collection is overlooked. This can be expensive. While the vendor has the right to collect from the purchaser, it may be impractical or imprudent. Even if the vendor is fortunate enough to collect the tax from the customer after the fact, the penalties, interest, and cost of collection can be steep.

In summary, if your business sells inventory or services, be sure to follow proper sales and use tax guidelines and regulation, collecting and remitting the appropriate taxes on applicable sales. Talk with a tax expert for sales and use tax assurance, especially when adding new inventory items or services in your business, or selling into foreign tax jurisdictions.

Preface:  Tax codes and their implications to partnership or operating agreements may be like deciphering hieroglyphics to some entrepreneurs yet the implications of a well-written tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement by working with your attorney to keep you in compliance with tax laws. Here are examples of how they can add value.

A CPA Can Provide Valuable Opinions on Partnership or LLC Agreements.

Credit: Donald J. Sauder, CPA

Business’s taxed as a partnership filing a Federal Form 1065 for tax purposes always involve more than one individual or entity in ownership. The “agreement,” whether a partnership agreement for a general partnership (GP) or limited partnership (LP) or an operating agreement say or an LLC, outlines the business rules and legally describes the business relationship with rights and responsibilities among ownership.

Often an attorney tailors these agreements as “boiler plate” papers that may omit certain key characteristics or be ambiguous on certain details of the business relationship, e.g. distributions of cash, buy/sell terms, earnings or loss allocations or management oversight. While a CPA cannot write a partnership agreement or operating agreement, (it would be prohibited as unauthorized practice of law or UPL); they can provide valuable insights into aspects of the business agreement document.

There is a story where Noble Prize winner Richard Feynman was visiting a Tennessee plant where the atomic bomb was to constructed. Feynman was confused about a unique symbol on the blue prints, and not being an expert on reading design prints, he needed to know what he did not understand. As an expert authority on the project he took a risk and ask “what happens if that value gets stuck”. He feared the answer might be a response that would make him appear ignorant to the group. The engineer assigned to answered needed to trace the blue print to answer his question, discovering a serious design flaw that could have destroyed the  Facility. When Feynman was asked later how he identified the problem, Feynman’s answer was “sometimes you just need to ask if it’s a value;” when in actuality he simply ask a direct question. Why hadn’t anyone else in the entire group asked? Moral: group collaboration has benefits. Feynman humble approach to understanding what he did and did not know was very helpful to the other experts.

One reason a CPA can provide value to business agreements is that they understand the tax aspects of the agreement. Some attorneys have tax expertise; but wordsmithing and tax are two different areas.

In corporate agreements or LLC’s taxed as S-Corporations, the distributions provisions per ownership in S-Corporations can be an important detail to tax compliance. For instance, what if a shareholder draws a disproportionate share of capital during the year? Does the agreement resolve the tax risk? Secondly the economic arrangement of distributions whether liquidating distributions or special allocations including preferred returns or guaranteed payments and tax distributions are best described and agreed upon at the signing of the partnership agreement. Thirdly, many agreements boiler plate 704(b) book capital with three safe harbors.

Typically well versed agreements hold the most value in challenging business ownership situations and therefore an improperly drafted agreements that doesn’t prioritize distributions of capital can lead to substantial risks for agreements in a liquidation, or restructuring, e.g. say an agreement provision requiring capital accounts to at all times be in accordance with Code Section 704(b) regulations and qualified income offset provisions provide clear details on what happens if a capital goes negative.

Guaranteed payments on capital or for services should be specifically outlined in numeric terms with schedules with addendum updates following to that the business relationship on capital is well documented, e.g. A CPA can help assess if rates on capital are necessary.

In addition, allocations of profit and loss and an agreement on economically accrued earnings and distributions of built in gains or basis step-up on ownership changes are all relevant to a well-crafted agreement.

Another item is Code Section 469 Regulations on economic groupings or activities, a business agreement should outline who has authority to make grouping elections for the business or decision making authority with regards to an appropriate economic unit. An agreement can even state that a tax filing must be made available before a certain day, requiring adherence to tax filing deadlines among management. A CPA can also help edit boiler plate documents to not require a partnership be bound by Code Section 754 elections for basis adjustment.

While some of the Code Sections and tax implications of partnership or operating agreements described above may be like deciphering hieroglyphics to some entrepreneurs, the implications of a well-written, tax oriented ownership agreement is worth the investment. Your CPA can help you when writing a partnership or operating agreement, by working with your attorney to keep you in compliance with tax laws.

While paper sits quietly for anything, a well-documented business agreement is well-advised for your business.

Preface: Why is working capital management important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost”. Working capital is the science of cash flow management – an important fuel to any business craft.

Investing to Double Your Business’s Value – Part IX

Appreciation for astute working capital management is pillar nine of doubling your business’s value. Working capital techniques are vital to any entrepreneurial business; the difference between current assets and current liabilities is working capital simplified. A business with deep pockets, has plenty of working capital. Yet too many entrepreneurs do not understand the term working capital, nor the value of expert working capital management. (If you’re an entrepreneur and your business advisor or CPA has schooled you in working capital management — please take the time to email me; no response is a vote.) Cash flow management is a more frequent term applied to the science; but working capital management is the appropriate application of cash management, i.e. trend setting.

Working capital is the fuel of business. Often your lead technicians, sales team, production supervisor, shop supervisor, or office staff are not attending to working capital or cash flow management, and yet calculating and maintaining optimal levels of working capital is imperative, and as important as good customer service, or product quality, for any business.

Working capital can be segregated into level one and level two balances. Level one working capital is a minimal balance of working capital required at all time. Dip below that level = fuel lights. While a business current ratio measures working capital metrics, it doesn’t give you a level one or level two balance requirement. Level two is peak working capital requirements for peak season cash requirements, e.g. financing holiday inventory levels.

Few entrepreneurs have an adequate understanding of what their business level one and level two working capital balances should be; and fewer have accurate accounting records to calculate the balance. In order to accurately calculate working capital, you need to account not only accurately for inventory balances and accounts receivables on the assets side, but also for current liabilities, e.g. portions of long-term, accrued payroll, accrued expenses; and of course, accounts payable. This requires accurate accounting records.

Working capital, or operating cash liquidity, can be measured with a formula of currents assets, i.e. accounts receivable days + inventory days – current liabilities, i.e. accounts payable days. Therefore if your average accounts receivables are 30 days and $50,000 and your inventory is an average of 50 days or $100,000 and your accounts payable are 20 days or $30,000, then the $50,000 + $100,000 – $30,00 is your working capital requirement, i.e. $120,000. If sales are $1,200,00 your business working capital is 10% of revenues. Inventory increases financing on a line of credit will increase both the numerator and denominator of the current ratio. Operating expenses financed with a line of credit will only adjust liabilities and equity, e.g. assets stagnate while liabilities increase.

Now you’re likely asking how is working capital management applicable to doubling business value? Each adjustment to current assets or liabilities is an adjustment to working capital or operating liquidity. Let’s consider a hypothetical scenario. If a business wants to expand and increase sales with the assumption of a $50,000 software development contract it will need to increase working capital based on the % of those additional potential sales, i.e. it is challenging to increase value without increasing revenues, e.g. you will need finance the cost of the contract either with customer deposits or other sources of cash say equity or debt.

For a service business that has only accounts receivables and accounts payable the scenario would work like this example. With $150,000 sales a month, and $145,000 of expenses per month, if receivables are 30 days and payables 30 days, then working capital before cash balances would be $5,000. In this scenario working capital would 2% of revenues, before cash is added.

A child once ask a successful businessman what was required to be in his industry. The response: Deep pockets. In accounting that is working capital. Software businesses that invest $4m say in development of a license must have adequate working capital to finance the start-up development and programming phase leading to implementation. If your business burn is $20,000 per year on start-up, you need working capital access to fuel the craft.

A secure business often has a current ratio minimum of 2.0 – 2.5 typically. This business’s current ratio would be a concerning 1.03, before cash. Therefore, unbeknownst to many, firstly, increased sales are connected to increased working capital, i.e. current ratio management. In this example, the business would need cash reserves of $140,000 before it should embark on a business expansion of sales revenues from a CFO advisor perspective, e.g. cash of $140k + AR of $150k / AP of $145k = current ratio of 2.0.

If the business has $20,000 of cash it should not plan to immediately implement to double business value. It should plan instead build a foundation of solid level one working capital, i.e. $140k of cash, before implementing increases in sales; and therefore associated overhead expenses.

Once the business builds the foundation of the accurate financial metrics, then it would need to calculate the sale increase and working capital requirements. In the above example the $1.8m of sales with $145k or working capital would equal 8% of sales. Therefore, for every $100,000 increase of planned sales would require $8,000 of working capital. Every entrepreneur should understand the science of working capital management to ease financial management and make more informed decisions. [Too many entrepreneurs rationalize financial performance without adequate financial oversight, i.e. analytical intelligence, resulting in non-optimal performance. The opportunity to access analytical resources for the entrepreneur with powerful accounting software is quickly changing the landscape of small business accounting. Authors note]

A good CPA is more than a qualified tax preparer or financial statement expert. For the astute entrepreneurs they are an advisor for financial decisions, with accurate financials as a map for business decision. To an expert CPA, financials provide insightful information that has substantial business value, i.e. well-advised decision making from financial metrics.

A business advisor consulting to develop your business should always rely on accurate numbers as a substantial factor in successful business decisions. Be very respectful of analytics and financial metrics, e.g. working capital calculations, because when appropriately applied, they can help you make very successful business decisions.

Again, why is working capital management so important to doubling a business value? We’ll quote a conversation of Jesus at the table with one of the chief Pharisees “For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it? Lest haply, after he hath laid the foundation, and is not able to finish it, all that behold it begin to mock him, Saying, This man began to build, and was not able to finish.” Luke 14:28-30.

Working capital management in this blog context, is about proactively counting the costs when planning a doubling of your business’s value.

Part IX of doubling your business value– Working capital management.

Preface: Hobby loss rules are applicable to small activities, i.e. hobby farms. The following blog is pertinent to those who would like to deduct expenses on say small flock activities in the backyard.

Farm Hobby Losses Are an IRS Audit Risk

Credit: Jacob M. Dietz, CPA

Do you operate a small farm in addition to your main source of income? If so, does profit motivate your small farming operation? The answer to that question may determine how the farming operation is taxed. The question is not “is the farm profitable” but “is there a profit motive?” The tax law limits deductions for farms with no profit motive under the hobby loss rules. If you operate a small farm with a profit motive but no profit, then know what a hobby loss is, learn what the IRS factors into its decisions, and act to avoid the hobby loss classification.

Although the term hobby is frequently applied to the rules limiting deductions when there is no profit motive, the activity doesn’t need to be pleasurable. A taxpayer cannot escape the hobby loss rules by explaining that dealing with a frozen watering hose in winter is not pleasurable. The key is lack of a profit motive. Someone running a small farm on the side who never tries to turn a profit appears to lack a profit motive. On the other hand, a farmer sincerely motivated to make a profit but who suffers a loss due to crop failure is not a hobby loss farmer. The profit motive was there even if the profits weren’t.

So how does the IRS determine if there is a profit motive? The IRS lists some factors to determine if there is a profit motive. These factors are:

“You carry on the activity in a businesslike manner,

The time and effort you put into the activity indicate you intend to make it profitable,

You depend on the income for your livelihood,

Your losses are due to circumstances beyond your control (or are normal in the start­up phase of your type of business),

You change your methods of operation in an attempt to improve profitability,

You (or your advisors) have the knowledge needed to carry on the activity as a successful business,

You were successful in making a profit in similar activities in the past,

The activity makes a profit in some years, and

You can expect to make a future profit from the appreciation of the assets used in the activity.”

 

What can you do if you have a small unprofitable farming operation that is not your main source of income, but you have a sincere profit motive? First, continue to try making a profit. Second, demonstrate that you have a profit motive using factors listed by the IRS.

• Farm like it is a business. Track your income and expenses, and prepare reports showing how the operation performed.
• Track how much time you spend on the farming operation. It might surprise you, and the IRS, how much you work if you add up all those Saturdays and evenings.
• If you have another main source of income, then you might not be able to say that you depend on the farm for your livelihood. Losing on a single factor, however, doesn’t mean that there is no profit motive.
• If something beyond your control hurts your profitability, document it. You can’t help that a tornado ravished your corn right before harvest.
• If you are changing the crops you plant to increase profitability, document that change and your reason.
• If you have skill in farming, considering documenting it. Document attempts to gain farming skill, such as through reading, classes, talking with seasoned farmers, etc.
• If you made money farming in the past, keep tax returns or other records to substantiate that income.
• If the activity occasionally makes a profit, keep records of that. The IRS presumes an operation to have a profit motive if 3 out of 5 years, or 2 out of 7 years for some activities, it shows a profit. If you expect to make profits later in the 5 or 7-year period, but not at the beginning, you can file a form asking the IRS to wait until enough time has passed to apply the time test.
• If you expect to make profit by selling the farm, let the IRS know that if they question you. Perhaps you can show that the value has already appreciated since you bought it. Note that if you are planning to pass the farm to your descendants upon your death, then the appreciated value doesn’t help your case.

While the best way to demonstrate a profit motive is with profits, unfortunately that is not always possible. If you are trying unsuccessfully to make profits, then be familiar with the IRS factors, and try to document the ones that support your profit motive. If you have questions about your small farming operation and the hobby loss rules, talk to your accountant.

Preface: In business, journaling is useful for gathering data that can be applied in the future too. If you understand the purpose of reflections about business, and the value of working on your business, and not always in it, you’ll do well to read and apply the Harvard Business Review advice from January of 2016.

Investing to Double Your Businesses Value – Part VIII

Credit: Donald J. Sauder, CPA

Investing to Double Your Businesses Value – Part VIII is not about history being written in Word documents with auto saved features; it’s about you, having the opportunity to reflect on, and write, your own history.

Let’s reflect for a moment on a Harvard Business Review article from January 2016, that outlines the value of advised journaling in business leadership:

Research has documented that outstanding leaders take time to reflect. Their success depends on the ability to access their unique perspective and bring it to their decisions and sense-making every day.

 Extraordinary leadership is rooted in several capabilities: seeing before others see, understanding before others understand, and acting before others act. A leader’s unique perspective is an important source of creativity and competitive advantage. But the reality is that most of us live such fast-paced, frenzied lives that we fail to leave time to listen to ourselves.

Connect to purpose. All too many leaders have a surfeit of opportunities but suffer a paucity of meaning. Asking questions that bring us back to what is most meaningful to us personally, as well as to what we believe is most important for society and the planet, deepens our sense of purpose. For example, you might ask: What is my daily work? What is my life’s work? Similarly, reflecting in your journal on inspirational words from world leaders or wisdom traditions can act as an antidote to superficiality and parochialism

Gaining access to your own insight isn’t difficult; you simply need to commit to reflecting on a daily basis. Based on research (my own and others’) and many years of work with global business leaders as a consultant and international management professor, I recommend the simple act of regularly writing in a journal: 

https://hbr.org/2016/01/want-to-be-an-outstanding-leader-keep-a-journal

Journaling your business’s history as it unfolds, helps you see, understand and act before other entrepreneurs. It also, helps you understand yourself, your business and your marketplace. When reflecting on your business journal, you could quietly say; Hi! Stories of my Business! A journal helps you step back to avoid risks, and reflect to make more successful decisions in the future. A journal helps you navigate a common denominator or say numerator. Shifting from reactive business, to proactive business, requires the ability to see, understand, and act first.

One of my favorite stories is Rob McEwen, CEO of Goldcorp in 1999. McEwen was leading his company on discovering additional deposits at the Red Lake Mine in Ontario. In his search for inspiration from a demand for immediate exploration results, McEwen didn’t spend more time working on the business problem himself; instead he took some time to reflect, and traveled to MIT where he attended a lecture about open-source software systems.

Minutes after the lecture, he got an idea that worth billions. Applying a contrarian and vanguard approach, McEwen launched the Goldcorp Challenge. Sharing proprietary geological data with the public, he created a contest with a $575,000 cash prize: present exploration plans and techniques on where to find gold in Red Lake based on the data. Resource findings and results would award the winners. Millions of entries were submitted, within weeks, from mathematicians, graduate students, and experienced geologists. More than 100 targets, all hidden beforehand, were identified. The idea resulted in 8 million plus ounces of gold reserves; and a substantial world-class discovery.

In the minerals and mining business, exploration is for the purpose of gathering data that will be useful in the future, e.g. resource and reserve harvesting. In business, journaling is useful for gathering data that can be applied in the future too. If you understand the purpose of reflections about business, and the value of working on your business, and not always in it, you’ll do well to read and apply the Harvard Business Review advice from January of 2016. In 2014, did you journal where you’d be in three year? A thanksgiving and reflection are advised if that answer is yea.

Investing to Double Your Businesses Value Part VIII – Investing time to reflect on the past, and the present, while writing today your future business history.

Preface: Looking at your business through the eyes of prospective buyers, while working to double business value will likely improve profitability, (while you still own your company), and help you locate area’s that can increase value from a better understanding of how value is created, sustained, and successful transferred, i.e. doubled.

Investing to Double Your Businesses Value – Part VII

Credit: Donald J. Sauder, CPA

Exit planning for life after business, is a pillar to successful business strategy. Only the best of the best entrepreneurs get it right. You’re advised to exercise a plan to think about exit planning early for your business from the perspective of prospective buyers, even if you have only been in business a few years. It’s a necessary step to double business value, not to say managing your business like a great entrepreneur.

Exit planning usually is accomplished with a sale to family or a third-party, i.e. key employee. It is more than signing on an articulate will, or grooming a family member successor. The sooner you start planning a business exit, the more options, and opportunities your business will hold to harvest optimal value, and transfer business wealth successfully in an ownership succession transfer. Planning your exit from a business requires more thinking through a buy/sell agreement with an advisor, or obtaining continuity insurance. Although some entrepreneurs think exit planning is only necessary if estate or trust planning are required to effectively distribute business wealth, effective exit planning in the scope of doubling business value, is strategizing your business from the perspective of potential buyers.

In a third-party sale, you can have an enterprise sale or partial sale. A partial sale typically will result in the entrepreneur continuing to own from 80% to 20% of the business equity. Exit planning is often advised three to five before retirement, or a succession transfer, but the best entrepreneurs will plan the exit early, before it is even necessary. At least half of entrepreneurs exit their business unplanned; i.e. they haven’t prepared there business for a second generation life.

In addition to value creation, you should think about exit planning strategy early because people count on your business, e.g. if you’re a manufacture for a business, and a major source of vendor supply, your business should feel a responsibility to not domino problems for the business chain because your materials or services are not easily available elsewhere. Transition and exit planning is not self-centered, it’s responsible business; because transition risks are relevant not only to you, but your customers and clients too. Good entrepreneurship should advisedly include strategies to reduce exit risks to valued customers or clients.

Don Feldman, Sage advisor at Keystone Business Transitions, LLC in Lancaster, PA, has the following advice for entrepreneurs with regards to exit planning:

When valuing a closely held business, I frequently pose the following question to the business owner: what do you think the business is worth without you?  A similar question can be asked in regard to key employees:  what is the business worth without your key employees?   If they are critical to the success of the business their possible departure represents a risk to the business.

……The more difficult problem is when the owner is “key” to the business and can’t easily be replaced.  We see this most frequently when the current owner was the founder of the business and retains the principal customer contacts or the “know-how” essential to the business.

This situation is a good example of why, when I ask the business owner “how much is the business is worth without you” the best answer is “it doesn’t matter if I am running the business or not”.  This means that the business will have just as much value in the buyer’s hands as it does in the seller’s and it is relatively easy to sell the business.    However, we are frequently presented with a situation that is not ideal. The art of the exit planner is to be able to develop solutions that will work in the “non-optimal” case.

https://keystonebt.com/2016/09/key-employees-are-key-to-your-exit/

The purpose of planning or strategizing what your business exit plan is before beginning the doubling of value to your business is advised for two reasons, 1) Intrinsic business value is only realized tangibly with a successful exit from ownership; and 2) You need to understand what will encompass that value at exit, e.g. tangible assets; or intangible assets.

Looking at your business through the eyes of prospective buyers, when working to double business value will likely improve profitability, while you still own your company, and help you locate area’s that can increase value from a better understanding of how that value is created, sustained, and successful transferred.

Part VII of Investing to Double Your Businesses Value – think through your business exit plan today, from the eyes of prospective buyers.

Preface: The value of a business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. A business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science; and adds the art of deal.

The Science and Art of Business Valuation

Credit: Donald J. Sauder, CPA

“Price is what you pay, value is what you get,” a famous Warren Buffett quote, is certainly most applicable to business valuation. Purposes of a business valuation, from setting value for buy/sell agreements, to obtaining bank financing for an acquisition, alternative financing, or exit planning in a transition, a look at what a business valuation process encompasses should be helpful for entrepreneurs.

Business valuation is both an art and science. With the science of the process and set of procedures applied to a valuation approach 1) Asset approach; 2) Market approach; 3) Income approach; and an art applied to the normalization of company activity, say with a controlling interest. There are as many specific values for a business as there are valuation experts, because business value means different things to different people. For investors, the value is based upon cash flows; for a strategic bidder, e.g. a vertical integration purchase, a business value is determined from consolidation metrics, or market share advantages. The circumstances surrounding the valuation report is part of the art, e.g. exit planning for retirement, relocation, or partners joining.

Albert Einstein is quoted as say, “Try not be a man of success, but rather try to be a man of value. This is true for business valuations too. A business valuation is not a success because the business value is the highest stretch, the valuation is a success because it is objective, independent and a fair market value; and a value achievable in a public marketplace bid. Business value, while both an art and science, is not saying that valuations reports should have substantial ranges in value; while each is unique and different, good valuations should be similar. Price expectations for a professional report usually include a value appraised for a fair market,

 

• i.e. fair market value: the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. {NOTE: In Canada, the term “price” should be replaced with the term “highest price.”} as define in Statement on Standards for Valuation Service No. 1.

 

The approaches to valuation are the methods for determining a business value. The Income approach include a profit multiplier or capitalization of earnings based upon normalized earnings of business. This approach is often used when a business has stable cash flows from year to year, and earnings or cash flows can be weighted for a number of historic year financial performance. The cash flows or net income can be multiplied or capitalized at either a pre-tax or after-tax performance metric. For an investor, it is important that your valuation use an after-tax approach. Why? You are purchasing the business for profit generation, and those profits will be taxed. Therefore, you must account the after-tax cash flows either for ROI (return on investment), ROE (return on equity), or credit financing repayments.

 

Another income approach is the discounted future cash flows. This method is often used for companies with variable earnings or variable cash flows, and requires the preparation of financial projections for discounted earnings of financial performance for a determined value, i.e. what is the value today of $1,000,000 of future cash flows in the next 10 years? The excess earnings method is a third income approach that applied an intangible and tangible rate of return on business assets, with multiple calculation metrics.

 

The asset approach is not based upon income or cash flows, but the net value of the business. This would be most applicable to real estate partnerships say, where the asset is most the business value.

 

The market approach to valuation, applies comparisons of other marketplace transactions to guide values. This approach required the valuator to access comparable market transactions, i.e. a BIZCOMPS or IBA Market Data, and compare similar size business transactions. The market method is subjection to differences to location, and management performance that influence appraised value. For instance, 10 business transactions with a value determined with the capitalization of income approach would result in 10 data points for the market approach BIZCOMPS sale price data. The subjective factors in those values would ultimately influence the market approach of a discretionary earnings multiple or multiple of revenues.

 

NACVA Standards have two types of value. A calculation of value and a conclusion of value. A calculation of value simply calculates and documents a calculation of a business value and is often a report between 18 to 34 pages. A conclusion of value requires economic and industry analysis and additional steps of documentation for the appraisal conclusion. A conclusion of value is often a report more than 50 pages required to appropriately document the business appraised value. Conclusions of value are required for litigation and compliance-oriented engagements, i.e. tax matters, e.g. gift tax compliance or estates.

 

“The value of an idea lies in the using of it.” Thomas Edison’s words could be rephrased for business valuations to say, the value of a business valuation lies in its marketplace relevance. The value can be modified annually from shifts in economic circumstances or transactional circumstances. The valuation report documents why that value is defensible, fair, and accurate.

 

In summary, the value of business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. In a competitive market, there are few competitive advantages, and therefore, the businesses are somewhat comparable, e.g. the method or model consistently applied accurately determines appraisal value of the business. A professional business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science, and adds the art of deal.