Basic Accounting Considerations

Once you’ve chosen your form of business you must secure an EIN – or Employer Identification Number. An EIN is requested from the IRS and can be done online. An EIN is a TIN (Tax Identification Number) for a business just as a Social Security number is for a person.

You also have to select an accounting method. The two acceptable methods are cash basis and accrual basis.

The cash method of accounting records the cash flow of financial events when they occur. This method recognizes revenues when cash is received and recognizes expenses when cash is paid out. In cash accounting, revenues and expenses are also called cash receipts and cash payments. The cash method of accounting does not recognize promises to pay, either from the business or from the business’s clients. When the cash method of accounting is elected, it is also used when reporting to the IRS.

The accrual method of accounting records all economic activities and financial events of the business. According to this method, revenues and expenses are recognized whether or not they have been received or paid. The accrual basis of accounting is the most accurate if you require an economic snapshot of a business or need to compare business activity between different periods. Accrual accounting is required for all public companies.

The accrual basis of accounting tends to be more costly to maintain properly, because it requires a bookkeeper to record many more transactions as well as to identify and recognize transactions that are contracted to occur (or not occur) at some date in the future.

Accrual is the better form for accounting, as it’s more authentic and informative. However, typically I suggest that small businesses use the cash basis of accounting and that they only switch to accrual before they intend to sell the business, or when the business has grown to a sufficient size that the accrual method is required for proper planning. Be aware that if you elect to operate your business using the cash method, you can elect to switch to accrual at a later date – you cannot switch from accrual to cash.

If there’s going to be more than one owner in a business, I cannot stress enough the involvement of an attorney to draft the formation documents. You will require the firm’s services to prepare the proper articles and bylaws for corporations or member and management agreements for LLCs, as well as to formulate a buyout agreement. Not only will you need some professional advice on how to deal with other owners, but also there will come a day when an owner needs to sell. Sometimes it’s not a choice to sell, but rather normal events of life that force a sale. For example: The shares of your corporation that belong to your investor are now in the hands of a bankruptcy trustee, and the bankruptcy judge sees a need to liquidate the shares and/or the business to satisfy creditors. Another possibility, more common, is the untimely death of a partner or shareholder whereupon the shares are passed to heirs, and the heirs want to sell. The small amount of time and money required to properly prepare a business structure is cheap insurance and should provide you some comfort as you go forward. Keep in mind that any issues that are not identified and dealt with in the foundational documents will need to be dealt with in arbitration or litigation.

I fully admit that none of this is any fun. I get it. Preparation for a journey is tedious, but so important.

L7 Comment: It is not if you will sell or die – it is when. The alternatives are you die first or the business closes.

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