Accounting for overhead costs


Accurate overhead allocations are essential to understanding financial performance and making informed pricing decisions. Here’s guidance on how to estimate overhead rates to allocate these indirect costs to your products and how to adjust for variances that may occur.

What’s included in overhead?

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly allocated to production, including:

  • Equipment maintenance and depreciation,
  • Factory and warehouse rent,
  • Building maintenance,
  • Administrative and executive salaries,
  • Taxes,
  • Insurance, and
  • Utilities.

Generally, such indirect costs of production are fixed, meaning they won’t change appreciably whether production increases or diminishes.

How are overhead rates calculated?

The challenge comes in deciding how to allocate these costs to products using an overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period of time. Then you multiply the rate by the actual number of direct labor hours for each product (or batch of products) to establish the amount of overhead that should be applied.

In some organizations, the rate is applied companywide, across all products. This is particularly appropriate for organizations that make single, standard products — such as bricks — over long periods of time. If your product mix is more complex and customized, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.

How do you handle variances from actual costs?

There’s one problem with accounting for overhead costs: Variances are almost certain. There are likely to be more variances if you use a simple companywide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.

The result? Large accounts that many managers don’t understand and that require constant adjustment. This situation creates opportunities for errors — and for dishonest people to commit fraud. Fortunately, you can reduce the chance of overhead anomalies with strong internal control procedures, such as:

  • Conducting independent reviews of all adjustments to overhead and inventory accounts,
  • Studying significant overhead adjustments over different periods of time to spot anomalies,
  • Discussing complaints about high product costs with nonaccounting managers, and
  • Evaluating your existing overhead allocation and making adjustments as necessary.

Allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to make prudent pricing decisions — based on the production costs and market conditions — and then sell what you produce.

Need help?

Cost accounting can be complex, and indirect overhead costs can be difficult to trace. We can help you understand how to minimize the guesswork in accounting for overhead and identify when it’s time to adjust your allocation rates. Our accounting pros can also suggest ways to monitor cost allocations to prevent errors and mismanagement.

© 2018

Assessing the effectiveness of internal controls

 

Strong internal controls can help prevent and detect fraud. That’s why Section 404(a) of the Sarbanes-Oxley Act (SOX) requires a public company’s management to annually assess the effectiveness of internal controls over financial reporting. And Sec. 404(b) requires the company’s independent auditors to provide an attestation report on management’s assessment of internal controls. Some smaller entities may be exempt from the latter requirement — but not the former one.

Burdensome for smaller entities

When the SEC published the regulations, smaller public companies told the SEC that the costs of complying with Sec. 404(b) would outweigh the benefits for investors. While the SEC explored ways to ease the compliance burden, the compliance deadline for Sec. 404(b) was repeatedly delayed for nonaccelerated filers — companies with a public float of less than $75 million on the last business day of their most recent second fiscal quarter.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act instructed the SEC to permanently exempt nonaccelerated filers from SOX Sec. 404(b). Absent this exemption, nonaccelerated filers would have been required to comply with Sec. 404(b) beginning with fiscal years ending on or after June 15, 2010.

New definition provides no new Sec. 404(b) relief

Earlier this year, the SEC expanded its definition of “smaller reporting companies” from companies with a public float of less than $75 million to those with a public float of less than $250 million. This change will allow nearly 1,000 more companies to qualify for a lighter set of disclosure rules available to smaller reporting companies. However, the SEC did not raise the public float thresholds for when a company qualifies as an accelerated filer. This means the $75 million threshold still applies in relation to the Sec. 404(b) exemption.

SEC Commissioners Michael Piwowar and Hester Peirce favored raising the accelerated filer threshold to $250 million to expand the number of companies that would be exempt from Sec. 404(b). But, based on feedback from auditors and investor advocate groups, SEC Chairman Jay Clayton decided to keep the current threshold at $75 million — at least for now.

It’s also important to note that not all companies with a public float of less than $75 million are considered nonaccelerated filers. If a company’s public float drops below $75 million, it continues to be an accelerated filer until it drops below $50 million, and thereby “exits” accelerated status.

Still on the hook

Even if your company is exempt from Sec.404(b), you’re still responsible for assessing the effectiveness of internal controls over financial reporting pursuant to Sec. 404(a). Contact us for any questions about complying with the SOX rules or for information regarding best practices in internal controls.

© 2018

Audit opinions: How your financial statements measure up

 

Audit opinions differ depending on the information available, financial viability, errors discovered during audit procedures and other limiting factors. The type of opinion your auditor issues tells stakeholders whether you’re in compliance with accounting rules and likely to continue operating as a going concern.

The basics

To find out what type of audit opinion you’ve received, scan the first page of your financial statements. Known as the “audit opinion letter,” this is where your auditor states whether the financial statements are fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement. But the opinion doesn’t constitute an endorsement or evaluation of the company’s financial results.

Most audit opinion letters consist of three paragraphs. The introductory paragraph identifies the company, accounting period and auditor’s responsibilities. The second discusses the scope of work performed. The third paragraph contains the audit opinion.

In general, there are four types of audit opinions, ranked from most to least desirable.

1. Unqualified. A clean “unqualified” opinion is the most common (and desirable). Here the auditor states that the company’s financial condition, position and operations are fairly presented in the financial statements.

2. Qualified. The auditor expresses a qualified opinion if the financial statements appear to contain a small deviation from GAAP, but are otherwise fairly presented. To illustrate: An auditor will “qualify” his or her opinion if a borrower incorrectly estimates warranty expense, but the exception doesn’t affect the rest of the financial statements.

Qualified opinions are also given if the company’s management limits the scope of audit procedures. For example, a qualified opinion may result if you deny the auditor access to a warehouse to observe year-end inventory counts.

3. Adverse. When an auditor issues an adverse opinion, there are material exceptions to GAAP that affect the financial statements as a whole. Here the auditor indicates that the financial statements aren’t presented fairly. Typically, an adverse opinion letter contains a fourth paragraph that outlines these exceptions.

4. Disclaimer. Even more alarming to lenders and investors is a disclaimer opinion. Disclaimers occur when an auditor gives up midaudit. Reasons for disclaimers may include significant scope limitations, material doubt about the company’s going-concern status and uncertainties within the subject company itself. A disclaimer opinion letter briefly outlines the auditor’s reasons for throwing in the towel.

Ready, set, audit

Before fieldwork starts for the audit of your 2018 financial statements, let’s discuss any foreseeable scope limitations and possible deviations from GAAP. Depending on the situation, we may be able to recommend corrective actions and help you proactively communicate with stakeholders about the reasons for a less-than-perfect audit opinion.

© 2018

Should cloud computing setup costs be expensed or capitalized?

Companies will be able to capitalize, or spread out the costs of, setting up pricey business systems that operate on cloud technology under an update to U.S. Generally Accepted Accounting Principles (GAAP). Here are the details.

FASB responds to business complaints

Over the last three years, businesses have complained to the Financial Accounting Standards Board (FASB) about the different accounting treatment for cloud-based services vs. those operated on physical servers onsite. Businesses told the FASB that the economics of these arrangements are virtually the same.

As more businesses moved to cloud-based business applications, those complaints grew louder. So, in August, the FASB published Accounting Standards Update (ASU) No. 2018-15, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.

Existing GAAP “resulted in unnecessary complexity and needed to be updated to reflect emerging transactions in cloud computing arrangements that are service contracts,” FASB Chairman Russell Golden said in a statement. “To address this diversity in practice, this standard aligns the accounting for implementation costs of hosting arrangements — regardless of whether they convey a license to the hosted software.”

Old rules, new rules

Under existing GAAP, the accounting for services managed in the cloud differs depending on the type of contract a business has with a software provider. When a cloud computing (or hosting) arrangement doesn’t include a software license, the arrangement must be accounted for as a service contract. This means businesses must expense the costs as incurred.

Under the updated guidance, businesses will be able to treat the expenses of reconfiguring their systems and setting up cloud-managed business services as long-term assets and amortize them over the life of the arrangement.

The update also will align the accounting for implementation costs for cloud-managed systems with the accounting for costs associated with developing or obtaining internal-use software. Businesses will have to record the expense related to the capitalized implementation costs in the same line item in the income statement as the expense for the fees for the hosting arrangement.

Coming soon

The update is effective for public businesses for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. (This means 2020 for calendar-year companies.) For all other entities, the update is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. Early adoption is also permitted.

© 2018

Auditing royalty agreements

 

Companies often grant licenses to others allowing them to use intellectual property — such as a patent or proprietary computer code — in exchange for royalties. Licensors can hire an external audit firm to ensure the licensee pays the correct royalty rate and amount. Here’s how the audit process works.

The agreement

The parties’ attorneys usually create a royalty agreement that governs the use of the intellectual property. This legal contract between the licensor and licensee details the terms of the arrangement. It spells out how the licensee may use the asset, the duration of the license and how much the licensee agrees to pay the licensor in royalties for the right to use the asset.

Unfortunately, royalty payments sometimes fall short of the agreed-upon amount. This may be due to a clerical error, confusion regarding the agreement’s terms — or even fraud. To detect and deter shortfalls, most contracts include a “right-to-audit” clause, meaning that the licensor retains the legal right to hire an outside firm to audit the licensee’s payments to confirm compliance with the terms detailed in the agreement.

The auditor’s role

When auditing royalty agreements, CPAs typically perform the following six steps:

1. Review the agreement to understand its scope, including the asset under license, the duration of the contract, prohibited uses and the royalty rate.

2. Analyze sales data used to derive royalty payments to date. Depending on the type of asset under license, the audit team may request production and inventory records.

3. Perform a detailed walk-through of the process the licensee follows to identify, track and report sales subject to a royalty payment.

4. Conduct random sampling of sales data to ensure the licensee applies the correct rate to generate the royalty payment.

5. Review sales and royalty payment trends to confirm that the licensee’s sales align with the royalty payments.

6. Gather individual invoices from key customers to locate and confirm that sales transactions subject to royalties actually generated a royalty payment.

Usually, the licensor assumes the cost of the royalty audit. However, some agreements include a clause that requires the licensee to assume responsibility for the cost of the audit if the audit uncovers underpayment of royalties by a certain margin.

Keep licensees on their toes

Most licensing arrangements function without a hitch. But a minor error or oversight could result in a significant shortfall in royalty payments. Periodic royalty audits can prevent small, but honest, mistakes from spiraling out of control — and help reduce the temptation for dishonest licensees to commit fraud. Contact us to discuss the benefits of auditing your royalty agreements.

© 2018

Cash vs. accrual reporting: Which is right for your business?

 

Small businesses often use the cash-basis method of accounting. As businesses grow, they usually convert to accrual-basis reporting for federal tax purposes and to conform with U.S. Generally Accepted Accounting Principles (GAAP).

Starting this tax year, the Tax Cuts and Jobs Act (TCJA) has increased the threshold for businesses that qualify for the simpler cash method for federal tax purposes. Here’s how these accounting methods compare and how the TCJA could affect your financial and tax reporting decisions.

Cash method

Companies that use the cash-basis method of accounting recognize revenue as customers pay invoices and expenses as they pay bills. So, cash-basis entities often report large fluctuations in profits from period to period, especially if they’re engaged in long-term projects. This can make it hard to benchmark a company’s performance from year to year — or against other entities that use the accrual method.

Cash-basis entities also tend to postpone revenue recognition and accelerate expense payments at year end. This strategy can temporarily defer the company’s tax liability. But the flipside is that it can make a company appear less profitable to lenders and investors.

Accrual method

The more complex accrual-basis accounting method conforms to the matching principle under GAAP. That is, revenue (and expenses) are “matched” to the periods in which they’re earned (or incurred).

Accrual-basis entities report several asset and liability accounts that are generally absent on a cash-basis balance sheet. Examples include prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses and deferred taxes.

TCJA considerations

Under the TCJA, for tax years beginning after 2017, businesses with average annual gross receipts of $25 million or less for the previous three tax years are eligible for the cash method of accounting for federal income tax purposes. Under prior law, the gross-receipts threshold for the cash method was only $5 million.

In addition, for tax years beginning after 2017, the TCJA modifies Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it’s recognized for financial reporting purposes. So, if you use the accrual method for financial reporting purposes, you must also use it for federal income tax purposes.

These changes could prompt more companies to opt for the simpler, tax-deferred cash method for both financial reporting and tax purposes. But it’s not right for everyone.

Look before you leap

As your small business grows, you might be tempted to switch to the accrual method of accounting to reduce variability in financial reporting from year to year — and to attract more sophisticated lenders and investors who prefer GAAP financials. But doing so could accelerate your tax obligations. On the other hand, if you’re newly eligible for the cash method for tax purposes, you may want to switch to that method for the simplicity and tax deferral it offers.

If you’re in either situation, contact us to discuss the pros and cons of these two options to ensure you’re using the optimal method based on your circumstances.

© 2018

Be sure your employee travel expense reimbursements will pass muster with the IRS

 

Does your business reimburse employees’ work-related travel expenses? If you do, you know that it can help you attract and retain employees. If you don’t, you might want to start, because changes under the Tax Cuts and Jobs Act (TCJA) make such reimbursements even more attractive to employees. Travel reimbursements also come with tax benefits, but only if you follow a method that passes muster with the IRS.

The TCJA’s impact

Before the TCJA, unreimbursed work-related travel expenses generally were deductible on an employee’s individual tax return (subject to a 50% limit for meals and entertainment) as a miscellaneous itemized deduction. However, many employees weren’t able to benefit from the deduction because either they didn’t itemize deductions or they didn’t have enough miscellaneous itemized expenses to exceed the 2% of adjusted gross income (AGI) floor that applied.

For 2018 through 2025, the TCJA suspends miscellaneous itemized deductions subject to the 2% of AGI floor. That means even employees who itemize deductions and have enough expenses that they would exceed the floor won’t be able to enjoy a tax deduction for business travel. Therefore, business travel expense reimbursements are now more important to employees.

The potential tax benefits

Your business can deduct qualifying reimbursements, and they’re excluded from the employee’s taxable income. The deduction is subject to a 50% limit for meals. But, under the TCJA, entertainment expenses are no longer deductible.

To be deductible and excludable, travel expenses must be legitimate business expenses and the reimbursements must comply with IRS rules. You can use either an accountable plan or the per diem method to ensure compliance.

Reimbursing actual expenses

An accountable plan is a formal arrangement to advance, reimburse or provide allowances for business expenses. To qualify as “accountable,” your plan must meet the following criteria:

  • Payments must be for “ordinary and necessary” business expenses.
  • Employees must substantiate these expenses — including amounts, times and places — ideally at least monthly.
  • Employees must return any advances or allowances they can’t substantiate within a reasonable time, typically 120 days.

The IRS will treat plans that fail to meet these conditions as nonaccountable, transforming all reimbursements into wages taxable to the employee, subject to income taxes (employee) and employment taxes (employer and employee).

Keeping it simple

With the per diem method, instead of tracking actual expenses, you use IRS tables to determine reimbursements for lodging, meals and incidental expenses, or just for meals and incidental expenses, based on location. (If you don’t go with the per diem method for lodging, you’ll need receipts to substantiate those expenses.)

Be sure you don’t pay employees more than the appropriate per diem amount. The IRS imposes heavy penalties on businesses that routinely overpay per diems.

What’s right for your business?

To learn more about business travel expense deductions and reimbursements post-TCJA, contact us. We can help you determine whether you should reimburse such expenses and which reimbursement option is better for you.

©2018

Keeping a king in the castle with a well-maintained cash reserve

 

You’ve no doubt heard the old business cliché “cash is king.” And it’s true: A company in a strong cash position stands a much better chance of obtaining the financing it needs, attracting outside investors or simply executing its own strategic plans.

One way to ensure that there’s always a king in the castle, so to speak, is to maintain a cash reserve. Granted, setting aside a substantial amount of dollars isn’t the easiest thing to do — particularly for start-ups and smaller companies. But once your reserve is in place, life can get a lot easier.

Common metrics

Now you may wonder: What’s the optimal amount of cash to keep in reserve? The right answer is different for every business and may change over time, given fluctuations in the economy or degree of competitiveness in your industry.

If you’ve already obtained financing, your bank’s liquidity covenants can give you a good idea of how much of a cash reserve is reasonable and expected of your company. To take it a step further, you can calculate various liquidity metrics and compare them to industry benchmarks. These might include:

• Working capital = current assets – current liabilities,• Current ratio = current assets / current liabilities, and• Accounts payable turnover = cost of goods sold / accounts payable.
There may be other, more complex metrics that better apply to the nature and size of your business.

Financial forecasts

Believe it or not, many companies don’t suffer from a lack of cash reserves but rather a surplus. This often occurs because a business owner decides to start hoarding cash following a dip in the local or national economy.

What’s the problem? Substantial increases in liquidity — or metrics well above industry norms — can signal an inefficient deployment of capital.

To keep your cash reserve from getting too high, create financial forecasts for the next 12 to 18 months. For example, a monthly projected balance sheet might estimate seasonal ebbs and flows in the cash cycle. Or a projection of the worst-case scenario might be used to establish your optimal cash balance. Projections should consider future cash flows, capital expenditures, debt maturities and working capital requirements.

Formal financial forecasts provide a coherent method to building up cash reserves, which is infinitely better than relying on rough estimates or gut instinct. Be sure to compare actual performance to your projections regularly and adjust as necessary.

More isn’t always better

Just as individuals should set aside some money for a rainy day, so should businesses. But, when it comes to your company’s cash reserves, the notion that “more is better” isn’t necessarily correct. You’ve got to find the right balance. Contact us to discuss your reserve and identify your ideal liquidity metrics.

© 2018

Sustainability reports look beyond the numbers

 

In recent years, environmental, social and governance (ESG) issues have become a hot topic. Many companies voluntarily include so-called “sustainability disclosures” about these issues in their financial statements. But should the Securities and Exchange Commission (SEC) make these disclosures mandatory and more consistent?

Identifying ESG issues

The term “sustainability” refers to anything that helps your company sustain itself — its people, its profits — into the future. A variety of nonfinancial issues fall under the ESG umbrella, including:

  • Pollution and carbon emissions,
  • Union relations,
  • Political spending,
  • Tax strategies,
  • Employee training and education programs,
  • Diversity practices,
  • Health and safety matters, and
  • Human rights policies.

There’s often a link between ESG issues and financial performance. For example, regulatory violations can lead to fines, remedial costs and reputational damage. And the sale of toxic or unsafe products can result in product liability lawsuits, recalls and boycotts.

On the flipside, identifying and successfully navigating ESG issues can add value by building trust with stakeholders, providing improved access to capital and lower borrowing costs, and enhancing loyalty with customers and employees. Tracking sustainability also helps companies identify ways to reduce their energy consumption, streamline their supply chains, eliminate waste and operate more efficiently.

Studying the costs of mandatory disclosures

Currently, most sustainability disclosures are made voluntarily. The Securities and Exchange Commission (SEC) does require companies to describe the effects of climate change under Release No. 33-9106, Commission Guidance Regarding Disclosure Related to Climate Change. Unfortunately, these disclosures have been criticized by investors for being too general and not useful.

Recently, Sen. Mark Warner (D-VA) asked the Government Accountability Office (GAO) — an independent, nonpartisan U.S. government watchdog agency — to study the costs of requiring public companies to make ESG disclosures. His letter to the GAO references a 2015 survey, which found that 73% of institutional investors take ESG issues into consideration when they’re evaluating investment or voting decisions and managing investment risks.

Specifically, Warner asked the GAO to:

  • Analyze the effect of revising U.S. Generally Accepted Accounting Principles (GAAP) to account for ESG issues,
  • Evaluate the extent to which 1) companies address ESG issues in their disclosures, and 2) investors seek ESG disclosures and why,
  • Identify possible regulatory and nonregulatory actions that could improve and standardize ESG disclosures, and
  • Compare U.S. and foreign ESG disclosure regimes.

A major downside to today’s disclosures is inconsistency. Warner would like the GAO to explore ways to help investors “understand the likelihood of ESG risks and cut through boilerplate disclosure.”

Not everyone wants the GAO to proceed with the study, however. Some business groups, including the U.S. Chamber of Commerce and Business Roundtable, believe the SEC should focus on providing material information to investors and not cater to what they call “special interest groups.”

Sustainability audits

It’s uncertain whether ESG disclosures will become mandatory, but many companies already share information about green business practices, diversity programs, fraud prevention policies and other ESG issues. These disclosures can help add long-term value and improve relationships with stakeholders. Contact us for help preparing or auditing an independent, integrated sustainability report for 2018.

© 2018

How to trim the fat from your inventory

 

Inventory is expensive. So, it needs to be as lean as possible. Here are some smart ways to cut back inventory without compromising revenue and customer service.

Objective inventory counts

Effective inventory management starts with a physical inventory count. Accuracy is essential to knowing your cost of goods sold — and to identifying and remedying discrepancies between your physical count and perpetual inventory records. A CPA can introduce an element of objectivity to the counting process and help minimize errors.

Inventory ratios

The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:

  • Gross margin [(revenue – cost of sales) / revenue],
  • Net profit margin (net income / revenue), and
  • Days in inventory (annual revenue / average inventory × 365 days).

Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from the manufacturer. But the inventory account is more complicated for manufacturers and construction firms; it’s a function of raw materials, labor and overhead costs.

The composition of your company’s cost of goods will guide you on where to cut. In a tight labor market, it’s hard to reduce labor costs. But it may be possible to renegotiate prices with suppliers.

And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing antitheft devices or opting for less expensive insurance coverage.

Product mix

To cut your days-in-inventory ratio, compute product-by-product margins. Stock more products with high margins and high demand — and less of everything else. Whenever possible, return excessive supplies of slow moving materials or products to your suppliers.

Product mix can be a delicate balance, however. It should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.

Reorder point

Another important metric that’s not available from benchmarking studies is reorder point. That’s the quantity level that triggers a new order. Reorder point is a function of your volume and the purchase order lead time. If your suppliers have access to your inventory system, they can automatically ship additional stock once inventory levels reach the reorder point.

Take inventory of your inventory

Often management is so focused on sales, HR issues and product innovation that they lose control over inventory. Contact us for a reality check. We can provide industry benchmarks and calculate ratios to help minimize the guesswork in managing your inventory.

© 2018