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176 Part III: Accounting in Managing a Business Invested capital is only one of three factors that generally play into profit allocation in partnerships and LLCs:  Treasure: Owners may be rewarded according to how much of the treasure — invested capital — they contributed. So if Jane invested twice as much as Joe did, her cut of the profit may be twice as much as Joe’s.  Time: Owners who invest more time in the business may receive more of the profit. Some partners or owners, for example, may generate more billable hours to clients than others, and the profit-sharing plan reflects this disparity. Some partners or owners may work only part-time, so the profit-sharing plan takes this factor into account.  Talent: Regardless of capital and time, some partners bring more to the business than others. Maybe they have better business contacts, or they’re better rainmakers (they have a knack for making deals happen), or they’re celebrities whose names alone are worth a special share of the profit. Whatever it is that they do for the business, they contribute much more to the business’s success than their capital or time suggests. A partnership needs to maintain a separate capital (ownership) account for each partner. The total profit of the entity is allocated into these capital accounts, as spelled out in the partnership agreement. The agreement also specifies how much money each partner can withdraw from his capital account. For example, partners may be limited to withdrawing no more than 80 percent of their anticipated share of profit for the coming year, or they may be allowed to withdraw only a certain amount until they’ve built up their capital accounts. Going It Alone: Sole Proprietorships A sole proprietorship is, basically, the business arm of an individual who has decided not to carry on his or her business activity as a separate legal entity (as a corporation, partnership, or limited liability company). This is the default when you don’t establish a legal entity. This kind of business is not a separate entity; it’s like the front porch of a house — attached to the house but a separate and distinct area. You may be a sole proprietor of a business without knowing it! An individual may do house repair work on a part-time basis or be a full-time barber who operates on his own. Both are sole proprietorships. Anytime you regularly provide services for a fee, sell things at a flea market, or engage in any business activity whose primary purpose is to make profit, you are a sole proprietor. If you carry on business activity to make profit or income, the IRS requires that you file a separate Schedule C “Profit or Loss From Business” with your annual individual income tax return. Schedule C summarizes your income and expenses from your sole proprietorship business. Chapter 8: Deciding the Legal Structure for a Business Sharing profit with customers: Business cooperatives A business that shares its profit with its customers? Nobody can be that generous. Actually, one type of business entity does just that: A cooperative pays its customers patronage dividends based on its profit for the year — each customer receives a year-end refund based on his or her purchases from the business over the year. Imagine that. Oh, did I mention that in a cooperative, the customers are the owners? To shop in the cooperative, a customer must invest a certain amount of money in the business. (You knew there had to be a catch somewhere!) I grew up in Iowa. You see the silos of grain co-ops (cooperative associations) all over the state. They are owned by the farmers who use the co-ops to store and deliver their crops. Business cooperatives deduct patronage dividends in determining their taxable income for the year. If the business returns all profit to customers as patronage dividends, taxable income is zero. But the owners have to list their patronage dividends on their individual income tax returns for the year (and the co-op reports these distributions to the IRS). As the sole owner (proprietor), you have unlimited liability, meaning that if your business can’t pay all its liabilities, the creditors to whom your business owes money can come after your personal assets. Many part-time entrepreneurs may not know this or may put it out of their minds, but this is a big risk to take. I have friends who are part-time business consultants and they operate their consulting businesses as sole proprietorships. If they are sued for giving bad advice, all their personal assets are at risk — though they may be able to buy malpractice insurance to cover these losses. Obviously, a sole proprietorship has no other owners to prepare financial statements for, but the proprietor should still prepare these statements to know how his or her business is doing. Banks usually require financial statements from sole proprietors who apply for loans. One other piece of advice for sole proprietors: Although you don’t have to separate invested capital from retained earnings like corporations do, you should still keep these two separate accounts for owners’ equity — not only for the purpose of tracking the business but for the benefit of any future buyers of the business as well. 177 178 Part III: Accounting in Managing a Business Choosing the Right Legal Structure for Income Tax While deciding which type of legal structure is best for securing capital and managing their business, owners should also consider the dreaded income tax factor. They should know the key differences between the two alternative kinds of business entities from the income tax point of view:  Taxable-entity, C corporations: These corporations are subject to income tax on their annual taxable income. Plus, their stockholders pay a second income tax on cash dividends that the business distributes to them from profit, making C corporations and their owners subject to double taxation. The owners (stockholders) of a C corporation include in their individual income tax returns the cash distributions from the after-tax profit paid to them by the business.  Pass-through entities — partnerships, S corporations, and LLCs: These entities do not pay income tax on their annual taxable income; instead, they pass through their taxable income to their owners, who pick up their shares of the taxable income on their individual tax returns. Pass-through entities still have to file tax returns with the IRS, even though they don’t pay income tax on their taxable income. In their tax returns, they inform the IRS how much taxable income is allocated to each owner, and they send each owner a copy of this information to include with his or her individual income tax return. Most LLCs opt to be treated as pass-through entities for income tax purposes. But an LCC can choose instead to be taxed as a C corporation and pay income tax on its taxable income for the year, with its individual shareholders paying a second tax on cash distributions of profit from the LLC. Why would an LCC choose double taxation? Keep reading. The following sections illustrate the differences between the two types of tax entities for deciding on the legal structure for a business. In these examples, I assume that the business uses the same accounting methods in preparing its income statement that it uses for determining its taxable income — a generally realistic assumption. (I readily admit, however, that there are many technical exceptions to this general rule.) To keep this discussion simple, I consider just the federal income tax, which is much larger than any state income tax that may apply. Chapter 8: Deciding the Legal Structure for a Business C corporations A corporation that cannot qualify as an S corporation (which I explain in the next section) or that does not elect this alternative if it does qualify is referred to as a C corporation in the tax law. A C corporation is subject to federal income tax based on its taxable income for the year, keeping in mind that there are a host of special tax credits (offsets) that could reduce or even eliminate the amount of income tax a corporation has to pay. I probably don’t need to remind you how complicated the federal income tax is. Suppose a business is taxed as a C corporation. Its abbreviated income statement for the year just ended is as follows (see Chapter 4 for more about income statements): Abbreviated Annual Income Statement for a C Corporation Sales revenue $26,000,000 Expenses, except income tax (23,800,000) Earnings before income tax Income tax Net income $2,200,000 (748,000) $1,452,000 Now, at this point I had to make a decision. One alternative was to refer to income tax form numbers and to use the tax rates in effect at the time of writing this chapter. The income tax form numbers have remained the same for many years, but the rest of the tax law keeps changing. For instance, Congress shifts tax rates every so often. Furthermore, tax rates are not flat; they’re progressive, which means that the rates step up from one taxable income bracket to the next higher bracket — for both businesses and individuals. As I have already alluded to, there are many special deductions to determine taxable income, and there are many special tax credits that offset the normal amount of income tax. (And I haven’t even said anything about the increasingly serious problems caused by the alternative minimum tax provision in the income tax law.) Given the complexity and changing nature of the income tax law, in the following discussion I avoid going into details about income tax form numbers and the income tax rates that I use to determine the income tax amounts in each example. By the time you read this section, the tax rates probably will have changed anyway. Let me assure you, however, that I use realistic income tax numbers in the following discussion. (I didn’t just look out the window and make up income tax amounts.) Refer to the C corporation income statement example again. Based on its $2.2 million taxable income for the year, the business owes $748,000 income tax — most of which should have been paid to the IRS before year-end. The income 179 180 Part III: Accounting in Managing a Business tax is a big chunk of the business’s hard-earned profit before income tax. Finally, don’t forget that net income means bottom-line profit after income tax expense. Being a C corporation, the business pays $748,000 income tax on its profit before tax, which leaves $1,452,000 net income after income tax. Suppose the business distributes $500,000 of its after-tax profit to its stockholders as their just rewards for investing capital in the business. The stockholders include the cash dividends as income in their individual income tax returns. Assuming that all the individual stockholders have to pay income tax on this additional layer of income, as a group they would pay something in the neighborhood of $75,000 income tax to Uncle Sam. A business corporation is not legally required to distribute cash dividends, even when it reports a profit and has good cash flow from its operating activities. But paying zero cash dividends may not go down well with all the stockholders. If you’ve persuaded your Aunt Hilda and Uncle Harry to invest some of their money in your business, and if the business doesn’t pay any cash dividends, they may be very upset. The average large public corporation pays out about 30 percent of its after-tax annual net income as cash dividends to its stockholders. It’s difficult to say what privately owned corporations do regarding dividends, since the information is not available to the public. S corporations A business that meets the following criteria (and certain other conditions) can elect to be treated as an S corporation:  It has issued only one class of stock.  It has 100 or fewer people holding its stock shares.  It has received approval for becoming an S corporation from all its stockholders. Suppose that the business example I discuss in the previous section qualifies and elects to be taxed as an S corporation. Its abbreviated income statement for the year is as follows: Abbreviated Annual Income Statement for an S Corporation Sales revenue $26,000,000 Expenses, except income tax (23,800,000) Earnings before income tax $2,200,000 Income tax 0 Net income $2,200,000 Chapter 8: Deciding the Legal Structure for a Business An S corporation pays no income tax itself, as you see in this abbreviated income statement. But it must allocate its $2.2 million taxable income among its owners (stockholders) in proportion to the number of stock shares each owner holds. If you own one-tenth of the total shares, you include $220,000 of the business’s taxable income in your individual income tax return for the year whether or not you receive any cash distribution from the profit of the S corporation. That probably pushes you into a high income tax rate bracket. When its stockholders read the bottom line of this S corporation’s annual income statement, it’s a good news/bad news thing. The good news is that the business made $2.2 million net income and does not have to pay any corporate income tax on this profit. The bad news is that the stockholders must include their respective shares of the $2.2 million in their individual income tax returns for the year. I can only speculate on the total amount of individual income tax that would be paid by the stockholders as a group. But I would hazard a guess that the amount would be $300,000 or more. An S corporation could distribute cash dividends to its stockholders, to provide them the money to pay the income tax on their shares of the company’s taxable income that is passed through to them. The main tax question concerns how to minimize the overall income tax burden on the business entity and its stockholders. Should the business be an S corporation (assuming it qualifies) and pass through its taxable income to its stockholders, which generates taxable income to them? Or should the business operate as a C corporation (which always is an option) and have its stockholders pay a second tax on dividends paid to them in addition to the income tax paid by the business? Here’s another twist: In some cases, stockholders may prefer that their S corporation not distribute any cash dividends. They are willing to finance the growth of the business by paying income tax on the taxable profits of the business, which relieves the business from paying income tax. Many factors come into play in choosing between an S and C corporation. There are no simple answers. I strongly advise you to consult a CPA or other tax professional. Partnerships and LLCs The LLC type of business entity borrows some features from the corporate form and some features from the partnership form. The LLC is neither fish nor fowl; it’s an unusual blending of features that have worked well for many business ventures. A business organized as an LLC has the option to be a pass-through tax entity instead of paying income tax on its taxable income. A partnership doesn’t have an option; it’s a pass-through tax entity by virtue of being a partnership. 181 182 Part III: Accounting in Managing a Business Following are the key income tax features of partnerships and LLCs:  A partnership is a pass-through tax entity, just like an S corporation. When two or more owners join together and invest money to start a business and don’t incorporate and don’t form an LLC, the tax law treats the business as a de facto partnership. Most partnerships are based on written agreements among the owners, but even without a formal, written agreement, a partnership exists in the eyes of the income tax law (and in the eyes of the law in general).  An LLC has the choice between being treated as a pass-through tax entity and being treated as a taxable entity (like a C corporation). All you need to do is check off a box in the business’s tax return to make the choice. (It’s hard to believe that anything related to taxes and the IRS is as simple as that!) Many businesses organize as LLCs because they want to be passthrough tax entities (although the flexible structure of the LLC is also a strong motive for choosing this type of legal organization). The partners in a partnership and the shareholders of an LLC pick up their shares of the business’s taxable income in the same manner as the stockholders of an S corporation. They include their shares of the entity’s taxable income in their individual income tax returns for the year. For example, suppose your share of the annual profit as a partner, or as one of the LLC’s shareholders, is $150,000. You include this amount in your personal income tax return. Once more, I must mention that choosing the best legal structure for a business is a complicated affair that goes beyond just the income tax factor. You need to consider many other factors, such as the number of equity investors who will be active managers in the business, state laws regarding business legal entities, ease of transferring ownership shares, and so on. After you select a particular legal structure, changing it later is not easy. Asking the advice of a qualified professional is well worth the money and can prevent costly mistakes. Sometimes the search for the ideal legal structure that minimizes income tax and maximizes other benefits is like the search for the Holy Grail. Business owners should not expect to find the perfect answer — they have to make compromises and balance the advantages and disadvantages. In its external financial reports, a business has to make clear which type of legal entity it is. The type of entity is a very important factor to the lenders and other creditors of the business, and to its owners of course. Chapter 9 Analyzing and Managing Profit In This Chapter
Recognizing the profit-making function of business managers
Scoping the field of managerial accounting
Centering on profit centers
Understanding P&L reports
Analyzing profit for fun and profit A s a manager, you get paid to make profit happen. That’s what separates you from the employees at your business. Of course, you should be a motivator, innovator, consensus builder, lobbyist, and maybe sometimes a babysitter, too, but the hard-core purpose of your job is to make and improve profit. No matter how much your staff loves you (or do they love those doughnuts you bring in every Monday?), if you don’t meet your profit goals, you’re facing the unemployment line. Competition in most industries is fierce, and you can never take profit performance for granted. Changes take place all the time — changes initiated by the business and changes from outside forces. Maybe a new superstore down the street is causing your profit to fall off, and you figure that you’ll have a huge sale to draw customers, complete with splashy ads on TV and Dimbo the Clown in the store. Whoa, not so fast. First make sure that you can afford to cut prices and spend money on advertising and still turn a profit. Maybe price cuts and Dimbo’s balloon creations will keep your cash register singing, but making sales does not guarantee that you make a profit. Profit is a twoheaded beast: Profit comes from making sales and controlling expenses. This chapter focuses on the fundamental financial factors that drive profit — what you could call the levers of profit. Business managers need a sure-handed grip on these profit handles. Profit reports prepared for people outside the business don’t disclose all the vital information that business managers need to plan and control profit performance. A manager needs to thoroughly understand external income statements and also needs to look deep into the bowels of the business. 184 Part III: Accounting in Managing a Business Helping Managers Do Their Jobs As previous chapters explain, accounting serves critical functions in a business. A business needs a dependable recordkeeping and bookkeeping system for operating in a smooth and efficient manner. Strong internal accounting controls are needed to minimize errors and fraud. A business must comply with a myriad of tax laws, and it depends on its chief accountant (controller) to make sure that all its tax returns are prepared on time and correctly. A business prepares financial statements that must conform with established accounting standards, which are reported on a regular basis to its creditors and external shareowners. In addition, accounting should help managers in their decision-making, control, and planning. This sub-field of accounting is generally called managerial or management accounting. This is the first of three chapters devoted to this branch of accounting. In this chapter, I pay particular attention to the internal accounting report to managers that provides essential feedback information needed for controlling current profit performance, and which also serves as the platform for planning future profit performance. I also explain how managers use accounting information for analyzing how they make profit and why profit changes from one period to the next. Chapter 10 concentrates on financial planning and budgeting, and Chapter 11 examines the methods and problems of determining product costs (generally called cost accounting). Designing and monitoring the accounting system, complying with tax laws, and preparing external financial reports all put heavy demands on the time and attention of the accounting department of a business. Even so, managers’ needs for accounting information should not be given second-level priority. The chief accountant (controller) has the responsibility of ensuring that the financial information needs of managers are served with maximum usefulness. Ideally, a manager tells the accountant exactly what information he needs and how to report the information. In the real world, however, this is not exactly how it works. The accountant has to more or less read the mind of the manager. Oftentimes the accountant has to take the initiative regarding the information to report to managers and how to report it. Following the organizational structure The first rule of managerial accounting is to follow the organizational structure: to report relevant information for which each manager is responsible. (This principle is sometimes referred to as responsibility accounting.) If a manager is in charge of sales in a territory, for instance, the controller reports the sales activity for that territory during the period to the sales manager. Two Chapter 9: Analyzing and Managing Profit types of organizational units in a business are of primary interest to managerial accountants:  Profit centers: These are separate, identifiable sources of sales revenue that expenses can be matched with, so that a measure of profit can be determined for each. A profit center can be a particular product or a product line, a particular location or territory in which a wide range of products are sold, or a channel of distribution. Rarely is the entire business managed as one conglomerate profit center, with no differentiation of its different sources of sales and profit.  Cost centers: Some departments and other organizational units do not generate sales, but they have costs that can be identified to their operations. Examples are the accounting department, the headquarters staff of a business, the legal department, and the security department. The managers responsible for these organizational units need accounting reports that keep them informed about the costs of running their departments. The managers should keep their costs under control, of course, and they need informative accounting reports to do this. In this chapter, I concentrate on accounting reports for managers of profit centers. I don’t mean to shun cost centers, but, frankly, the type of accounting information needed by the managers of cost centers is relatively straightforward. They need a lot of detailed information, including comparisons with last period and with the budgeted targets for the current period. I don’t mean to suggest that the design of cost center reports is a trivial matter. Sorting out significant cost variances and highlighting these cost problems for management attention is very important. But the spotlight of this chapter is on profit analysis methods and the primary accounting report for managers of profit centers. Note: I should mention that large businesses commonly create relatively autonomous units within the organization that, in addition to having responsibility for their profit and cost centers, also have broad authority and control over investing in assets and raising capital for their assets. These organization units are called, quite logically, investment centers. Basically, an investment center is a mini business within the larger conglomerate. Discussing investment centers is beyond the scope of this chapter. Centering on profit centers From a one-person sole proprietorship to a mammoth business organization like General Electric or IBM, one of the most important tasks of managerial accounting is to identify each source of profit within the business and to accumulate the sales revenue and the expenses for each of these sources of profit. Can you imagine an auto dealership, for example, not separating revenue and expenses between its new car sales and its service department? For that 185