While you’ve likely heard of the term “goodwill,” are you aware of its application in accounting? Goodwill is an account on the balance sheet of certain businesses, and it falls into the category of assets. Specifically, it’s what’s known as an intangible asset, or one that isn’t physical. Examples of other intangible assets are copyrights, patents, and trademarks.
Understanding Goodwill in Accounting
Goodwill arises when one company purchases another. When a company pays more for the company that it is acquiring, the difference is booked as goodwill. Goodwill represents the extra value that the acquisition provides for the purchasing company.
When the purchase happens, the assets and liabilities of the acquired company are taken over by the purchasing company. They are recorded on the purchasing company’s books at their fair value. The balancing entry between the fair value of the assets and liabilities purchased and the purchase price is booked to the goodwill account.
What could lead a company to pay more for another company? Things that are not on the balance sheet but are valued could include a solid customer base, great employees, brand reputation, the company name and what it means, technology owned by the company, and a great reputation for customer service.
Normally, an intangible asset like goodwill would be amortized, but it is not. Amortization is when a portion of the asset is expensed each year. A patent, for example, is amortized over its useful life, not to exceed 20 years. If it sounds similar to depreciation, that’s because it is; some physical assets are depreciated, while some intangible assets are amortized.
Before 2001, goodwill was amortized for up to 40 years, but the accounting rules have changed to something less arbitrary. Now, goodwill must be checked each year for “impairment.”
Goodwill impairment happens when the value of the acquisition declines after it has been purchased. One famous example of impairment write-down occurred right after this new accounting rule was implemented. In 2002, $54.2 billion in impairment costs was reported for the AOL Time Warner, Inc. merger.
More recently, in 2020, a few of the largest impairment write-downs included companies, such as Baker Hughes, Berkshire Hathaway, and ATT, due to the latter’s acquisition of DirecTV in earlier years. In 2022, impairment write-downs included Teladoc Health and Comcast. Covid-19 was in part responsible for a large number of impairment write-downs in recent years.
If impairment is required to be booked, the journal entry will look like this:
Debit Impairment Expense (increases expenses and therefore reduces profits)
Credit Goodwill (reduces the asset amount)
If your company has acquired other companies and you have a goodwill account on your balance sheet, you can work with your accountant to determine how to check for impairment and if you are required to correct your books. While this process can be complex and time-consuming, it is crucial in ensuring that the financial statements are a true reflection of the company’s financial position. Goodwill is an important accounting concept that can have a significant impact on the financial statements of a business.
Most small businesses own at least some type of fixed asset, which could include items like land, buildings, equipment, and automobiles. The investments of adding, replacing, or improving upon fixed assets are called capital expenditures (or “capex” for short).
It seems like there is never enough money for all the capital expenditures that are on a business’s wish list. To make the best spending decisions, it’s a good idea to establish a process for capex activities in your organization. There should be three phases of your process:
- Initiation, estimating, and evaluating return on investment for each capex project.
- Prioritization of projects based on ROI
- Managing and monitoring the projects once they have started.
Step 1: Initiate, Estimate, and Evaluate the capex initiatives you’re considering
The first step is to list all the capital projects you’re considering. Here are some examples:
- Buy an additional truck for deliveries.
- Expand the warehouse space.
- Purchase a piece of equipment for the manufacturing line.
- Redo the dock area to improve loading efficiency.
Once you’ve made your list, you can begin to formalize your capital expenditure process. Each project should be detailed and estimated, with bids from vendors, so you have a realistic idea of the cost.
Step 2: Prioritize your capex initiatives
The next step is the most important. What are the estimated savings for each project? In other words, what will your return on investment (ROI) be? In capital expenditure spending, this answer is crucial. For each project, estimate the expected savings in time, money, and intangible benefits, and determine the break-even point.
This step can be challenging because the savings might be more qualitative than quantitative. For example, the benefit could be an improved customer experience, which should result in future sales. In this case, you’ll still want to estimate how you think future sales will be impacted. In many cases, it can take years for an item of capital expenditure to start paying off from a cash flow standpoint.
Next, it’s time to visualize the data you’ve accumulated into something like this:
|First year: $9,000 savings.
Second year savings: $49,000.
(Break-even comes in second year.)
|Increases sales capacity and reduces delivery times.
|Redo the dock area
|Time saved – payroll costs decrease by 1/2 headcount. Savings of $27,000. If attrition is used, defer savings.
|First year savings: -$7,000.
Second year savings: $27,000.
(Break-even comes at end of second year.)
|Employee happiness, reduced turnover are intangibles.
When deciding which project to choose, return on investment is only one factor to consider. You must also consider employee satisfaction and turnover issues, customer service, capacity management, tax breaks, break-even time, cash flow, lending limits and financial ratios, and other factors specific to your industry.
The key is to have a process that makes sense for your organization. If you don’t have a process, choosing the cheapest project first could seem like the best decision, but it may not have the highest return on investment. This missing link in insight today could lead to cashflow and profitability issues tomorrow.
Tax implications also need to be considered, and we want to point out that these have been left off of the above example since every business’s tax planning circumstance is unique. Always consult with your tax accountant before making a capex decision and as you approach year-end. They can provide valuable feedback about how certain purchases will affect your tax liability. For example, making a capex investment before year-end when you’ve had high profits could be a strategic way to offset your tax obligations.
Another factor to consider is whether you’ll need a loan to complete these capital improvement(s). Interest rates have been rising in 2023, and these costs, plus your cash flow impact, need to be evaluated. As your debt increases, your financial ratios also need to be assessed. You have to be careful not to go into too much debt overall.
After documenting all considerations, you’ll be poised to make a well-informed decision on which capex project to prioritize next. You might even consider creating a capex committee to help you decide. Be sure to include your accounting advisor on the committee!
Step 3: Manage your capex initiative
You’ve decided on the capex project you want to take on now. Great! You’ll want to appoint a project manager to oversee the project’s progress and take action for any necessary course corrections. Once the project is complete, set milestones so that you can see how accurate your estimates of costs and benefits were. You might need to set milestones every year for several years in order to accurately measure the actual ROI, and taking these measures will make you a more accurate estimator in the future.
Spending at the right time on capex projects is as much an art as a science. However, putting formal processes into place will improve your chances for a better return, smoother cash flow, and improved profits.
For taxpayers collecting payments through a third-party payment platform such as PayPal, the American Rescue Plan Act of 2021 (which we’ll refer to as “the Act” in this article) established a significant change to tax reporting rules to prevent businesses and contractors from hiding income through the receipt of electronic payments. Form 1099-K is the tax form issued by credit card companies and third-party payment processors to report payments made via debit card, credit card, stored value cards (like gift cards), and payment apps (like Stripe, PayPal, or Venmo). As part of the Act, the reporting threshold for issuing the form was lowered significantly. Although this change was set to take effect starting with the 2022 tax year, the IRS delayed implementation of the new rule – however, it is expected to be required for 2023.
Existing rules (which are still currently in place for 2022 due to the IRS postponement) require credit card companies and payment processors to file Form 1099-K with the IRS and issue it to payees when:
- gross earnings are more than $20,000, and
- the number of transactions exceeds 200 for the year
Many lawmakers argued that this “two-step” threshold created a situation where contractors/sellers could easily omit income from their tax returns. As a result, the single “$600 or more” threshold was created, meaning that any recipient with receipts of $600 or more for the year through a particular payment platform will be issued a 1099-K form, regardless of the number of transactions or other factors. Barring any additional action from Congress, this new reporting threshold will be enforced starting with 2023 forms, meaning that a substantially higher number of 1099-K forms will be sent out in early 2024 for the 2023 tax year.
Considerations and Concerns
Even though tax law has always required taxpayers to report ALL income earned/received, regardless of whether associated tax forms are received, this law change has raised concerns about several logistical challenges, including:
- What about personal transactions? For example, will taxpayers who use platforms like Venmo to receive personal payments, such as a birthday gift from a relative or a rent deposit from a roommate, be taxed on those payments? According to IRS, 1099-K forms will only be issued for accounts listed as business or merchant accounts, or for personal accounts where transactions are tagged as “goods and services.” Despite these reassurances, there are still questions about how this will play out as the change is implemented, especially for those who use the same account for business and personal transactions, or casual sellers who are selling used goods for less than what they paid/are not in the business of selling such goods for a profit.
- What if the 1099-K and 1099-NEC forms report the same payment? Although this should not happen per IRS due to the fact that payment processors are responsible for issuing 1099-K forms and individual clients are responsible for sending 1099-NEC forms, it’s still possible, particularly if clients misunderstand the rules and don’t realize they shouldn’t be issuing 1099s for payments made through credit card or payment apps. This raises concerns about the double-reporting of income and how to account for such errors on a tax return so that the recipient is only taxed once on income.
- How will IRS handle the resulting influx of paperwork they’ll have to sort through? IRS has already been dealing with understaffing and, as a result, processing backlogs and inadequate phone support over the last few years. Many believe this compliance change will increase the burden on the IRS, lead to widespread confusion in the tax system, and produce a rise in IRS correspondence.
For freelancers, contractors, or anyone receiving payments through a third-party platform, make sure to save any 1099-K forms received, which you will need to refer to when you file your tax returns. Consult with your tax professional about any actions you may need to take as a result of these rule changes and if/how your tax situation may be impacted.
One of the most challenging aspects of running a business is figuring out how to pay yourself. It’s not always clear what the rules are, and many entrepreneurs struggle to strike a balance between reinvesting profits into their company and taking home a fair salary.
Entrepreneurs typically have a couple options available when it comes to paying themselves, which are dependent on the structure of a business. One option is to take a draw, which is a withdrawal of funds from the business’s profits. This is used by sole proprietorships and partnerships. The other option is to receive a paycheck, which must be used by incorporated businesses. Paychecks are compensation based on a predetermined salary and are subject to taxes and other deductions.
It’s important for entrepreneurs to understand the differences between these two methods and choose the one that is required for their specific business structure and meets their financial goals. If you have any questions about the best option for you, discuss the matter with your accountant. In this article, however, we’ll focus on some key considerations to keep in mind as you determine how much to compensate yourself for your hard work.
1. Reasonable Compensation
What would your pay be if you were doing the same work for a company that hired you? Are you making at least market equivalent or better? Many times, entrepreneurs remain focused on ONLY this aspect of their compensation, when doing so is actually a big mistake. There are tax implications of paying yourself too little (to avoid payroll taxes if you take a paycheck, for example) or too much.
2. Retirement plan
When you work for yourself, no one is going to fund your retirement for you. Although the Social Security program helps, it’s up to you to set aside additional money for a livable future when you can’t or don’t want to work anymore. Talk to your accountant and retirement advisor about how much you should be setting aside for your retirement and how you can factor that into your own pay.
Employees get paid time off, health insurance, and bonuses–and you should too! These benefits should be part of your compensation package as an entrepreneur, and there are many tax advantages as well
You need to cover taxes that will be incurred on your pay and your business profits, including:
- Normal withholding for federal income taxes, state and local income taxes, Medicare, and social security. If you receive a paycheck, these will be deducted; however, those deductions may not be sufficient to cover your entire tax obligation since they don’t account for taxes on your profits. If you take a draw, you may not have withholding, but you will need to factor in self-employment taxes at 15.3%
- Taxes on your profits. For sole proprietors, partnerships, LLCs, and S Corps, your taxes will be figured on your business’s profits when you complete your federal income taxes. They will “pass-through” from your business to your personal return. Don’t let this part surprise you!
- State business taxes. If your business does business in multiple states, you must file a tax return for each state. Many states collect taxes based on flat corporate fees, the revenue you earned in that state, state payrolls, and/or the value of property owned in that state.
Check with your tax advisor so that there are no surprises in your tax bill for your business or your personal returns.
As an entrepreneur, you take on additional risk in owning your own company and should be compensated accordingly. Your capital is tied up in your business and should be earning a good return in addition to your regular salary or draw.
It’s normal to take a smaller paycheck in the first few years as your business grows, and you might even feel like you can’t afford to pay yourself an amount that reflects all the above components. In that case, it might be a good idea to evaluate your pricing, your volume of work, or your business model.
Remember to review your salary regularly and adjust as necessary to ensure that you’re meeting your financial goals and building a sustainable business. Determining the right amount to pay yourself as a business owner can be a complex process, but it is a key component of achieving long-term personal and professional success. By following the steps outlined in this article and seeking guidance from trusted financial experts, you can ensure you’re compensating yourself fairly and sustainably.
Running a business can feel like a whirlwind of responsibilities! Time is a precious resource for entrepreneurs, and taking shortcuts can be tempting. However, there’s one shortcut we really recommend against: sharing sensitive documents like bank statements, financial reports, tax forms, and more over email.
When safeguarding your valuable information (and that of your customers!), prioritizing security is essential. With cyber threats constantly evolving, email is an increasingly vulnerable method for transmitting confidential data. How should you be sharing your sensitive documents instead? By embracing secure document-sharing portals.
Document-sharing portals like SmartVault employ state-of-the-art encryption techniques to prevent bad actors from accessing your information. They can streamline your workflows, save time, and reduce errors. Most have user-friendly, intuitive interfaces, too, making it easy for you and your team to implement the new tech successfully.
Portals don’t just benefit you and your business, however! They can benefit your customer relationships, too. Adopting a portal can demonstrate a commitment to protecting your customers’ data, safeguard your reputation, and help you comply with data protection regulations.
While attaching a file to an email may feel more convenient in the moment, the tradeoff could be catastrophic. Instead, by taking an extra step to secure your documents, you’re investing in the long-term success of your business. We, as accountants, cannot overstate the importance of robust data security, and we encourage you to embrace the convenience and peace of mind that secure document-sharing portals provide!