Docs > Big Picture > Tax Accounting, Cost Accounting and the IRS Audit
"Learn the rules well, so you know how to break them properly" - The Dalai Lama. In 5 to 7 minutes your monthly banking statements can tell a tale about your Net Income that might blow your mind. Likewise, with another 3-5 minutes of analysis, other cross checks can be made that can catch all who think they are clever but don't understand the power of basic math as related to Accounting. With all this understanding you will see where our Tax Accounting First Methodology comes from.
The Basics related to Small Business Accounting are stupidly simple. People get so wrapped up and riled up by the tax code they forget it's all just addition and subtraction, with some light multiplication and division tossed in sparigingly. Here's the little bit you need to know to get going...
The Basics related to Small Business Accounting are stupidly simple. People get so wrapped up and riled up by the tax code they forget it's all just addition and subtraction, with some light multiplication and division tossed in sparigingly. Here's the little bit you need to know to get going...
Two Types of Accounting
There are two types of Accounting:
Cost Accounting is accounting for your own personal use. It is done to assist you with assessing all aspects of your business that you deem are worthy of watching.
The primary difference in these two accounting systems is related to the "category" that you assign to each transaction, and the goal of the accounting process. That's it... nothing more. Most responsible companies or businesses do both to some degree, even though Tax Accounting is the only one that is truly required
- Tax Accounting (aka Financial Accounting)
- Cost Accounting (aka Managerial Accounting)
Cost Accounting is accounting for your own personal use. It is done to assist you with assessing all aspects of your business that you deem are worthy of watching.
The primary difference in these two accounting systems is related to the "category" that you assign to each transaction, and the goal of the accounting process. That's it... nothing more. Most responsible companies or businesses do both to some degree, even though Tax Accounting is the only one that is truly required
Tax Accounting vs Cost Accounting
The difference between Tax Accounting and Cost Accounting is simply related to the categories assigned to various transactions and the goal of the accounting process. In Tax Accounting you will use categories that align with forms the IRS requires you to use to report your financial information, and in Cost Accounting you will use a separate set of categories that makes more sense for your analysis and/or your reporting needs.
If you had a list of transactions in a spreadsheet with two empty columns to the right, one column being for a simplified category the government wants to see for Tax calculation purposes and one column being for a category more suited for your own insight into your business, you would have a perfectly functional accounting system or accounting software -- believe it or not...
Here are the questions you should be asking yourself first...
If you had a list of transactions in a spreadsheet with two empty columns to the right, one column being for a simplified category the government wants to see for Tax calculation purposes and one column being for a category more suited for your own insight into your business, you would have a perfectly functional accounting system or accounting software -- believe it or not...
Here are the questions you should be asking yourself first...
- Do you know how much accounting you should be doing and what the best way is to do it?
- Do you fully understand the minimum requirements for reporting income for Tax purposes?
- Do you realize the amount of accounting needed for reporting taxes is actually very minimal?
- Do you fully understand that not even the IRS expects perfection with your accounting?
- Do you understand that CPAs make small and reasonable adjustment for things that don't add up on a daily basis?
- Do you fully understand that all accounting done beyond Tax Accounting is only for your own use?
- Do you realize the IRS does NOT rely on your digital accounting records to audit you??
- Do you realize the IRS (and your accountant) can use incredibly simple math to very quickly figure out if you are manipulating your data?
Net Income
Net Income = Income - Expenses
You will be taxed on Net Income one way or another.
A transaction is either related to Income, or it's related to an Expense. That's it.
You will be taxed on Net Income one way or another.
A transaction is either related to Income, or it's related to an Expense. That's it.
- (We are oversimplifying this for conversation purposes. In some cases there are some magical expenses that aren't material, like depreciation for rental properties, and there are some expenses that have to be spread out over a period of time or deferred, but forget you know about those for now.)
The IRS Audit of Net Income
As part of the 18 Rules of Living, the Dalai Lama rule 6 is "Learn the rules well, so you know how to break them properly", and I can't think of a better quote for this entire educational adventure.
If you don't know how the IRS is going to audit you, and what is weighed more and less, you have no real clue what you need to be paying attention to, nor the level to which you need to achieve perfection. As a result of this ignorance, you are either putting in too much effort or too little effort and both stand to cost you dearly in the long haul.
Here's Step 1 of the Audit in a nutshell.
Notice, they did NOT need any part of your digital record keeping to get a gross picture of your truthfulness and they got it in 7 minutes. If they can get all that in 7 minutes or so, does it make sense that you should need to spend more than an hour or a few getting the details together for that 7 minute analysis?
If you don't know how the IRS is going to audit you, and what is weighed more and less, you have no real clue what you need to be paying attention to, nor the level to which you need to achieve perfection. As a result of this ignorance, you are either putting in too much effort or too little effort and both stand to cost you dearly in the long haul.
Here's Step 1 of the Audit in a nutshell.
- The will gather your checking account statements for 12 months.
- They will take all of your deposits and credits for each month and add them up.
- They will take all of your withdraws and debits for each month and add them up.
- They will subtract your withdrawals from your deposits and generally speaking, your Net Income claimed had better be close to that, or you are in trouble.
Notice, they did NOT need any part of your digital record keeping to get a gross picture of your truthfulness and they got it in 7 minutes. If they can get all that in 7 minutes or so, does it make sense that you should need to spend more than an hour or a few getting the details together for that 7 minute analysis?
Ways to Cheat on Net Income -- (aka ways you may try to cheat the IRS and ways employees and others may attempt to cheat you...)
The IRS and your Accountant know every way you might try to cheat. You are the only one in the dark. Sharing this with you makes sure you understand that there is little you can do to trick others who do this for a living. The more beneficial aspect of this sharing is in fact informing the more naive folks of the ways they will get their clocks cleaned by employees and rogue bookkeepers and accountants if they make bad hiring choices.
Artificially Decrease Your Income
The best way to artificially decrease your income is to make sure income transactions never get into your business bank account. Ideally they should not touch your point of sale system either, but truth be told, if your point of sale system isn't automatically connected to your accounting system, which it should not be for other reasons, deflating your income for Tax Reporting purposes is still easy, although it would be easy to pick up on that rouse with an in depth audit if you can't modify your Point of Sale System reports to match your claimed deposits.
Artificially Increase your Expenses
Artificially Decrease Your Income
The best way to artificially decrease your income is to make sure income transactions never get into your business bank account. Ideally they should not touch your point of sale system either, but truth be told, if your point of sale system isn't automatically connected to your accounting system, which it should not be for other reasons, deflating your income for Tax Reporting purposes is still easy, although it would be easy to pick up on that rouse with an in depth audit if you can't modify your Point of Sale System reports to match your claimed deposits.
- Cash -- You will take cash sales transactions and you will not deposit the money in the bank. If you are smart, those transactions would also not be in your point of stale system either. Have you ever seen a clerk working at a convenience store or elsewhere tell you a total without closing the drawer and ringing it up? One reason to do that is to pocket the money from that sale.
- Checks -- Instead of depositing checks written to the business, you will cash them. If you are smart, those transactions would also not be in your point of stale system either. To this you might say "hey wait a minute, banks won't let you cash checks written to a business" and to that I'd say, "yes, you are correct". And then I'd go on to tell you about check cashing places that have agreements with their banks which enables them to cash checks written to business entities. Yes, contrary to popular belief, there is a fully fraudulent check cashing system in the United States that has been thriving for decades. The FEDs will tell you this does not exist. The Banks will tell you this does not exist. Unfortunately I can pretty well assure you that as of 2017, this still exists. The check gets endorsed from the company the check was written to to the check cashing company and in the mean time, the person cashing the check gets the check amount less a check cashing fee, and there is very little history indicating they ever participated in a revenue generating transaction.
- Credit Cards - There is no logical way to hide credit card sales. Your merchant account provider will be issuing a 1099 to you at the end of the year documenting all of those sales. With this, you can see why the government would like to shift to all digital currency.
Artificially Increase your Expenses
- Submit fake cash receipts to the company for reimbursement for things like taxi cabs and tips
- Submit receipts for meals and entertainment which are not relevant to your business.
- Use company money to pay for personal expenses.
- Write a check to yourself and record it in your ledger as a sale to a regular vendor. Employees who get their hands on the checkbooks of companies where owners aren't paying attention will do this regularly. Their inability to realize they will have little to no cover when that business owner wakes up.
- Write a check to a vendor that is in on the scam with you. They will get the check and deposit it as a sale, and then refund it to the person not the company who wrote the check.
And then there's the Balance Sheet...
The Balance Sheet is a report that mixes annual net income with all Assest, Liability and Equity accounts in a way that makes it really darn difficult to add inappropriate Debt to the company, remove cash from the company, or otherwise manipulate your bank accounts. It's like a Chinese finger-lock that ties a bunch of numbers together and it makes it tougher to pull one over on the IRS and Investors.
The IRS Goes after easy money and big money...
Given the IRS knows all of this, and given much of this would be incredibly time consuming to check, do you think they are going to care about this if the gross 5-7 minute analysis indicates no improprieties and if the general aspects of the income and expenses are believable?
The IRS Agents are like any other employee. They're job is to find places where money is owed. They will not get kudo's from their boss if they spend a month try to catch you cheating them out of a few thousand dollars. IRS Agents need to bring in way more than they cost to employ, or we wouldn't be employing them.
As you come to learn about the rules, you can learn to break them in small ways that are likely insignificant. But if you do really dumb stuff, thinking that won't catch up to you one way or another, that's just naive. I have heard of some stories of some folks getting away with some amazing stuff -- but I can pretty well assure you that the egregios stuff missed by the IRS gets picked up by the Karmic System, so at that point it's just about picking one's poison.
The IRS Agents are like any other employee. They're job is to find places where money is owed. They will not get kudo's from their boss if they spend a month try to catch you cheating them out of a few thousand dollars. IRS Agents need to bring in way more than they cost to employ, or we wouldn't be employing them.
As you come to learn about the rules, you can learn to break them in small ways that are likely insignificant. But if you do really dumb stuff, thinking that won't catch up to you one way or another, that's just naive. I have heard of some stories of some folks getting away with some amazing stuff -- but I can pretty well assure you that the egregios stuff missed by the IRS gets picked up by the Karmic System, so at that point it's just about picking one's poison.
Summary -- The Methodology Lead in...
With this very basic and very simple understanding of accounting and the audit playing field, hopefully now the idea of doing your cost accounting first and doing it well with only the minimal details needed to get it close makes sense.
If so, you are ready to move on to our Methodology document...
If so, you are ready to move on to our Methodology document...