A Guide to Accounting and Compliance for SMBs
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This post is made in partnership with Tukel, Inc. Accounting
Accounting and compliance are the fundamentals for a successful and sustainable business, as well as your tax obligations.
As you will be relying on your company's financials to make smart business decisions and manage your tax compliance requirements, you need to assess your accounting needs and ensure full compliance for your company.
Do you need a bookkeeper, an accountant, or a CPA?
A professional bookkeeper or an accountant is not a mandate for most SMBs. If you have internal resources, you can perform these tasks internally but ensure that you have an accounting policy and consistently maintain your financial books.
A CPA is a licensed professional who can do audits, reviews, and compilations, whereas a bookkeeper or an accountant (if not a CPA) cannot do these and sign off on the results. CPAs also have the authority to represent a client in front of the IRS.
CPA services are usually more costly and require far more diligence and cooperation/admin time from the owners. Many SMBs do not need these services and may acquire them if and when needed, thus reducing their costs.
Financial statements of your company will be needed for a few primary reasons:
- Though the IRS does not mandate SMBs (usually businesses with less than $26 million in revenue in the last 3 years) to maintain financial books, you would need a simple income statement (and probably a balance sheet after a certain scale) to be able to prepare your tax returns.
- In case of an inspection, the IRS would see your arguments as more defendable (and sometimes as a minimum requirement) if you have a consistent accounting policy applied to the financials and the books are maintained as required.
- You, as the shareholder, and also your current/potential investors will rely on the financials to make business decisions and projections. Therefore, you need to assess whether you need to outsource accounting from day one.
- If you will apply for a loan, you may also need your books and financial statements.
It is highly recommended that you have an accounting policy and also maintain your financial books consistent with that policy. Bank statements, collection/payment documents are not financial books or financial records—they are what are called substantiating documents.
If you're not ready to have an accountant in your company, it's advisable to engage with a professional consultant to ensure your books are in check.
Do you have your income statement and balance sheet?
You will need a balance sheet and income statement of your company to evaluate your financial situation and profitability, project your tax liabilities, analyze sector-based ratios, and so on.
A balance sheet shows the photograph of your financial position at a certain point in time (such as “as of Dec 31st 2022”), showing the assets, liabilities, and the resultant equity of the company.
An income statement shows the financial performance of the company in a certain period of time (such as a certain month like “August 2022” or a certain year like “Jan 1st - Dec 31st 2022”)
On top of this, you may be required to report your annual balance sheet and income statement when filing tax returns.
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Cash versus Accrual Basis of Accounting versus USGAAP
Not all financial statements are the same. You need to understand what basis of accounting is used to generate them. Your financial statements, like the balance sheet and income statement, reflect your financial position and depend on the accounting methodology used.
Under cash basis accounting, revenue is recorded as income when cash is received, and expenses are deducted when actually paid. For SMBs, cash basis accounting and taxes is allowed by the IRS.
However, if you use accrual basis accounting, revenue and expenses are recorded as they incur, even if there is no actual cash-in or cash-out. Accrual basis is the general norm and represents a more accurate position of the company. The more strict accounting policies, such as USGAAP and IFRS methodologies, are both accrual basis.
Since the basis of accounting you use would have a significant impact on your taxable income and also your balance sheet, you need to assess which one is more convenient to adapt as per your business structure. For example, cash basis accounting may suit you better if you run a small business.
Businesses with certain criteria are required to keep their books as per USGAAP, which is a more strict and descriptive accounting methodology. Many small and medium-sized businesses prefer to keep it simple and use the cash or accrual basis accounting (both can be categorized as ”Other Comprehensive Basis of Accounting”) unless it is required by their investors or they see that they meet the USGAAP mandate earlier in their life cycle.
It is very difficult and costly to change the accounting and tax methodology later. We recommend that you assess this as you start your business and maybe even seek professional advice as to which one fits your business the best.
Transaction Documentation Requirements
The IRS requires you to substantiate all the transactions of your company by documenting and archiving them for at least 5 years (and you must do this to protect yourself in case of a tax inspection). These documents may include invoices, receipts, bills, contracts, timesheets, tax forms, and bank statements.
Moreover, the documents may also be required by investors as supporting evidence for expenses and as proof that you have not commingled personal and business expenses. Consequently, you need to determine how to store and backup your company documents.
Research and Development Expenses
Research and development expenses are expenditures incurred in the course of finding, developing, and improving new products and services, such as software development, product formulation, process designs, etc.
Some of these expenses may not be allowed for deduction but may need to be capitalized. The treatment of R&D expenses is very complex and may change over the years, materially impacting your reported profitability and taxes.
Accounting policies establish the basis of accounting used, maintain consistency, and increase efficiency. These policies serve as evidence that accounting transactions are evaluated systematically and processed consistently, as mandated by the IRS.
Policies can also be useful for a general review of financial statements by potential investors. Accordingly, you need to substantiate your accounting procedures with policies, such as accounting methodology, fixed assets, travel and entertainment expenses, non-deductible expenses and so on.
Related Parties and Transfer Pricing
Your U.S. company may have related parties, such as owners, shareholders, subsidiaries, parent companies and/or companies owned by any of these.
Transactions between your U.S. company and related parties should be priced in compliance with the arm’s length principle and may need to be disclosed with your annual tax return. To ensure your company transactions are in compliance with transfer pricing, tax, and disclosure regulations, you need to identify your related parties, have substantiating contracts, and inform your tax preparer.
Investors and Cap Table
Especially for the shareholders and investors of your company, you need to have an up-to-date cap table (capitalization table) to track the equity ownership and make sure that it is accounted correctly. We recommend that your corporate lawyer maintain your cap table.
If your business has inventory items that you produce or buy to sell, you need to assess how to track them efficiently and calculate the cost of goods sold. You should also conduct regular physical stock counts. You can use an online inventory management system to help you track your inventory’s quantity and USD value.
The IRS and certain states provide many tax exemptions and incentives, especially to help small and medium businesses, such as R&D support, COVID recovery incentives and aids, and income tax exemptions.
Deductible vs. Non-deductible Expenses
You can only deduct expenses related to the business activities of your company, though certain business expenses may be specifically disallowed for deduction, such as fines.
Personal expenses (even of owners’ or shareholders’) are generally non-deductible. To ensure tax compliance, you need to assess which of your expenses are deductible or not and keep in mind not to commingle your personal and business expenses.
Personal vs. Business Bank Account
Ensure that all bank and PSP accounts of your business are in the company’s name, not yourself or any other person. You should keep your personal and business finances in separate bank accounts.
Governance and Operations
Apart from tax and legal requirements, you need to consider many aspects of governance and operations to run and maintain a successful business.
Corporate Governance Structure
Shareholders (General Assembly)
Shareholders of the company appoint and mandate the board of directors with certain powers and duties for corporate governance by issuing a schedule of authority.
Directors (Board of Directors)
The Board of Directors then hire the officers of the company to manage the day-to-day operations, guided by their own sub-set of schedule of authority and company policies approved by the directors.
Officers (e.g. CEO, CFO, CTO, CMO)
In small businesses, typically, shareholders, board members, and officers can be the same people.
A general assembly may be required at least once a year as per the by-laws of the company for the execution of appointments and mandates. It is also recommended to protect the corporate veil.
How to remove or add someone as a shareholder or a co-founder?
Removing or adding shareholders or co-founders should be carried out in compliance with the by-laws and stock purchase agreements (SPAs) of the company. We suggest that you consult your corporate lawyer to learn more.
How to remove or add someone from the board?
Removal of board members should be made according to the by-laws of the company and conducted as a result of a general assembly decision. Note that a board member or a director may be different than the shareholder or the officer of the company (e.g. CEO, CFO).
You may need different types of insurance to secure your business against potential risks. Some insurances are mandatory (such as workers’ compensation if you have U.S. employees, etc.), and some others are optional (such as security, data privacy, loss of business, etc.).
Your insurance requirements may differ based on your unique business risks, industry, licenses, operating environment, state, etc. You may need to work with professionals to assess your risks and requirements.
Data Security and Compliance
Other than legal requirements, you may also want to take precautions to protect data from hackers and data breaches.
IPs, Trademarks, Assets
You can secure your intellectual property, such as brand name, trade name, or product development, through registering a trademark, patent, commercial agreements, etc. In addition, these assets may also need to be reflected in your financial records.
Funding Your Company
You can fund your company in many ways, such as getting investors, injecting self-capital, or loans. Clearly, capital investors are the best way to go. But if you are self-funding your business, you may consider injecting capital or giving a loan to your business. You can discuss the options with your accountant or corporate lawyer.
It is very important to account for these fundings correctly as the accounting records feed into the tax returns and may also be used in court in case of a dispute with shareholders or investors.
Paying Yourself as an Employee or Contractor
If you're a non-U.S. owner of a U.S. company without an SSN or work/residency permit, you cannot be treated as an employee. Nevertheless, you can still get paid by your company in different formats, such as a contractor or through dividends.
By Cenk Tukel, founder and CEO of Tukel, Inc. Accounting and licensed U.S. CPA
Disclaimer: This guide is presented for informational purposes and should not be considered professional or legal advice. Consult a professional such as a certified accountant for help.