In Part 1 of this series, we spoke at length about determining what your business needs, the basic information we’ll need as tax accountants, updating your corporate record book, and recording major events in the business.

In Part 2 of this series, we’re going to start looking at the books and what we, as tax accountants, need to see in order to prepare the T2 Corporate Tax return.

Be cautioned, this is a long read and contains some accountanese …

Accountants are not All Equal

Just like every profession, not all accountants are equal. Some have high standards, such as our team at KATA, and others have no standards at all. We are approaching this article from our perspective, what we’ll be looking for when preparing a T2 Corporate Tax return.

If you want a CPA to prepare your taxes, make sure you look them up on the relevant CPA sites to ensure they are a CPA in good standing and are running or working for a registered CPA firm. 

There are a lot of people out there who will say they are a CPA and might be, but aren’t necessarily appropriately designated in Canada. There are also people out there who call themselves accountants who aren’t in any way designated or qualified.

When considering an accountant, if the price is too good to be true, it probably is.

Remember, you’ll often get what you pay for.

The Balance Sheet

The Balance Sheet is where we spend most of our time. This helps us feel comfortable that we aren’t being associated with anything false or misleading – which would be a violation of the CPA code of conduct.

We review certain accounts and balances to ensure they make sense, but we do not review every transaction that was entered during the year. There is no level of engagement where all the transactions are reviewed in detail. Even during an audit, only a sample of transactions are tested to ensure they are correct.

Cash is King (or Queen)

The first thing we look at are the bank accounts and credit cards. Specifically, we look to see if they have been reconciled and that the balances make sense. In general, the principles are the same, so when I say bank account, consider it interchangeable with credit card for the purposes of this section.

Reconciliations are the First Step to Quality Control

The balances of the bank accounts and credit cards on the balance sheet won’t necessarily be the same as the balances reflected on the statement from the bank or credit card company.  

This could be for a variety of reasons. Perhaps there is a cheque that you wrote that hasn’t yet been cashed, or there are transactions that occurred that haven’t yet been posted by the credit card company or bank. 

When looking at a reconciliation, you should look for missing transactions and “hanging” transactions. Missing transactions should be investigated and entered into the books so you can complete your reconciliations. Old transactions that are “hanging” around are transactions that are in your books but are not on the statements.

Hanging Transactions

All hanging transactions should be reviewed each time you do a reconciliation. Although some may be appropriate, many can be due to errors in bookkeeping such as duplicate entries or entries being posted to the wrong payment account. 

Though there could be timing differences – such as a cheque being issued, but not yet cashed – there should be nothing more than 6 months old. (Cheques are considered “Stale-dated” after 6 months.) Any hanging transactions should be investigated and either verified or corrected.

Other Reconciliations

There are other accounts that should be reconciled and all good accounting software empowers you to reconcile key accounts. (If yours doesn’t, you should probably consider making a change.) For instance, loans and mortgages should be reconciled to ensure that the appropriate amount of interest revenue or expense has been recorded (more on loans a few sections down.) 

Also, clearing accounts should be reconciled regularly to ensure they are clearing the balances that go through them. This can be a bit trickier since there are no third-party statements to reconcile against, but understanding how clearing accounts work and what should be moving in and out of them will allow you to reconcile and feel comfortable with their ending balance.

Receivables and Payables

All Accounts Receivable (AR) and Accounts Payable (AP) should be reviewed by customer or supplier before your books are sent to the tax accountant. You should check to ensure that the balances make sense and that all payments received or made are tied to the correct invoice or bill. A good way to look at this is the AR or AP Aging Summary Report.

AR and AP Aging Summary

These reports will show you how old items are based on their due date. Items that are older should be reviewed to ensure that they haven’t already been paid, that any payments made are appropriately matched to the bill or invoice they relate to, and to ensure that the terms have been set correctly. 

For instance, a bill that is 60 days old might be way overdue, or it might be that the supplier extended terms, such as net due in 60 days, and the bill should be paid soon.

Balances should also be reviewed to ensure that they make sense. Generally speaking, a company doing $500,000 of revenue a year should not have $500,000 of accounts receivable.  

Also, you’ll want to review individual account balances to ensure they make sense. It’s rare that a customer is owed money by the company or the supplier owes the company, but it is possible.  

This would appear to be a negative balance in the customer or supplier’s account. This is why it’s important to review your AR and AP at a customer or supplier level to ensure that all the balances are correct and make sense.

Items that are old and unpaid should be collected or paid off. Not paying bills is a good way to ensure suppliers won’t want to do business with you in the future. Not collecting overdue invoices is a sure way to get your business into a cash crunch.

“Write it off”

We’ll often hear people say that things should be written off. However, this is often not well understood.

On the payables side of things, if you write off an overdue bill, you are decreasing the expenses incurred by your business, and possibly upsetting a supplier. This results in an increase in net income and increased taxes payable. 

Before writing these items off, you should find out if they are a duplicate of another transaction, or if they have been paid by other means, such as by a shareholder or an employee. If they were paid by the shareholder or employee, those amounts should be tracked so they can be repaid accordingly.

Bad Debt

Writing off an invoice that you’re owed creates a bad debt. If you are claiming bad debts, make sure you’ve documented your collection efforts or have evidence that the bill is not collectible. 

Unethical business owners will sometimes collect payment in cash, put it in their pocket instead of the bank account, and indicate that it is bad debt to their bookkeeper. (If this describes you, please don’t call us.) CRA is aware of this potential source of fraud by the business owner.  

Make sure your bad debts are well documented so you can provide proof if you’re ever challenged by CRA.

Accrual Basis of Accounting

Almost all Canadian businesses are required to use accrual- based accounting. (This is an area where less-than-ethical accountants will take shortcuts.) One of the fundamental tenets of accrual-based accounting is that revenues and expenses should be recorded in the period in which they occur. This results in two key accounts that are often overlooked.

Prepaid Expenses or Assets

Prepaid Expenses are exactly what they sound like. Expenses that are paid for now, but relate to a later period. For instance, if you pay for an annual insurance policy at the beginning of every July, but the policy is good for 12 months and you have a fiscal year-end of December 31, half of this payment is a prepaid expense. 

Similarly, there could be times when you order and pay for something in December that won’t arrive until the following year. A common example of this is inventory ordered from overseas.

Some examples of Prepaid Expenses or Assets include:

• First month’s rent or prepaid rent
• Security deposits
• Software licenses
• Insurance policies
• Inventory in transit
• Deposits on major purchases

Accrued Liabilities

Sometimes, you may know that there’s an expense you’ve incurred relating to the current year, but you haven’t received the bill yet. Since you haven’t received the bill, you might have to make an estimate of the amount of the liability that you’re accruing. The most common accrued liabilities are legal fees and accounting fees.

Make a Schedule

Provide your accountant with a schedule for these accounts. When an accountant asks for a schedule of an account, they are essentially asking for a breakdown of the balance.

Make a list of the items in your Prepaid Expenses and Accrued Liabilities accounts and show the amounts that add up to the final balance. This will make your accountant happy and, hopefully, help keep your bill down.

Inventory

If you have inventory, it needs to be tracked properly. Inventory can be a major source of cash crunch, theft, and fraud in your business. Do a count regularly, I’d suggest monthly, and ensure your books reflect the same balance. If they don’t, you need to ask questions and investigate what is causing these differences.

Perhaps you have inventory that has spoiled or become obsolete. Possibly people are stealing from you. Perhaps inventory isn’t being appropriately recorded in the accounting system. Regardless, inventory control is vital to the success of businesses that carry inventory.

Make sure your balances make sense. It is impossible to have a negative inventory. Make sure that any items that can’t be sold or need to be deeply discounted to be sold are impaired. 

Generally speaking, inventory is recorded at cost, so if an item isn’t worth what you paid for it, you should consider writing it down or impairing it. This is something you should discuss with your accountant to ensure it is appropriately handled.

Property, Plant and Equipment (AKA, Fixed Assets)

A fixed asset is something that is generally more expensive (over $500 as a general rule for small businesses) and provides value over multiple years. The accounting and tax treatments of these items are different from other expenses. Although you get to expense the item, it will usually take several years for it to be fully expensed.

Make a Register

Your Fixed Assets should be recorded at an individual level on a Fixed Asset Register. Essentially, this is a list of the individual items that have the following:

• Item name
• Acquisition date
• Cost
• Location
• Unique identifier such as a serial number or VIN
• Responsible person or department

Every year, the company should look at each item on the Register to see if it is still where it is supposed to be and hasn’t been stolen, and if it is in good working order. Sometimes, an asset might need to be repaired and this is a good time to make that determination and schedule the repairs. 

At other times, the asset is no longer functioning, is damaged beyond repair, or is obsolete. When this is the case, the business should consider selling the asset if it still has value, or impairing the asset if it does not.

Depreciation and Amortization

This is the expense portion of a fixed asset that you can recognize each year. Often, these calculations and entries are done by the tax accountant.

However, if you are performing these calculations and making the entries, you should prepare a Fixed Asset Continuity Schedule that shows your calculations and the impact on the net book value year-over-year for each individual or class of asset.

Intangible Assets

Intangible Assets are another type of fixed asset that are different from physical assets. These assets can be the crux of the value of a corporation, particularly for a start-up. Some examples of Intangible Assets include:

• Goodwill – this occurs when a business or group of assets are purchased at a premium
• Organizational Costs – these could be incorporation costs, reorganization costs, or other costs that will have a long-lasting impact on the business
• Trademarks
• Patents
• Licenses
• Other Intellectual Property

When bookkeeping for these types of items, it is important to understand whether the money spent is creating an asset or not. We can’t get into detail for this article, but keeping good documentation can be vital for helping your business claim SR&ED (Scientific Research and Experimental Development) tax credits or achieve the valuation you need to attract investors.

Similar to Property, Plant, and Equipment, you should keep a Register and Continuity Schedule for these assets.

Loans

Loans, whether payable or receivable, should be reconciled to ensure that all interest revenue and interest expenses are appropriately recognized. They should also be split into their current and long-term portions. The current portion of a loan is the amount expected to be repaid in the next 12 months, and the long-term portion would be paid after the next 12 months.

Make sure your loans are documented with a loan agreement, and, if possible, provide a loan amortization schedule. A loan amortization schedule will show the date and amount of payments, and what portions of the payment are principal and interest.

Intercompany and Shareholder Loans

Using your business as your personal bank account is a terrible idea. Similarly, using it to pay for expenses from other businesses you own creates a lot of unnecessary complications.

First and foremost, you are paying your bookkeeper to do unnecessary work. This means that you’re paying more fees than you need to. You are also creating more possibilities for error due to the increased complexity. Finally, you are creating more areas that the CRA can challenge and cause you headache, or require you to pay more tax than necessary.

Shareholder Loans

Shareholder loans are a place where business owners can get themselves into trouble or into conflict. When the business owes the shareholder, generally speaking, the CRA doesn’t care all that much. 

An interest rate should be considered and there are situations where interest must be charged to the business.

However, when the Shareholder owes the corporation, this is where things can get sticky. If the shareholder owes the business for more than one year, the CRA can force that loan into income for the shareholder AND deny any expense to the corporation. 

In this instance, it can create a situation of double taxation. If you owe your business, you need to pay it back within a year or discuss with your accountant how to bring it into your personal income.

Conflict

The worst scenario we’ve seen was when one shareholder went into significant personal debt to keep the business operating, while another kept taking money out of the business to fund their lifestyle. 

Essentially, one shareholder was paying for his lifestyle on the personal debts of another shareholder. Needless to say, when this was brought up, it created a lot of conflict.

Avoid Entanglement

It’s best to keep business and personal separate whenever possible and avoid intermingling different businesses you own. If you absolutely must pay for a business expense from personal means, it needs to be recorded and tracked appropriately so you can be paid back.

Equity

Equity transactions are quite rare, and whenever they occur, a qualified accountant should be consulted.  For instance, a share sale from one individual to another has no impact on the books but may cause a change in control of the corporation, which would require an additional corporate tax return to be filed. It’s best to consult an accountant BEFORE equity transactions occur.

Convertible Debt

While growing, a company may take on convertible debt. It is absolutely necessary to have these agreements properly documented. 

Your tax accountant will need an understanding of this agreement and the equity structure of the company to ensure it is being reported appropriately. Specifically, this needs to be disclosed in the notes to the financial statements.

Dividends

Dividends also need to be recorded properly, both in the books and in the corporate record book, and T5s will need to be issued to the recipients. It’s best to plan these out in advance with your accountant before declaring dividends.

What’s Next?

This extraordinarily long read hasn’t even touched on the Income Statement, the place where most owners and managers focus most of their attention.

In our conclusion to this series, we’ll discuss some of the key considerations for the Income Statement and the appropriate bookkeeping and documentation that the tax accountant will be requesting.