Important to Know: Financial Reporting and Tax Reporting
I always enjoy having this discussion, the differences between financial reporting and tax reporting. Tax planning does not have to damage financial presentation as the small business can have the best of both worlds. What’s not to like when taxes are minimized while demonstrating solid financial statements that will impress lenders.
Let’s start with a very basic discussion of accounting methods. Financial reporting will use the accrual method most normally which recognizes revenue when earned and expenses when incurred. There will be accounts receivable and accounts payable on the balance sheet and earnings on the income statement will include the effects of each of these accounts. Using the accrual method for income tax reporting will likely cause the highest possible income and the highest tax exposure.
The accounting method usually most favorable for income tax purposes relates to the cash basis. The cash basis method of accounting recognizes revenue when cash is actually received and expenses when paid. This will allow a business to escape paying taxes on large receivables in the current year postponing to the following year when funds are actually collected. It is not an uncommon strategy for a small business to pay down it’s cash balance to the extent there are accounts payable. Remember, expenses are recognized when paid under this method of accounting so paying incurred expenses will create a deduction for income tax purposes.
For purposes of this discussion, let’s discuss one other difference regarding financial reporting and tax reporting. This major difference would involve the acquisition of fixed assets. Fixed assets would be machinery and equipment or office equipment such as desks and computers. Let’s suppose that on July 1st of 2015, a business buys $25,000 in computers. The computers will last for five years. For financial reporting purposes, a depreciation expense in the amount of $5,000 will be taken each year. For the first year in 2015, a depreciation deduction in the amount of $2,500 will be charged against income as the asset was acquired and placed in service midyear. For income tax purposes, current tax law allows for the immediate expensing of up to $25,000 of fixed assets placed in service during the year. Therefore, there is now available an additional depreciation deduction for tax purposes in the amount of $22,500 ($25,000 les $2,500).
Nothing brings home the point of a discussion better than an example. Suppose a new small business started on January 1, 2015. For the year ending December 31, 2015, this business has a net income of $47,500 for financial reporting purposes. This includes accounts receivable of $50,000, accounts payable of $25,000, and depreciation of $2,500 on $25,000 of computers purchased on July 1st of the same year. Should this business pay tax on $47,500? What if this business elects to use the cash basis method of accounting for income tax reporting? If it does, the conversion from the accrual to cash basis method will involve reducing net income by $50,000 in accounts receivable as the business has not received these earnings in cash. However, net income will have to be increased by $25,000 for the accounts payable balance. This group of expenses has been incurred but remains unpaid at year end. Cash basis net income is now adjusted downward to $22,500. Don’t forget, this business can claim an additional depreciation of $22,500 if it elects to expense up to the permitted limit of $25,000. For tax purposes, taxable income is reduced to zero, legally. For Internal Revenue Service purposes, this small business simply needs to demonstrate how it got from the financial statement to the tax return.
Please remember, this example does not include a discussion of deferred income taxes that is the result of using different methods of accounting regarding financial reporting and tax reporting. This is a discussion reserved for later at a more advanced level. This discussion does illustrate that a small business can display it’s true financial position and results of operations while legally minimizing income tax exposure. It also serves to put the small business owner on alert that when someone asks to see a copy of the tax return to make a loan eligibility analysis, make sure to include a copy of the financial statement and be prepared to explain why they are different. This discussion will also serve to alert loan underwriters to ask for both financial statements and tax returns and to understand why they are different.