Financial Reporting and Tax Reporting

 I like talking about how financial reporting and tax reporting are different all the time. Small businesses can have the best of both worlds when it comes to tax planning and financial presentation. What's not to like when taxes are kept to a minimum and strong financial statements are shown that will make lenders happy?

Let's start by talking about the most basic ways to do accounting. Most of the time, financial reporting will use the accrual method, which counts income and costs when they happen. On the balance sheet, there will be accounts receivable and accounts payable. The effects of each of these accounts will be shown on the income statement. If you use the accrual method to report your income tax, you will probably have the most income and the most tax to pay.

The cash basis is usually the best way to account for taxes when it comes to accounting. With the cash basis of accounting, income is counted when cash is actually received and expenses are counted when they are paid. This means that a business won't have to pay taxes on large receivables until the next year, when the money is actually received. It's not unusual for a small business to pay down its cash balance until it has no more bills to pay. Remember that under this method of accounting, expenses are counted when they are paid. This means that paying expenses that have already been incurred will create a tax deduction.

Let's talk about one more difference between financial reporting and tax reporting for the purposes of this discussion. Buying fixed assets would be a big part of this major difference. Machines and equipment, like desks and computers, are examples of fixed assets. Let's say that a business spends $25,000 on computers on July 1, 2015. The computers will work for five years. For the purposes of financial reporting, a $5,000 depreciation expense will be taken each year. For the first year, 2015, a $2,500 depreciation deduction will be taken out of income because the asset was bought and put to use in the middle of the year. For income tax purposes, up to $25,000 of fixed assets that are put into use during the year can be written off right away. So, you can now take an extra $22,500 ($25,000 minus $2,500) tax deduction for depreciation ($25,000 minus $2,500).

An example is the best way to show why something is important. On January 1, 2015, a new small business opened. For financial reporting purposes, this business had a net income of $47,500 for the year that ended on December 31, 2015. This includes accounts receivable of $50,000, accounts payable of $25,000, and depreciation of $2,500 on computers that cost $25,000 and were bought on July 1 of the same year. Should $47,500 in business income be taxed? What if this business decides to report its income tax using the cash basis method of accounting? If it does, switching from the accrual method to the cash method will mean taking $50,000 out of the business's net income in accounts receivable because the business hasn't gotten this money yet. But the accounts payable balance means that the net income will have to go up by $25,000. This group of costs has been incurred, but none of them have been paid by the end of the year. The cash-basis net income has been changed down to $22,500. Don't forget that this business can get an extra $22,500 in depreciation if it chooses to spend up to the limit of $25,000. Legally, taxable income is cut down to zero for tax purposes. This small business only needs to show the Internal Revenue Service how it got from the financial statement to the tax return.

Please keep in mind that this example does not talk about deferred income taxes, which happen when different accounting methods are used for financial reporting and tax reporting. This is a topic that should be talked about later, when you know more. This discussion does show that a small business can show its true financial position and results of operations while legally minimizing its income tax exposure. It also lets the small business owner know that if someone asks to see a copy of the tax return to figure out if the business is eligible for a loan, they should include a copy of the financial statement and be ready to explain why the two are different. This conversation will also let loan underwriters know that they need to ask for both financial statements and tax returns, and they need to know what makes them different.