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“Profit” vs. “Taxable Income”

Posted on March 15th, 2016

Jack Kern
Owner, President
Outsourced Accounting Department, Inc. 

Recently I had a small business owner say to me, “I used to have a partner who was very smart about business finances – he said you should never show a profit in order to keep from paying taxes.”  To which I replied (as his company was not doing so hot), “Well, your partner was not as smart as you think he was.”

Not that minimizing taxes is not important, it is of course. But what many small business owners don’t understand is that the way you prepare your books for managing your business, and the way your accounting firm reports your income for tax purposes, are two entirely different methods of accounting, and both are entirely appropriate for their intended purpose.

Over the last couple of decades, for their own internal efficiency reasons, there has been a trend in the banking industry to rely on tax returns to evaluate a company’s profit and cash flow, particularly for smaller companies, so tax preparation is the only type of accounting service many small businesses now require from their outside CPA firm. The problem with this is that small business owners these days really have no idea of whether they are making money or losing money, and therefore, the real underlying components of their cash flow (or lack thereof).

Below are a few of the major differences between the two methods of accounting.

Accrual vs. Cash Basis Accounting

Account / Financial Measure Accrual (“Book”) Basis Cash (“Tax”) Basis
 

1) Sales

 

= All invoiced sales = Cash /AR collections; gross income is distorted. 
2) Cost of Sales Recorded at time of sale Recorded when paid
 

3) Gross Profit Margin

 

Reflects true mark-up, more consistent from month to month. Not meaningful, very erratic from month to month.
4) Expenses Recorded when incurred Recorded when paid
5) Net Income  

Reflects true “Profit” needed to evaluate performance from month to month.

 

“Taxable Income,” not meaningful for evaluating  business performance.

The difference between the above two methods is then merely reconciled in the tax return (only) via what’s called an “M-1 adjustment at the bottom of the balance sheet page. So there is no need to adjust your books to look like your tax return. In fact, you shouldn’t, and you should not allow your accounting firm to adjust your books this way either. That’s for their own convenience, not what’s best for your company.

Obviously, knowing whether your company is making money or losing money is critical to its survival, as hidden operating losses will  erode the company’s cash flow, liquidity, and ultimately, the owner’s personal cash reserves. So be sure to set your books up properly to enable you to evaluate how your business is performing. (For further discussion on this topic, see our other articles in our blog, “The Difference Your Method of Accounting Can Make,” and coming soon.)

 


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