By Steve Trojan, CPA
One of the reasons we encourage clients to take advantage of our monthly bookkeeping or QuickBooks review plans is a question we frequently receive from many clients that see us only at tax time. Invariably there are clients who bring us their books for the annual tax return in January or February. After we’ve had a chance to review their books, make the necessary adjustments, and prepare their tax return, sometimes we tell them the “bad” news that they made a profit and they owe Uncle Sam. ”What? How could I have made money? I’m broke!”, they plead.
The reason for the surprise is a lack of understanding as to what profit really means. It also sometimes points to issues with poor cash management policies and procedures.
In it’s simplest form, profit is defined as gross sales less total expenses. The definition of an “expense” is usually one of the culprits in the surprise factor. An expense is money expended or cost incurred in a company’s efforts to generate revenue. It represents the company’s expense of doing business. Typical expenses are wages, advertising, professional fees, licenses, cost of goods sold (but not unsold inventory), interest expenses, bad debt (if you are an accrual basis tax payer), office supplies, etc.
What is NOT an expense causes confusion with some business owners. The following list of cash outflows are not expenses and do not reduce taxable income:
- Shareholder distributions (if you are an s-corp) or partner distributions (if you are a partnership)
- Dividend payments to shareholders (if you are a c-corp)
- Owner draws (if you are a sole proprietor)
- Re-payments of debt; the principal payment is not an expense
- Increase in the amount of inventory on hand. Inventory is a deductible cost only when it is sold, not before.
- Prepaid expenses such as rent deposits
- Asset purchases. Technically assets are depreciated over their useful life. Assets can be fully depreciated in the year of purchase so many times this is not an issue. But it is sometimes an area that causes differences in net profit and cash flow.
Since the above items are cash outflows but not deductible for tax purposes, it results in the year-end surprise that a business showed a profit and owes taxes, but has no cash to account for it. The cash generated by profits went to pay down debt, distributions to shareholders, purchase inventory, etc.
Accounts receivable (uncollected amounts billed to customers) is another area that causes distortion between profitability and cash flow. Poor management of accounts receivable can lead to cash flow problems, especially in a growing company. For example, if a company is extremely busy, it spends a large amount of cash on wages and materials to produce a product or service. Typically these expenses are paid within 10-30 days of incurring the expense. But if you are not collecting your receivables for 45-60 days, severe cash shortages can result. If you don’t have good collection procedures in place, the problems can get even worse.
Business owners need to monitor their balance sheet as well as their income statement to more fully understand their cash flow. It is extremely useful to engage your accountant to review your financial data on at least a quarterly basis to help you understand the trends and how it affects cash flow. We have both monthly and quarterly plans available; we can handle the entire bookkeeping function for you, or review your QuickBooks data. Our services include year-round tax planning and consultations so you avoid year-end surprises and better understand your the financial aspects of your business.
The key is to get in a habit of reviewing your data on a regular basis and to engage a professional to assist in your understanding of the data. The result will be better knowledge of your business, more intelligent business decisions, and better business and tax planning.
Steve Trojan is a licensed CPA and owns SMT & Associates, a Crystal Lake, IL based tax and accounting firm.
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Excellent article.
One of the other factors that people forget is reduction in debt. They’ll buy that $50,000 piece of equipment last year that’s being financed, allowing you, as their accountant, to save the day and make sure they show no taxes because you can finagle expensing the whole $50,000. The trouble is , and that’s the value of PLANNING, is in year two, you can’t take a tax deduction for paying down the loan that was used to pay for that equipment. Oftentimes, this can then get the small business owner into a vicious cycle, and forced to buy even more equipment on credit.