I just compared the tax returns I recently received from a borrower to the financial statements they provided last year prior to the completion of the returns. The net profit is significantly different. Is the borrower pulling a fast one or are the differences legitimate? How do I tell?
Jerry, you actually have two questions rolled into one. First, does a significant difference alert me to the potential for fraud? And second, how do I combine analysis of two year’s historical tax returns with the financial statement from the most recent year (for which the return is not yet filed) and an interim year-to-date financial statement when Tax and GAAP accounting are so different? Let’s take those one at a time…
Why does it come up?Whether you are doing global cash flow analysis on the tax returns of several entities owned by the same owner/guarantor or a stand-alone analysis of just one business, it is common to combine tax returns and financial statements in the analysis. So first let’s consider the difference between tax- and GAAP-basis statements and then the tax returns versus financial statements for the same borrower.
GAAP stands for Generally Accepted Accounting Principles. GAAP statements follow those principles that are primarily prescribed by the Financial Accounting and Standards Board. If you hear an accountant or auditor refer to ‘Fasby’ that is shorthand for FASB.
Tax-basis financial statements simply follow the IRS rules for reporting on a tax return. This approach is considered by accountants to be an ‘Aukboa’. No, that is not a very large snake from Australia. It stands for OCBOA…which stands for Other Comprehensive Basis of Accounting. It is common for small businesses to use this OCBOA since it drops nicely right into their tax return.
So the first question I would have…are the financial statements GAAP or Tax-based? If tax-based there should not be as much of a difference between the financial statements and the tax returns for the same period. Read on…
Whether it is between Tax- and GAAP-basis financial statements or tax returns and GAAP statements, timing differences can throw off a lender. This is true both in comparing tax returns to financial statements and in combining them in one analysis.
- Revenue…the big difference is timing.
- Cash versus Accrual basis
- Who uses what:
- Cash basis…tax returns may use this method for small- to medium-size businesses.
- Accrual basis…tax returns may use this method for small- to medium-size businesses and must for larger businesses. GAAP statements do not use cash-basis.
- General rules for recognition
- Generally income is recognized when received on cash basis
- Generally income is recognized when earned on accrual basis
- Examples of the difference
- Business receives a deposit on work to be completed the following period
- Cash basis…recognize as income now
- Accrual basis…show as ‘Deferred Income’ in the liability section of the balance sheet (if you don’t do the work you have to pay it back). Recognize as income the following period when (if) you complete the work.
- Business bills a client who then does not pay
- Cash basis…the business never reports the revenue because it was never received. The lender cannot tell by looking whether the revenue is down because less work was done or if it is down because a major customer did not pay. Even thought ‘Bad Debt Expense’ is a line item on the business tax return, it will be blank. That does not mean the business had not bad debts.
- Accrual basis…the revenue is recognized when the work is completed and the client is billed. Later when the business determines the client will not pay, the business recognizes a bad debt expense.
- Expenses…some examples:
- Cash versus Accrual Basis
- Similar impact as to income above. See example of a client who does not pay
- Tax-basis is based on IRS rules and often is used as a tax deferral tool. If the business is paying taxes, they will accelerate depreciation as much as possible.
- GAAP uses a variety of methods to more closely match the useful life of the asset. This relates to the matching concept in which we try to include expenses in the same period in which they help to create revenue. If equipment will last 5 years we will depreciate it over that five-year period. Straight-line, declining balance, sum of digits and activity based methods are common.
- Amortization of Goodwill
- Tax-basis this is amortized (written off) over 15 years
- GAAP has been changing but since 2001 Goodwill is no longer amortized. Instead the company must test it for impairment each year and write-it down if necessary. Some of the changes that would lead to impairment might be legal issues, regulatory issues, unanticipated competition or loss of key personnel.
- Cost of Goods Sold
- Inventory figures can vary because of IRS rules regarding indirect expenses.
- Start-up expenses
- Tax-basis these are amortized over 15 years
- GAAP these are written off as incurred
As I write this I am wondering if there just might be too much information. As is often the case, I don’t think you need to memorize the above list. But I hope it is enough to alleviate your concern about fraud…at least on the face of it.
Consider fraud if the differences do not seem to make sense to you. With the tax returns of 1120-, 1065- or 1120S- filing entities, take a look at Schedule M-1. This is where the taxpayer has to reconcile the income per books to the income per return. If it is depreciation, cash-to-accrual adjustments, nondeducted expenses or nontaxed income, inventory or currency adjustments…you are probably fine.
And if it does not make sense, consider this question: “Can you help me understand the difference between your financial statements and the tax return for the period?”
How do you combine them?
That was is a bit more simple…with great caution. If there are significant differences look to the M-1. And if that schedule has a lot of adjustments, I think I would not try to combine them. If you have an accrual-basis balance sheet you can convert from accrual back to cash-basis for comparison purposes. My Financial Statement manuals and online modules can give you the depth of knowledge to do just that. ‘-)
You are right to be comparing and asking questions, Jerry. What other differences have you run into that have you concerned?