Our bank used CPA-prepared financials on the accrual basis last year to calculate cashflow available to service debt and qualify the borrower. We have been acquired and the ‘new’ bank uses tax return analysis for cashflow instead. On the borrower’s 1120S, Schedule B indicates cash basis. Does that mean that the 1120S M-1, net income per books is based on the cash basis? If so, why would the taxable income still be different than net income per books?
Thomas, the Schedule L Balance Sheets on any of the business returns (1120, 1120S, 1065) should be based on the client’s books and records. Even if the tax return is on the cash basis, the balance sheets can be on the accrual basis, or the cash basis, whichever is used by the business in their internal records.
Here is where it gets tricky…
Are tax preparers consistent?
Come now, do you really have to ask? Actually, Thomas, you might since you are more familiar with using financial statements. But most lenders with experience using tax return analysis to determine cashflow available to pay debt (or the owners) know that there is an amazing amount of variety in how they are completed.
So while I would present Schedule L on the accrual basis if the underlying books were on the accrual basis, not every tax preparer would.
Why cash basis?
Many small businesses choose cash basis because it is easier and in some cases, can reduce taxes. If your receivables are growing because your company is growing, on the cash basis you do not pay on that additional income until you actually receive it.
The cash basis is available to service businesses. If inventory is necessary to account for income, the business may still be able to use cash basis. They may if their average gross receipts for the three prior years is $1 million or less. And they might, depending on other factors, if it is $10 million or less.
You asked why else…
Taxable income can be different than net income per books for many reasons. It is all about timing…and sometimes deductibility. Depreciation and inventory rules can be different between GAAP (Generally Accepted Accounting Principles) and tax returns accounting. Some expenses are fully recognized in accounting generally but limited on the tax return. Then later they are carried over on the tax return, but not on the books.
That is why we need the M-1 schedule in the first place, to reconcile the two.
I called Thomas…there’s more!
In a further phone conversation, it came out that the Schedule L was on the cash basis but the CPA firm then provided accrual basis financial statements. So I am guessing that either the books were on the accrual basis but the return’s balance sheet was presented on the cash basis, or the books were on the cash basis and the business asked the CPA firm to prepare accrual basis financials for the bank since they knew that it would look better.
What’s the lender to do?
I advised Thomas, since the bank used accrual basis financials the prior year to qualify the borrower in the first place, to
- get an aging of receivables and payables to show that the business is receiving payments from customers on a timely basis and paying their bills on time.
- calculate cash flow per the tax return using the current guidelines and process of the (new) bank .
- if the borrower does not qualify using the cash basis tax returns, do the analysis on the CPA-prepared accrual-basis financial statements.
- if the borrower does qualify using the accrual-basis financials and the aging shows everything is current, use this information as a compensating factor to justify the loan.
I have no idea if that will work, but at least Thomas will be able to apply a consistent approach to this borrower and show the (new) bank his thinking.