When Financial Statements and Tax Returns don’t match

Krista asks:

How should I approach the situation when I receive company-prepared financials and tax returns that significantly differ? I rarely encounter compiled financials. While I can usually navigate discrepancies with commercial real estate businesses, it’s more challenging with other types of businesses.

Linda says:

There are many differences between financial statements and tax returns. Credit analysts and underwriters must ensure that these differences are legitimate and not indicative of fraud. Here are a few possible causes and reasons for discrepancies:

• The company-prepared financials may be ‘preliminary’.
• In my experience with tax practice, smaller and mid-sized businesses often handle their own accounting throughout the year. At year-end, adjustments might be necessary before I could issue compiled, reviewed, or audited financial statements.

Even if the company doesn’t consider them preliminary, the CPA firm preparing the tax return might modify the underlying financial statements, leading to discrepancies.

Here are some legitimate reasons for differences between financial statements and tax returns:

• Financial statements might be on an accrual basis, while tax returns could be on a cash basis.
• There might be differences in depreciation methods.
• There might be differences in inventory methods.

For individual tax returns (1040), no balance sheet is required. For partnership (1065), corporate (1120), or S-corporation (1120S) returns, the Schedule M-1 (if included) can help explain the differences between book income and taxable income.

In your loan request write-up, make sure to identify and reconcile these differences.