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Startpoint: Taxable income or net income per books?

Tierney’s question:

We are being encouraged to start with the net income per tax return rather than using the M-1 schedule to reconcile back to the net income per books as the starting point. Is it more accurate to use net income per tax return if the underlying validity of the net income per books is in question?

Linda says:

There should not be a significant difference, if any, between using tax return income vs net income per books if you do it right. But then again…

Difference in use of M-1

Utilizing net income per books to get to cashflow available to pay debt and the owners requires that you adjust for all the items on the M-1. Starting with taxable income requires that you adjust only for cash spent on non-deducted expenses (lower left on the M-1) and cash received for non taxed income (upper right on the M-1).

Another variation…historical vs projected

To take it a step further, if you are determining projected cash flow instead of historical, you only adjust taxable income by subtracting non-deducted recurring cash spent and adding non-taxed recurring cash received.

Basis of Accounting

This could make a difference as well. It may be that the financial statements are accrual basis and the tax return cash basis. Lenders often find that accrual basis gives a better sense of how the business is doing, separate and apart from when they are collecting on receivables or paying their own bills.

If the income statement per books is accrual basis, you may prefer it. When that is the case, the M-1 will have an entry for adjustment to cash-basis that helps to explain the difference between net income per books and taxable income.

How the choice was (probably) made

I find it has more to do with the size of the business. For larger businesses, the lender is more likely to want to tie back to financial statements and reconcile to net worth change on the balance sheet. If so, you need to start with net income per books (M-1, Line 1). For smaller businesses, starting with taxable income is often simpler. Your bank or credit union guidelines for cashflow analysis (of tax returns or financial statements) will determine which way you go.

What is your concern with the financial statements?

Tierney, your comment about the underlying validity of the net income per books caught my attention. If you do not have confidence in the financial statements prepared from books and records, consider whether you should have any more confidence in the tax returns.

Often, the returns are simply putting in tax format the very same information supplied on the financial statements. You are familiar with the phrase garbage-in-garbage-out, right?

When the returns might be a better choice

If the returns are professionally prepared and the financial statements are interim and borrower-prepared, that might be a reason to have more confidence in the tax returns. With interim financial statements the basis of accounting, the competency of whoever prepared it and the seasonality of the business can skew the impression of profitability.

Other resources for you:

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.