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Truth or Lies…when the tax return really does not tell the story.

“Here is my tax return but let me tell you what I really make.”

At this point, many lenders want to put their hands over their ears and say “I can’t hear you!” Why? Because having a borrower come right out and tell you they cheat on their taxes is not helpful.

They are really saying: “I am willing to lie to the IRS for financial gain and I’ll lie to you, too, if I can get away with it.”

Or are they? Here are a few very legitimate reasons why the tax return may not give a good picture of the cashflow earned from business activities:

  • Cash basis returns…common with small to medium size businesses. If they finished the year with a higher receivable than usual, but had the same amount of earnings as usual, the tax return profits will be down. And the next year they’d be up even without an increase in revenue-generating activity. And of course, the reverse can be true. {Tip: Check to see if the return is cash or accrual before you compare the years.}
  • Unusual business or capital expenditures…perhaps due to a move of the business, a natural disaster or a bankruptcy of a major client. {Tip: Compare the years to see just what types of expenditures vary.}
  • A year where they reduced time on their usual revenue activities to write a book, put major content online, or launch a product. If they have finished that activity and are back at it at their previous levels, it makes sense that the year looked at on its own could be misleading. {Tip: Get a year-to-date financial statement to see what is happening now.}

I am not suggesting you turn a deaf ear when your borrower asserts that the year was really much better than it looks. I do recommend before you jump to conclusions that you hear the business owner out.

Next post: What to do when your borrower really does mean they cheated on their taxes.

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.