Is It Time For That 2Nd Set Of Books

Oct 05, 2010

If you're a small business, especially a very small business, chances are good that the financial statements that go to your bank are prepared using the "income tax basis".

These statements are prepared using the rules defined by the tax code. The result of the laws passed through political debate and compromise.  As you know, tax provisions are often founded on support of a specific "behavior" (i.e., increased investment in equipment) instead of the true economic effect (the cost amortizing over the life of the asset).  GAAP based statements communicate financial reality through the common body of knowledge know as "generally accepted accounting principles".  As defined by Wikipedia, "Generally Accepted Accounting Principles (GAAP) is a term used to refer to the standard framework of guidelines for financial accounting used in any given jurisdiction which are generally known as Accounting Standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements".

It is common practice for many small businesses to maintain their records to support their tax returns, not using the rules outlined in GAAP.  Some times, these differences don't make a "big" difference.  But, sometimes they can.

One Example

Many businesses have taken advantage of the aggressive tax deductions available from two provisions in the tax code when purchasing machinery & equipment. Under the first provision (Sec 179) maximum "one time" write-offs could have accumulated to $400,000 during 2007 through 2009.  With the Small Business Jobs Act of 2010, this amount is now $500,000 each year for 2010 and 2011.  Total Section 179 deductions could amount to $900,000 for the years 2007 through 2010.

The other provision, known as "bonus depreciation" allows additional deductions of 50% of the remaining balance of the acquisitions after the Sec. 179 deduction.  Then after the deductions allowed by Sec. 179 and the bonus depreciation, any remaining balance of the acquisition can be depreciated through more "normal" methods.  The details will vary based on the specific facts, but the point is that in one year companies can "expense" a significant portion of their acquisitions and potentially achieve significant savings through lower income taxes.  In our example, the total decrease in taxable income could be as much as $900,000 plus whatever "bonus depreciation" and regular depreciation was available the 2007-2010 time frame.

The effect not publicized so well, is that your "equity" or "capital account" has also seen the effect of the increased "depreciation expenses" generated for "tax purposes".  In other words, while you've been generating legitimate deductions you have also been decreasing your equity.   How big of an impact is $900,000 to your company's equity?  Many times this can be the difference between meeting the provisions of that new loan covenant from the bank or being in default on your financing agreement. Yet, most times the intent of all parties is to use GAAP for this calculation.

What do you do?  It is common practice to maintain your financial records using the principles of GAAP to assess your progress and financial situation and your tax records to legally support your tax situation.  At one time, making these calculations and maintaining two depreciation schedules for each asset was labor intensive and expensive.  Now, it's often an automatic byproduct of the software that is being used for your tax return preparation. If you have been making significant investments in property and equipment over the last few years, you should take a look at how these investments are reported on your financial statements and whether it's time for that second set of books.


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