Sep 30, 2021Tax Returns vs. Financial Statements: What we can learn from each
Tracking financial metrics is an essential part of running a successful company. Business owners are often bombarded with different accounting and financial information. In many cases, sorting through all of the different statements and workbooks can be a confusing headache. Compounding the problem, different types of financial reporting often require the same transaction to be reported in different ways. In this article, we’ll compare and contrast two of the most important financial reports. The financial statements and the tax return.
The Financial Statements
Most companies choose to report their financial statements on a “GAAP” basis. GAAP stands for “Generally Accepted Accounting Principles” and is the primary method for accounting for companies in the United States. Some private companies may choose to report their books in a different manner, though other methods of financial accounting are beyond the scope of this article.
GAAP rules were created to ensure that companies across industries were reporting transactional data in a consistent and fair way. GAAP rules were created and are modified by the Federal Accounting Standards Board (FASB) under the regulation of the Securities and Exchange Commission (SEC). Understanding the derivation of these rules is actually quite helpful to understanding the way they were written.
Because the SEC is the primary governing body for the creation of GAAP standards, they strived to create a reporting mechanism that was friendly to outside investors. This means that many of the rules contained within the GAAP standards require companies to defer the recognition of revenue while accelerating the recognition of expenses. In this way, the SEC hoped that investors would not be misled by the recognition of “future success” projected onto the financial statements.
Within a set of GAAP financial statements, there are four primary statements to be aware of. These are the balance sheet, income statement, statement of cash flows, and statement of retained earnings. Each of these statements provides useful information to investors about the current state of assets, operations, cash flow, and investor returns.
Ultimately, standards under GAAP were created to provide investors with important financial information about a company. Executives are often focused on these statements because they are used extensively in determining a company’s value.
The Tax Return
Viewed by many companies as a “necessary evil”, the tax return provides the IRS with important information about a company’s operations and taxable income. Much like GAAP financials, understanding the primary motivations behind the IRS is quite helpful in interpreting data on the tax return.
The IRS understands that most businesses want to pay as little in income tax as possible. This fundamental understanding has driven the rules and regulations pertaining to certain types of transactions from a tax standpoint. The government wants its share of the pie, and it wants it as soon as a business has the wherewithal to pay. Because of this, tax rules are in direct opposition to those under GAAP. Unlike the SEC, the IRS has written its rules to emphasize the acceleration of income and the deferral of deductions.
Unfortunately, the IRS has had many experiences with businesses being fraudulent on tax returns. Because of this, the IRS requires businesses to fill out either a Schedule M-1 or a Schedule M-3 (depending on the company’s size) to disclose all of the differences between the company’s GAAP books and their tax return. This helps the IRS to know the exact differences between a company’s financials and their tax return. In this way, a company would be very hard pressed to portray a great financial picture to investors while simultaneously recognizing very little in taxable income.
The Importance of Accuracy
Companies should invest heavily into maintaining accurate books. Not only does maintaining accurate books help drive internal decisions, but it also helps companies obtain required debt and equity financing. Additionally, maintaining accurate books reduces the cost of audits and tax compliance work.
Monitoring financial progress is vital in building a successful business. Understanding the differences between all types of reporting can be challenging, but once understood the benefits are enormous. Business executives should consider hiring a team of professionals to help them navigate this complex area.