In the U.S.’s fragile economic climate, financial statement presentation can mean the difference between lenders making loans to customers as needed during down times, as well as for the timing difference between the collection of receivables and payment of accounts payable or not.
Recently, a business owner and I met with a banker to discuss current and future borrowing needs. After some discussion, it was apparent, based upon the bank’s review of the customer’s financial statements, that there was concern over the value of company assets and the net income of the business.
We directed the banker to the basis of accounting upon which the financial statements were prepared. In this case, the financial statements were presented on the income tax basis of accounting.
The income tax basis of accounting reports depreciation in the financial statements using the same depreciation method as in the business’ income tax return. Some businesses use the income tax basis because it requires maintenance of only one set of depreciation schedules.
Different methods of financial presentation
One of the benchmarks of financial accounting is that all capital assets are recorded on the balance sheet at historical cost — for example, the price for which the item was purchased. In simple terms, financial statements do not necessarily reflect the “fair market value” of an asset.
Here’s an example: ABC Company purchases five new buses at $48,000 each. The “historical” cost figure of $240,000 would be reflected on the balance sheet under the “Property and Equipment” section for as long as the assets are owned by ABC Company.
For the purpose of reducing ABC Company’s income tax liability, the $240,000 would most likely be immediately depreciated under the federal Internal Revenue Service (IRS) Section 179 expensing rules. Financial statements issued under the income tax basis of accounting would reflect a zero “net book value” for the buses because they had been immediately expensed as allowed by the IRS as well as a substantial depreciation expense for the year.
However, the useful and realistic life of a new bus is probably 10 years or more. If ABC Company chose to present its financial statements under Generally Accepted Accounting Principles (GAAP), then the useful life of assets placed in service would be determined by management, and subsequently, the financial statements under GAAP would more accurately reflect the un-depreciated remainder of assets over time.
The chart below shows the asset difference on financial statements comparing accounting methods of income tax basis and GAAP basis one year after the equipment was purchased. This switch does not affect the tax return and/or subsequent tax liability. It is merely a different method of reporting the financial position of the company.
Income tax basisGAAP basis Cash $10,000 $10,000 Accounts receivable $20,000 $20,000 Buses $240,000 $240,000 Less: accumulated depreciation ($240,000) ($24,000) Net property and equipment - $216,000 Total assets$30,000$246,000
There are income thresholds and other rules affecting the amount of Section 179 expenses that can be taken in a tax year, and other factors, such as whether a capital asset is purchased new or used and how much is spent on capital assets.
Open communication is key
Communication is crucial for any business. Open communication with bankers and accountants form important passages for understanding the details of a financial statement presentation and, ultimately, help run a business successfully.
Kim Mahanna is a certified public accountant for Smith Schafer & Associates Ltd. For more information on this topic or tax-related questions, contact the Smith Schafer transportation team at (651) 770-8414.
