The sun has set on 2014 and your year-end financial statements look a bit gloomy. Maybe you are showing a bad loss – or maybe too much profit. You need financial statements that will impress your banker, let you pay less tax, and better position you for profits in the new year. But how?
Let’s take a look at six situations when we have legitimate choices that significantly change our financial statements.
1. Capitalizing Expenses
The fastest way to increase your ‘book profits’ is to move expenses off of the P&L and onto the balance sheet. A large purchase can be either “expensed” or “capitalized”. And “capitalizing” create an asset rather than an expense. Capitalizing an asset spreads the cost across many periods (as depreciation) and increases short term profits.
Sometimes capitalization is required — like building new walls in a rented office, for example. These leasehold improvements should be classified as an asset. Other times, the rules are not so clear. A new phone system is clearly an asset, but how about the cost to install it and to train the staff? If the training is listed as “free” on the contract, should you expense the value of training anyway?
You can make the decision to capitalize expenses or not: increasing or decreasing expenses in one period, and increasing or decreasing assets and depreciation costs over the long term. How you decide will impacts profits and perhaps taxes too.
2. Time Shifting Income and Expenses
The calendar year is now “closed”, but business spending continues past the end of any month or year. Loading expenses into an earlier period, or delaying deposits into a later one is one way to “shift” profits around on the calendar. That sounds nefarious, but there are some good, legitimate reasons to do this, including simply correcting quirks in the calendar. A power bill for example, is a monthly expense. If we do not receive the December power bill until January 10, that’s no reason to skip the expense in December. Clearly, the December P&L should contain an expense for power, so adjusting the date on the bill is a reasonable and legitimate use of this technique. Better yet — if you can anticipate the power bill in December and write the check (whether you have the bill or not), then the expense decreases taxable (cash) profits for the year.
NOTE: When financial statements are prepared for management (not for taxes or other legal purposes) this kind of time shifting is an important way to smooth out revenue and expenses. It is difficult to manage a business when several large invoices land arbitrarily in one month, so assigning part or all of the expense to another month may help make sense of what is actually going on in the business.
3. Changing Reporting Periods
One month or year can show a loss, while the next shows an extreme profit. That’s the nature of business. In order to generate financial statements that show more consistency, forget about reporting on a strict calendar year. Instead look at a more representative period, such as the last 12 months (sometimes called TTM — trailing twelve months). This is a respected way to characterize financial results, for example, in a fast-growing company, or toward the end of one period when the last period’s data would be out of date. With some help from a CPA you may even be able to change the reporting period for tax purposes.
4. Revenue Recognition
Businesses with multi-month delivery cycles and big invoice values are expected – even required – to spread income out as it is earned, rather than showing it all in the month when an invoice was paid. At year end, that means you might not have to pay tax on a large customer payment if you have not finished the work. Pre-payments from customers can be treated as “liabilities” and not income so long as the work remains incomplete. GAAP has some rules about this based on measuring the work actually completed during a period. Consult with a CFO or CPA about how to measure this!
5. Inventory Valuation
Inventory is one area where small changes in recording can have large impacts on the financial statements. Old inventory can be “written down” – meaning it is devalued or discounted – simply because it is old. The thought is that last year’s models left in inventory are not worth as much as this year’s. Writing down inventory is an accepted way to take an expense in the current period and adjust the cost of goods for future sales.
6. Inventory Expense Recognition
When a company sells a product from inventory, profit depends on how we calculate and recognize the cost of goods sold (COGS). Should we value it at the average price we paid for what we’ve got on hand? Or at the price we will pay to replace it next week? There are generally accepted rules for guiding this decision, and it is important to remain consistent. Which method you choose — and if you choose to change the method — can have a substantial impact on profitability since it will shift the cost of goods.
Make the Data Useful
There are plenty of legitimate reasons for changing the way we record things on our books. The rules of Generally Accepted Accounting Principles (GAAP) provide enough flexibility to push and mold our financial statements into useful reports.
Note that I said “useful reports”. I did not say tax or regulatory filings. If your business is submitting formal financial statements for legal or tax purposes, a thorough review from a knowledgeable CPA or tax attorney is always the right move. Just be sure to discuss the 6 issues above with your CPA in order to maximize your tax benefit.
In the meantime, remember that financial reports are meant to help you make better business decisions. Financial statements that are knowingly false, twist reality beyond recognition, or are based on wants instead of facts, will not give you meaningful information.
Dedicated to your (Year End) profits, David