Most businesses these days can produce a profit and loss (P&L) statement with a touch of a button. Some accounting systems are quite good and will track work-in-process and running inventory levels – making sure the P&L is current and up to date when that button is touched. But when it comes to officially documenting the performance of the business, the tax return is the official document, not the P&L.
However, often the tax return reflects strategies to reduce taxes and doesn’t reflect the true performance of the business. So why the heavy reliance on tax returns?
- Often that touch of a button to produce P&Ls is faulty, especially for small to medium sized companies that don’t have an accountant. Typically your CPA will make adjustments at the end of the year – calculating depreciation, moving stuff around and generally cleaning up the P&L. Educated buyers and banks know this, and will require tax returns (unless your business has reviewed or audited P&Ls, but most do not).
- Banks ONLY use tax returns. Since a vast majority of business buyers need financing, this means tax returns should be used to analyze the business in order to be on the same page as the bank.
I personally have had a challenging time with banks, because I KNOW at times that a business is more profitable than the tax returns show. For example, often a business will be on a cash basis tax accounting, which for a growing company typically under-reports sales and earnings. Theoretically, the correct way to look at a company’s performance is using accrual accounting (because revenue and earnings truly reflect the time period in which they happened). But many banks will not consider that. If the tax return is cash basis, then that is the official earnings number and they will not change it.
The importance on tax returns is why you should ideally prepare your company well ahead of time to sell – that way you can maximize earnings instead of minimizing taxes.