Small Business Accounting, Big Deal

In 2004, the nation was treated to a series of financial scandals involving predominantly large corporations. Charges included overstating profits, understating expenses, capitalizing expenditures and improperly reporting debt. Ultimately some of these large businesses filed for bankruptcy.

However, the problem of "creative accounting" is not necessarily limited to the big guys. But rather than overstating profits, many small businesses, to avoid a large tax bill, tend to do the reverse and understate earnings. Not only can this be detrimental to the business and the small business owner, but it can result in severe consequences lasting many years.

The other problem with this illegal strategy is that it can later compromise a company's ability to obtain financing for future projects or expansions. Many small business owners have turned to the bank to finance capital expenditures only to be turned down due to past sales performance. The bank uses previous tax returns to gauge growth and cash flow. If the business continually shows losses on the tax returns, the bank will require a greater amount of collateral or a larger capital injection from the owner before approving a loan.

Second, small business owners that are sole proprietors pay their Social Security taxes based on the income of the business. If they continually show losses in the business, they may fail to qualify for any substantial Social Security benefits. These same owners will also have difficulty obtaining personal loans because banks use personal tax returns to qualify the owners for loans. With little or no income reported on the tax return, the bank cannot justify the lending of large amounts without the owner showing the ability to make the payments. Owners may also find refinancing of existing debt difficult to obtain without a secondary source of repayment.

Another reason that improper accounting is detrimental to a small business is the potential for growth through investors or the opportunity to sell the business. If the small business owner is looking for growth and seeks investors, the investors will want to see past performance of the business. They too will rely on the numbers that have been reported on the tax returns. Potential buyers of the business will use past sales and profits in calculating what they determine to be the fair market value of the business. While investors and the banks may realize from an on-site visit to the business or by looking at the owner's personal financial statement that the business is successful, not reporting income properly brings the integrity and honesty of the owner into question. This causes the bankers and investors to question the character of the owner and makes lending to the owner or investing in the business a greater potential risk.

It is important for small businesses to use proper accounting practices. These practices involve properly recording all business receipts, (yes, even cash); making sure that only business expenses are included in the business's financial statements and on the tax return; and accounting properly for any debt incurred by the business and for any loans that the business makes to related parties.

One of the simplest ways to accomplish this is to keep all business and personal transactions separate. Make sure that all sales are deposited and that all expenses are recorded in the business checking account or on a business credit card. If personal funds are used, make a reimbursement from the business and include receipts for the purchases made on behalf of the business.

Small business owners can also find ways to use profits from their business and invest them in tax-free retirement funds. This allows the owner to properly show the business's profit potential and still minimize personal income taxes. In the end, proper accounting practices and financial planning will prove to be more beneficial than the short-term results of "cooking the books."

Note: This article originated from the Georgia SBDC, authored by Michelle Wright. It was adapted for MO SBDC by Mary Paulsell, Assistant State Director, Missouri Small Business Development Centers. Used with permission.