There are two different ways to keep your books. Today I’m not talking about cash or accrual. I’m talking about ‘book’ and ‘tax’ accounting.
Most of the small business owners and real estate investors I work with report their taxable income on the cash or hybrid method. Hybrid method means that everything is cash basis, except for inventory. Inventory you buy is not immediately deductible.
For some small business owners, tax accounting is the same as book accounting. These are for businesses that don’t have accounts receivable or accounts payable. It could also be people who are a little lazy about properly accounting for their business and its results.
I recommend that you do keep your records on an accrual book basis, regardless of how you report your taxes.
When it comes time to prepare your tax return, you’ll need to adjust for the accrual items, namely accounts receivable and accounts payable. If you have a higher accounts receivable balance this year than last year, that means your taxable income (cash basis) will be lower. If you have a lower accounts receivable balance, your taxable income (cash basis) will be higher than book basis of income. On the other hand, if your accounts payable goes up, then your income goes down. If your accounts payable goes down, your income goes up.
It’s important to know how to make those calculations. I’ve seen two big mistakes by bookkeepers and/or the tax preparers in this regard in the past few months, based on the tax returns I review.
- In on case, the accountant/tax preparer (a CPA, but one not used to doing tax returns) reversed out the A/R and A/P at the end of the year. That seems simple enough, at least at the surface. The problem is that you also need to add back in the adjustment you made for the previous year. If you’re not following this entry, that’s okay. Just make sure that your bookkeeping and CPA are talking and that they both understand the need for accounting for book and tax changes.
- In another case, the tax preparer completely ignored the fact that the books were kept on accrual basis and simply reported the income that was shown on the QuickBooks program. In this case, because the company was going through such a growth spurt, it actually caused the company to overstate their income by over $150,000. At an average 30% tax bracket, that meant they had overpaid their taxes by $45,000.
It really does matter who does your bookkeeping and who does your tax preparation. We can help with both. Please give my husband Richard a call at 888-592-4769 or drop him an email at Richard@USTaxAid.com.