Schedule M-1 and the Accrual Income Statement
Q: My institution has shifted to the use of Net Income from the M-1 rather than the front page of the tax return. This is the difference between book income and income for tax purposes. The analysis used is net income from M-1 + Depreciation + Interest Expense = CFADS (Cash flow available for debt service). However, when I deduct expenses from profit in the tax return, I come up with a different net income than what is reported in the M-1. In some cases, it can mean the difference between a 1.2x DSCR and a 1.05x DSCR. It appears that one difference is whether tax return depreciation or book depreciation is added back. How should we be doing this?
A: 1. Net income at Line 1 on Schedule M-1 is the place to start. Ordinary business income on the first page of the tax return does not include all income and expenses. For example interest income, dividend income, some types of gains or losses, charitable contributions, and non-deductible expenses are excluded from the first page but, rather, are reported separately on Schedule K. In addition, the depreciation expense on the first page is different from the depreciation expense used in computing net income at line 1 on Schedule M-1.
2. Net income at Line 1 on Schedule M-1 does include interest income, dividend incomes, all gains or losses on sale of assets, charitable contributions, and the non-deductible expenses disallowed on the business income tax returns.
3. It is essential to use the correct depreciation expense amount in computing traditional cash flow. The information for identifying the proper depreciation expense is reported on Schedule M-1. Please see the "Schedule M-1 (Form 1120S)" Credit Refresher which examines this issue and many others in adjusting business income tax returns to an accrual income statement.
4. Always use the accrual income statement rather than the business income tax returns. The accrual income statement is prepared according to GAAP while the income tax returns are prepared according to Congressional legislation. The latter frequently conflicts with GAAP guidance.
5. Hopefully, the Credit Refresher will clarify many of these issues. Note, too, that we address the issue of Schedule M-1 and the conversion of business income tax returns to an accrual income statement in Session 5 of our Credit College Course on Using Federal Tax Returns for Ratio and Cash Flow Analysis. The session is a live 90 minutes webinar.