Q: Shouldn't inventory be included on a cash basis statement?
A: According to the income tax regulations and guidelines, a cash-based taxpayer can expense the cost of inventory if the inventory is either sold or paid for in cash. That means the company could have sold inventory that remains unpaid for or it could have inventory on hand that it has neither sold nor used up but has paid for in cash. Either event allows the company to claim inventory as an expense on its cash-based income tax returns.
Of course a company could have inventory that it has not sold or paid for. In that event, the amount of inventory could be recorded on Schedule L on the cash-based income tax returns. However, we would then expect to see an equal and offsetting amount recorded on Schedule L for accounts payable.
In practice, it is common to find nothing recorded for inventory and accounts payable on Schedule L for cash-based taxpayers. The emphasis in preparing the income tax returns is on the allowable amount of expense deductions that leads to the bottom line amount at Line 22 on the Form 1065. We could say, in effect, that balance sheet amounts are a bit of an after-thought. All the focus is on computing taxable income.
Q: On schedule L, why are assets and liabilities the same if there was a $72K loss?
A: The information on Schedule M-1 explains the process of accounting for the $72,193 incurred by Great Lakes Distributors, LLC. The beginning balance for the partners’ capital account was $270,351, which is the same amount recorded on Schedule L in the “beginning of tax year” column. That amount is then reduced by the loss of $72,193 and distributions of $83,493 to provide an ending balance of $114,665 for the partners’ capital account. The balance sheet remains in balance as it must to honor the accounting equation, i.e., assets must equal the sum of liabilities and partners’ capital.
Q: Is it possible that the 2008 distributions were used to pay 2007 taxes (assuming the company had a profit in 2007)?
A: It’s likely that the quarterly income tax payment due by January 15th for the last four months of the prior year may have been made after December 31 and, therefore, counted as a 2008 distribution. The filing dates are April 15th (for first quarter profits), June 15th (for April and May), September 15th (for June, July, and August), and January 15th (for September, October, November, and December).
However, the final estimated payment for the final four months of 2007 was due by January 15th, 2007. Therefore, the two January 15th distributions may have roughly offset each other.
Q: Why did you use Line 22 on Page 1, Ordinary Business Income (Loss), in the business cash income example instead of Schedule M-1 Line 1, Net Income (Loss) per books?
A: In the Business Cash Income example, we used Ordinary Business Income – a negative $56,576 – at Line 22 on Form 1065 because that amount is the cash income for Great Lakes Distributors for 2008, which we then adjusted by removing the non-cash depreciation expense and including the cash distributions. We could have used the Schedule M-1 loss of $72,193. If we did so, we would then reduce that loss by a) the Section 179 deduction of $13,975, which is additional depreciation expense the owner can use to reduce his or her taxable income, and by b) the additional non-cash deduction of $1,642. By eliminating those two amounts, the Schedule M-1 loss of $72,193 falls to $56,576 – our starting point for computing Business Cash Income and the same amount at Line 22 on page.
Q: If only accrual based tax returns or financial statements are provided, how do you "reverse engineer" to cash based information?
A: It can be a fairly extensive process to manually create a cash flow statement from accrual financial statements, but it is well worth the effort. Most financial analysis software packages include an analytical report for the Uniform Credit Analysis (UCA) cash flow statement, which is the most useful of several statements created from two years of accrual balance sheet information and the income statement spanning the two balance sheet dates.
We offer a Webcast on the UCA cash flow statement, which illustrates the actual process of manually creating the statement.
Q: How do you determine if an S Corp tax return is being prepared as cash based?
A: The most direct method to determine if a Subchapter S corporation income tax return is being filed on a cash basis is to refer to Schedule B, Other Information, Line 1 which indicates the accounting method used. However, if doubts remain, contact your customer or, with their permission, the accountant who prepared the tax return.
Q: Can you go back to the comparison of the two companies? I missed the discussion about the leverage. Is a higher number or lower number better and why?
A. Because Great Lakes Distributors experienced considerable growth in both accounts receivable and inventory, it stands to reason that it was necessary to incur additional debt to support the growth. Therefore, the leverage ratio – the relationship between debt and equity or partner’s capital – would increase. As a general rule, the more debt a company has in relation to equity or partners’ capital, the greater the financial risk of that customer since more of every dollar of revenue is absorbed for interest expense and principal debt repayment.
A: According to the income tax regulations and guidelines, a cash-based taxpayer can expense the cost of inventory if the inventory is either sold or paid for in cash. That means the company could have sold inventory that remains unpaid for or it could have inventory on hand that it has neither sold nor used up but has paid for in cash. Either event allows the company to claim inventory as an expense on its cash-based income tax returns.
Of course a company could have inventory that it has not sold or paid for. In that event, the amount of inventory could be recorded on Schedule L on the cash-based income tax returns. However, we would then expect to see an equal and offsetting amount recorded on Schedule L for accounts payable.
In practice, it is common to find nothing recorded for inventory and accounts payable on Schedule L for cash-based taxpayers. The emphasis in preparing the income tax returns is on the allowable amount of expense deductions that leads to the bottom line amount at Line 22 on the Form 1065. We could say, in effect, that balance sheet amounts are a bit of an after-thought. All the focus is on computing taxable income.
Q: On schedule L, why are assets and liabilities the same if there was a $72K loss?
A: The information on Schedule M-1 explains the process of accounting for the $72,193 incurred by Great Lakes Distributors, LLC. The beginning balance for the partners’ capital account was $270,351, which is the same amount recorded on Schedule L in the “beginning of tax year” column. That amount is then reduced by the loss of $72,193 and distributions of $83,493 to provide an ending balance of $114,665 for the partners’ capital account. The balance sheet remains in balance as it must to honor the accounting equation, i.e., assets must equal the sum of liabilities and partners’ capital.
Q: Is it possible that the 2008 distributions were used to pay 2007 taxes (assuming the company had a profit in 2007)?
A: It’s likely that the quarterly income tax payment due by January 15th for the last four months of the prior year may have been made after December 31 and, therefore, counted as a 2008 distribution. The filing dates are April 15th (for first quarter profits), June 15th (for April and May), September 15th (for June, July, and August), and January 15th (for September, October, November, and December).
However, the final estimated payment for the final four months of 2007 was due by January 15th, 2007. Therefore, the two January 15th distributions may have roughly offset each other.
Q: Why did you use Line 22 on Page 1, Ordinary Business Income (Loss), in the business cash income example instead of Schedule M-1 Line 1, Net Income (Loss) per books?
A: In the Business Cash Income example, we used Ordinary Business Income – a negative $56,576 – at Line 22 on Form 1065 because that amount is the cash income for Great Lakes Distributors for 2008, which we then adjusted by removing the non-cash depreciation expense and including the cash distributions. We could have used the Schedule M-1 loss of $72,193. If we did so, we would then reduce that loss by a) the Section 179 deduction of $13,975, which is additional depreciation expense the owner can use to reduce his or her taxable income, and by b) the additional non-cash deduction of $1,642. By eliminating those two amounts, the Schedule M-1 loss of $72,193 falls to $56,576 – our starting point for computing Business Cash Income and the same amount at Line 22 on page.
Q: If only accrual based tax returns or financial statements are provided, how do you "reverse engineer" to cash based information?
A: It can be a fairly extensive process to manually create a cash flow statement from accrual financial statements, but it is well worth the effort. Most financial analysis software packages include an analytical report for the Uniform Credit Analysis (UCA) cash flow statement, which is the most useful of several statements created from two years of accrual balance sheet information and the income statement spanning the two balance sheet dates.
We offer a Webcast on the UCA cash flow statement, which illustrates the actual process of manually creating the statement.
Q: How do you determine if an S Corp tax return is being prepared as cash based?
A: The most direct method to determine if a Subchapter S corporation income tax return is being filed on a cash basis is to refer to Schedule B, Other Information, Line 1 which indicates the accounting method used. However, if doubts remain, contact your customer or, with their permission, the accountant who prepared the tax return.
Q: Can you go back to the comparison of the two companies? I missed the discussion about the leverage. Is a higher number or lower number better and why?
A. Because Great Lakes Distributors experienced considerable growth in both accounts receivable and inventory, it stands to reason that it was necessary to incur additional debt to support the growth. Therefore, the leverage ratio – the relationship between debt and equity or partner’s capital – would increase. As a general rule, the more debt a company has in relation to equity or partners’ capital, the greater the financial risk of that customer since more of every dollar of revenue is absorbed for interest expense and principal debt repayment.