Where's the Money? Income versus Cash Flow

By: Jennifer L. Pysnack, CPA (Apr, 2010)

The April 15th deadline has passed and many of you may be reflecting on your tax return and wondering where all that income is. Did I really make this kind of money and why isn't it in my bank account? There are many methods of calculating income from Generally Accepted Accounting Principles (GAAP) to varying ways allowed by the Internal Revenue Code. And then there is the amount that actually shows up in your checking account. All these ways of measuring your income can have substantially differing results.

Accrual based taxpayers will have much of their cash tied up in working capital such as inventory and accounts receivable. As that fluctuates from year-to-year, so too will the amount of cash generated by your business. GAAP based financial statements will often differ from the tax returns as inventories may be valued differently for tax purposes as obsolescence reserves are not acceptable for tax purposes and for larger companies the IRS requires capitalization of more general and administrative costs under Code Section 263A than is required for GAAP.

Business owners filing a corporate or partnership return can determine the differences in the income on their financial statements compared to the tax return by looking at page 5 of their return and reviewing Schedule M. Non-deductible items such as officer's life insurance and a portion of meal and entertainment expenses will appear here. Schedule M also details timing issues such as depreciation allowed for tax purposes that differ from normal GAAP depreciation, differences in valuing inventory or changes in reserve accounts that may be established for GAAP purposes and disallowed for tax purposes among other things. 

Many of our clients are "cash basis" for tax purposes and even this will create differences in income and the amount of cash generated. Most of our clients take a pension deduction that is calculated and paid well after year-end. These clients are always playing catch-up as they are paying out the cash after the expense has been taken.

The most significant areas in measuring differences in cash generated in a year versus taxable income involve loans and depreciation. Loan proceeds are not taxable and likewise principal repayments are not deductible. If loans are used to pay for equipment and if you use either the expensing election or bonus depreciation and write off a significant portion of the asset cost, you will be left with loan repayments in the out years without a corresponding depreciation deduction. What can be very good tax planning by taking a big deduction early may result in cash flow problems when the debt is repaid over the next few years when the tax benefit is all used up. 

Anyone that owns real estate with a mortgage will be faced with this mismatch in reverse as most mortgages amortize over a twenty year period and real estate has a thirty-nine year life. In the early years you will have greater principal payments than depreciation expense. When the loan is paid off there will be tax free cash-flow as the depreciation expense will continue on without the need to pay the mortgage to the bank. It's getting through the first fifteen or twenty years that is the hard part.

While tax returns and financial statements can be complicated and are not directly comparable to the changes in your bank account, the differences are reconcilable and you should be able to trace where all your money really is.

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