Saturday, December 15, 2007

More on Profit Versus Cash

The following is according to one of my professors:

What is the goal of major corporations? To generate earnings (i.e., profits) for its stockholders. Those earnings can increase the value of the stock itself, they are in some cases distributed to stockholders in the form of dividends, or they can be reinvested to generate even more earnings in the future. Major corporations want to maximize their earnings. Those earnings and dividends are both taxed by the government.

What is the goal of small businesses? To generate earnings for its owners, while shielding them from paying taxes on those earnings by allowing them to expense other items that employees in corporations may not get to expense. For instance, a small business can allow its owners to write off their automobiles, some travel expenses, home offices, and other items used in some way to help their business. Small businesses want to minimize taxable earnings while maximizing incoming cash.

I will note (for any IRS agent reading this blog) that I do not run my business with the specific goal of having little to no taxable income. I run it to maximize earnings. I do, however, use legitimate tax rules to minimize my tax liability, and some decisions I make might not make sense in a major corporation. We, for instance, started prepaying our insurance at the end of each year for the next year so we could reduce or tax bill. Those sorts of choices are not available to major corporations because they are required to report all income and expenses on an accrual basis.

Uh oh, those are accounting words, what does accrual mean? Accrual basis accounting means that income and expenses must be accounted for in the period they occur, regardless of whether cash was involved or not. So, if I prepay a year of insurance, I accrue it as a prepaid expense to be spread over the year (instead of all at once). Income must also be reported when the sale is made instead of when the payment is received. The difference for small business owners is they are allowed to use cash basis accounting. They record transactions when they receive the cash for or spend the cash on an item. The only exception being large assets, which are required to be expensed over time unless a special election of expense is made (which is, again, only allowed for some small businesses). What it comes down to is that large businesses must report their activities as they happen, whereas small business must report their activities when cash changes hand.

This post turned into a tax accounting lesson, but hopefully it is helpful to anyone considering opening their own business.

-- Robert

1 comment:

le35 said...

I'm a bit confused by this post, but that's alright. I'm looking forward to more laughs in the near future from this blog