Financial reports are extremely important management tools that are woefully underused by small business owners. Partly because they are often not understood by small business owners. How often have you looked at your income statement and your bank account and not been able to reconcile the two?
A lot of the confusion can be removed when small business owners understand that there are BIG differences between the following three things:
- Actual cashflow through the business
- Nett profit on your Income Statement
- Nett taxable profit
We have dealt with the difference between your income statement and your bank statement in a previous blogpost, so in this one we will deal with why there is a difference between financial profit and taxable profit.
The income statement that your bookkeeper (or you) produces is often different to the one your accountant produces and uses for your tax returns. When you are doing your bookkeeping capture, you should be capturing your transactions exactly as they happen. Then, at the end of the year, your accountant will make some provisions and changes that relate to fancy accounting rules instead of straight forward transactions. The four most common are:
One of the main reasons your income statement differs from your bank balance is the purchase of assets. You cannot claim the full value of your assets when you buy them, because an asset is defined by the fact that it will last a long time and provide you with value over an extended time period. This means that we need to spread the cost of that asset over the time period that it lasts. We do this with depreciation.
So, the first thing that happens when you buy the asset, is that goes straight to your Balance Sheet and the amount doesn’t touch your Income Statement at all. At the end of the year, you will have a financial profit that is bigger than it should be and your taxable income is higher than it should be. But, because you did use that asset for all or part of the year, your accountant uses industry standard percentages to account for that use and to reflect it as an expense on your income statement in the form of depreciation. Your running costs are now more accurate and your taxable income comes down – hooray!
If you have a generous heart and a tendency to make donations to worthy causes, it is important to be aware that not all donations are considered tax deductible.
The first requirement for a tax deductible donation is that the organisation being donated to is registered with the appropriate authorities. In South Africa, the organisation must be registered with SARS as a Public Benefit Organisation and as a result it will have a unique PBO number that it reflects on all donation certificates. The rule of thumb here is no PBO number, no deduction.
This does not preclude you from donating to other worthy causes – but you need to be aware that those donations will be pure generosity on your part and cannot be claimed as a taxable expense.
The next restriction to bear in mind is that SARS restricts the total value of donations that you may claim per year. You may only claim donations that total 20% of your total income for the year. Now, hopefully, this is a very large value! But for the very generous out there, you need to realise that there is a chance that some of your donations will not be allowed as an expense.
So once again, your accountant will sit at the end of the year and make adjustments, but this time they might increase your taxable income instead of reduce it, sadly.
In the course of running a business, circumstances arise that result in possible future costs. These costs have not actually physically gone through your bank account yet, but they are related to the work you did in that particular year.
For example, if you pay your staff incentive bonuses linked to the successful completion of projects then your accountant will (hopefully) make an allowance for these bonuses along with all the other costs related to these projects. You need to see these potential costs when evaluating how much a project is worth to you and the cost needs to be accounted for in the same period that the income was raised in order for your project profit to be correctly calculated.
Since the bonuses have not actually been paid, your bottom line on your Income Statement will not match your bank statement or actual cashflow, but – happily – this allowance can be put through to reduce your taxable income.
- Penalties & Fines
Another sad one. In the course of running your business there will be times that you have to pay penalties and fines to government authorities. These an range from speeding fines to penalties for late statutory returns.
The problem with these expenses, is that whether they were avoidable or not, they are real and the amount leaves your bank account. They will also be recorded on your Income Statement, because they are an actual physical expense for you.
But, in South Africa, the government does not allow you to claim these amounts off your taxable income. Fines & penalties from a government institution are essentially a payment for a crime or legal infringement. They are therefore not recognised as tax deductible expenses and your accountant has to remove them from your Income Statement before calculating your taxes.
These are the four most common reasons why your financial profit can differ from your taxable profit. There are other variances, but these four demonstrate the principles very clearly.
Now, when your accountant presents you with your taxable income for the year, you no longer have to wonder why it doesn’t match the Income Statement they sent you. However, you should still ask them for an explanation of the differences. Trust is good, but it is knowledge and understanding that make you into a better business owner – do not be scared to ask your accountant to explain their actions to you. A good accountant will always be more than happy to do so.