The pretax (accounting) profit that’s reported on your company’s income statement is an important metric. Lenders, investors, and other stakeholders rely on pretax profits to evaluate a company’s financial performance. However, business owners also need to keep their eyes on taxable income to optimize tax outcomes and manage cash flow effectively. Here’s an overview of how these profitability metrics differ.

Crunching the numbers

Under U.S. Generally Accepted Accounting Principles (GAAP), pretax profit includes all revenue and expenses (except income taxes) for the accounting period. Accrual-basis accounting rules require revenues earned during the period to be “matched” with the expenses that were incurred to generate them. Reporting higher profits on the financial statements is generally preferable because it’s equated with more robust financial performance.

In contrast, taxable income is reported to tax authorities using applicable tax laws. Higher taxable income leads to higher tax obligations. Accounting professionals can help companies implement legitimate tax planning strategies to reduce taxable income.

The tax rules and accounting standards may differ for certain items (such as depreciation methods, expenses, and deductions). This may lead to differences in timing and amounts between the two metrics.

Understanding common differences

To illustrate, consider the following calculations: A hypothetical calendar-year C corporation earns $10 million of revenue and incurs $4 million of general operating expenses for book and tax purposes in 2024. Under GAAP, the company’s income statement also reports the following items for 2024:

• $1 million of depreciation using the straight-line depreciation method,
• $500,000 of bad debt expense based on management’s estimated allowance,
• $600,000 of accrued bonuses, and
• $700,000 of regulatory fines to the Environmental Protection Agency (EPA).

So, the company’s pretax profit is $3.2 million ($10 million − $4 million − $1 million − $500,000 − $600,000 − $700,000).
On the other hand, the company’s Form 1120 reports the following for 2024:

• $1.6 million of depreciation using the accelerated depreciation methods, and
• $300,000 of bad debt expenses based on actual write-offs.

Under federal tax law, accrued bonuses are generally deductible in the year employees earn them, but only if they’re paid within 2.5 months of the year end. This company routinely pays year-end bonuses on April 30 of the following year. So, it can’t deduct its 2024 accrued bonuses until 2025. In addition, fines and penalties paid to a governmental agency aren’t deductible under current tax law. As a result, the company’s taxable income is $4.1 million for 2024 ($10 million − $4 million − $1.6 million − $300,000).

Most differences — such as those related to depreciation methods, accrued expenses, or bad debt deductions — are temporary and will reverse over time. But permanent differences, including nondeductible EPA fines, don’t reverse. It’s also important to note that state tax rules may differ from federal rules, adding complexity.

Why it matters

Had the business owners in this hypothetical scenario paid estimated taxes using only pretax profit estimates, they likely would have underpaid tax for 2024. This could result in a surprise tax bill, which also might include an underpayment penalty. Coming up with funds on Tax Day could be challenging.

Anticipating differences between pretax profits and taxable income is essential for tax planning and cash flow management. For instance, the company could reduce taxable income for 2024 by paying year-end bonuses by March 15, 2025. The owners also could adjust estimated tax payments or set up a tax reserve to avoid a shortfall when filing the company’s return.

We can help

Our experienced accounting professionals can help you understand how pretax profits and taxable income may differ based on your company’s situation and plan accordingly. Contact us for more information.

 

It’s critical for business owners and managers to understand how to present contingent liabilities accurately in the financial statements. Under U.S. Generally Accepted Accounting Principles (GAAP), some contingent losses may be reported on the balance sheet and income statement, while others are only disclosed in the footnotes. Here’s an overview of the rules for properly identifying, measuring, and reporting contingencies to provide a fair and complete picture of your company’s financial position.

Likelihood vs. measurability

Under GAAP, contingent liabilities are governed by Accounting Standards Codification (ASC) Topic 450, Contingencies. It requires companies to recognize liabilities for contingencies when two conditions are met:

1. The contingent event is probable, and
2. The amount can be reasonably estimated.

If these criteria aren’t met but the event is reasonably possible, companies must disclose the nature of the contingency and the potential amount (or range of amounts). If the likelihood is remote, no disclosure is generally required unless required under another ASC topic. However, if a remote contingency is significant enough to potentially mislead financial statement users, the company may voluntarily disclose it.

Common examples

For instance, a company must estimate a contingent liability for pending litigation if the outcome is probable and the loss can be reasonably estimated. In such cases, the company must recognize a liability on the balance sheet and record an expense in the income statement. If the loss is reasonably possible but not probable, the company must disclose the nature of the litigation and the potential loss range. However, when disclosing contingencies related to pending litigation, it’s important to avoid revealing the company’s legal strategies. If the outcome is remote, no accrual or disclosure is required.

Other common types of contingent liabilities include:

Product warranties. If the company can reasonably estimate the cost of warranty claims based on historical data, it should record a warranty liability. Otherwise, it should disclose potential warranty obligations.

Environmental claims. Some businesses may face environmental obligations, particularly in the manufacturing, energy, and mining sectors. If cleanup is probable and measurable, a liability should be recorded. If the obligation is uncertain, the business should disclose it, describing the nature and extent of the potential liability.

 

Tax disputes. If a company is involved in a dispute with the IRS or state tax agency, it should assess whether it is likely to result in a payment and whether the amount can be estimated.

Under GAAP, companies are generally prohibited from recognizing gain contingencies in financial statements until they’re realized. These may involve potential benefits, such as the favorable outcome of a lawsuit or a tax rebate.

Transparency is essential in financial reporting. However, some companies may be reluctant to recognize contingent liabilities because they lower earnings and increase liabilities, potentially raising a red flag for stakeholders.

Best practices

To help ensure transparency when reporting contingencies, companies must maintain thorough records of all contingencies. Proper documentation may include contracts, legal filings, and communications with attorneys and regulatory bodies. Legal and financial advisors can provide insights into the likelihood of contingencies and help estimate potential losses.

As new information becomes available, management may need to reassess contingencies. For instance, if new evidence in a lawsuit makes a favorable outcome more likely, the financial statements may need to be updated in future accounting periods.

We can help

In today’s uncertain marketplace, accurate, timely reporting of contingencies helps business owners and other stakeholders manage potential risks and make informed financial decisions. Contact us for help categorizing contingencies based on likelihood and measurability and disclosing relevant information in a clear, concise manner.

 

Running a closely held business is challenging. Owners usually prioritize core business operations — such as managing employees, serving customers and bringing in new sales — over tedious bookkeeping tasks. Plus, the accounting rules can be overwhelming.

However, access to timely, accurate financial data is critical to your business’s success. Could applying outsourced bookkeeping tasks to a third-party provider be a smart business decision? Here are five reasons why the answer might be a resounding “Yes!”

1. Lower costs and scalability

Your company could hire a full-time bookkeeper, but the expenses of hiring an employee go beyond just his or her salary. You also need to factor in benefits, payroll taxes, office space, and equipment. It’s one more employee for you to manage — and accounting talent may be hard to find these days, especially for smaller companies. Plus, your access to financial data may be interrupted if your in-house bookkeeper takes sick or vacation time — or leaves your company.

With outsourced bookkeeping, you pay for only the services you need. Outsourcing firms offer scalable packages for these services that you can dial up (or down) based on the complexity of your business at any given time. Outsourcing also involves a team of bookkeeping professionals, so you have continuous access to bookkeeping services without worrying about staff absences or departures.

2. Enhanced accuracy

Do-it-yourself bookkeeping can be perilous. Mistakes in recording transactions can have serious consequences, including tax assessments, cash flow problems, and loan defaults.

Professional bookkeepers are trained to pay close attention to detail and follow best practices, minimizing the risk of errors. Outsourcing firms work with many companies and are aware of common pitfalls — and how to steer clear of them. They’re also familiar with the latest fraud schemes and can help your business detect anomalies and implement accounting procedures to minimize fraud risks.

3. Expanded access to expertise

The accounting rules and tax regulations continually change. It may be difficult for you or an in-house bookkeeper to stay updated.

With outsourcing, you have experienced professionals at your disposal who specialize in bookkeeping, accounting, and tax. This helps ensure you comply with the latest rules, accurately report financial results, and minimize taxes. In addition, as you encounter special circumstances, such as a sales tax audit or a merger, you can quickly call on other professionals at the same firm who can help manage the situation. If your provider lacks the necessary in-house expertise, the firm can refer you to another reputable professional to meet your special needs.

4. Improved timeliness

Timely financial data helps you identify problems before they spiral out of control — and opportunities you need to jump on before your competitors do. Outsourcing professionals typically use cloud-based platforms and set up automated processes for routine tasks, like invoicing and expense management. This improves efficiency and gives you access to real-time financial data to make better-informed decisions.

5. Reliable security protocols

Cyberattacks are a serious threat to any business. Stolen data can lead to monetary losses, operational downtime, and reputational damage.

Many business owners are understandably cautious about sharing financial data with third parties. Reputable outsourced bookkeeping providers use advanced security measures, encryption, and secure software to protect your financial data and client records from hackers. However, not all providers have the same level of security. So, it’s essential to carefully vet outsourcing firms to ensure that your company’s data is adequately protected.

Work smarter, not harder

At any given moment, business owners are being pulled in multiple directions by customers, employees, lenders, investors, and other stakeholders. Outsourcing your bookkeeping helps alleviate some of that stress by ensuring your financial records are up-to-date, accurate, and secure. Contact us for more information.