Learn about some of the financial reporting difficulties in separating personal from business expenses, and why small business owners should keep good records of the use of joint-purpose assets.
- Let's say we've got a small business owner named Jeff. Jeff owns and operates his own construction business. Jeff also has a family. Jeff has small trucks and off-road vehicles that he uses in his business, but that he also sometimes uses for personal purposes. This common situation presents huge recordkeeping complications, both for financial reporting to banks and potential investors, and for income tax reporting. Here are some of the financial reporting difficulties. Should the trucks and off-road vehicles be reported on Jeff's business balance sheet, or are these personal assets? For example, he certainly wouldn't put the family couch on the company balance sheet.
But what about those pickup trucks? And what difference does it make? Well, the balance sheet is supposed to give the financial statement user a summary of the assets being used in the business. In this common situation, it is almost impossible to answer the most basic question, what is the total cost of the trucks and off-road vehicles currently being used by Jeff in his business? If you were negotiating with Jeff to buy his business, you would have to make sure to specifically define, in the purchase contract, which assets and which liabilities are associated with the business and which assets and liabilities are personal and stay with Jeff.
In addition, when Jeff computes the income of his business, does he subtract wear and tear on the trucks? And how about maintenance costs and gasoline? Again, this makes a difference because net income is supposed to show how much profit is being generated by the business. Answering the most basic income question, how much income is being generated by Jeff's business, is almost impossible because of the inability to separate business expenses from personal family costs.
If you are negotiating with Jeff to buy his business, how can you reliably know the profit being generated by the business? Now you might make an estimate regarding the business/personal split of joint expenses, but you are then at risk of seeing substantially-higher business expenses than you anticipated once you separate Jeff's business from his personal activities. In addition to financial-reporting problems, this inseparable mixture of small business and family life creates income tax problems.
The income tax regulations have the strict rule of law behind them. Violate the income tax rules, and you are potentially in big legal trouble. So, are the wear and tear on the trucks and off-road vehicles, and the gas and maintenance for these vehicles, legitimate legal business deductions for tax purposes or are they personal expenses which are not tax deductible? Because this question is so common, the Internal Revenue Service in the United States has very detailed and strict rules for separating business and personal expenses associated with vehicle use and home use.
Think about the different motivations for income statement reporting to banks and investors and income tax reporting to the legal authorities. For income statement reporting, Jeff wants to show the highest income possible so that his company looks as good as possible to potential investors or to potential lenders. For income tax reporting, he wants to report the lowest income possible, so he can pay the minimum necessary income tax. Accountants use the dry-sounding label of entity concept to represent this difficult issue of trying to align between a small business owner's business and personal activities.
In the end, the solution to this entity concept difficulty is good recordkeeping. For example, a real-time log of the use of vehicles that serve both a business and personal purpose is an extremely valuable data source when identifying the amount of vehicle expenses that are legitimate and necessary business expenses. It is in the best interest of the small business owner to keep good records of the use of joint-purpose assets. These records can be used to establish the credibility of financial reports given to banks and to investors, as well as of the income tax reports submitted to the legal taxing authority.
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