When selling and valuing a business many times, owners prefer to use internal financials versus their tax returns. But remember, tax returns matter most in a business valuation. The reasons for this are many, but just a few are:
- Tax returns are many times on the cash basis for smaller businesses since cash basis earnings are typically lower than those on the accrual basis.
- Tax returns are prepared to minimize taxes. Who wants to pay higher taxes? However, paying taxes on solid earnings are an “investment” when selling a business.
- The owner’s benefits can be buried in the fewer line items on the tax returns versus the unlimited accounts in the internal financials.
- Internal financials are typically ready within 15-30 days after month-end, while tax returns can be many months behind from the taxable year-end.
- Tax returns can be old data, while internal financials are a snapshot of the now. It’s hard for ownership to use the most recent tax returns as a measuring stick of recent changes to the business.
- Depreciation, amortization, and interest payments often aren’t adjusted every month for the internal financials.
- Uncollectable accounts are not written down or off, which can skew numbers and percentages.
A critical aspect of whether tax returns or internal financials are used is they MUST tie together. For instance, a seller or company owner may want to use the cash basis on the Tax Returns and Accrual on internals as big moves in payments, and inventory/job costing purchases skews the profit numbers one way or the other. Also, it is prudent for smaller businesses not to realize income until all monies are collected (cash versus accrual basis).
However, your CPA should be able to supply the journal entries for both the year’s beginning and end that tie the tax returns and internal financials together. It is critical that inventory (if applicable), job costing (if applicable), and the accounts receivable are clear, concise, and make sense as the company’s “bodies are buried” in inventory and Accounts Receivable and their quality, saleability, and collectability must be addressed.
Also, transactions typically are funded by banks or other types of lenders. Tax returns carry a higher level of validity with that audience than internals numbers. The lack of tax returns and YTD financials less than 45 days old has held up or canceled many a closing.
To summarize, when valuing and selling your business, it is important that tax returns are done promptly and that they are reconciled versus internal financials and those journal entries make sense to all parties involved. It is acceptable to have variances between financial statements and tax returns. However, those variances need to be understood by all parties involved.