I understand how intimidating taxes can be. There are a lot of rules to follow and tedious work that can lead a person to exhaustion.
So, I want to walk you through the bare-bones basics of tax deductions, but let me first start by telling you why tax accounting and bookkeeping are important.
First and foremost, let’s define what accounting and bookkeeping are.
They’re essentially taking a set of data and representing it as accurately as possible to the facts and circumstances of a business.
Keep in mind, if you don’t understand the numbers, you end up guessing. The simplicity of bookkeeping and accounting is just about bringing those numbers into reality; really giving you a true reflection of what your business is doing.
Here’s the key thing to remember: It’s not always going to be perfect.
Another thing to keep in mind, numbers don’t lie, but statisticians can. People can maneuver and manipulate numbers to paint just about any picture they want to create. Just take a look the Enron scandal. They took real numbers and moved them around to give a false representation of what they really were. Not only did it hurt a lot of good people, but it put their CEO in prison. If you don’t know about Enron’s story check it out here.
So, this is all a lead in to what I want to talk with you about: Income Statements. Another phrase for it in business is called a P&L, or a Profit and Loss.
Your P&L essentially tells you what your net profit is in your business..
Here is an important formula to remember.
Profit = revenue of the business minus the expenses of the business.
For example, if you own a lemonade stand and you made $1 in revenue and your cost to make the lemonade was 50 cents, you have a profit of 50 cents.
An income statement is really just the different sources of revenue that come into your business and then what the expenses are. These two basic things tell you what your profit look like at any given time.
Now, that brings us to what exactly is considered an expense?
Looking back at the lemonade example, if you need lemons, sugar and water to make lemonade, this would be considered an operational expense.
These “operational” expenses keep the business running and are fully deductible.
- Other examples of operational expenses include:
Make sense so far? Let’s take it one step further.
There are some expenses the IRS don’t consider deductible. It’ll still show up on the P&L but they just aren’t deductible expenses.
These expenses might be considered capital expenditures, which are nondeductible.
Let me give you an example.
A salary will always be considered an operational expense. But let’s say a real estate business decided they needed a swimming pool at their property and, in this case, it was not needed for a medical reason. This would be considered a capital expenditure or a “Cap-Ex.”
Even though this is considered a long-term investment for the real estate business, meaning the basis of the property will increase in value, it will not create a deduction because it is a capital expenses as defined by the IRS.
Sometimes this investment will show up on your income statement as reducing the profit of your business because you expensed a certain amount of money on that pool that you no longer have.
If you want to learn how to write off your swimming pool, check out our article here.
Hopefully now you see why having the basics of bookkeeping in place and how documenting properly on your P&L gives you decision power.
If you have a complete picture of your financials and rationale for why you’re doing something with your business and you can justify it, it’ll work for you. If you don’t have an accurate depiction of where your business currently sits financially or bad bookkeeping, you can potentially make the wrong decision and be in a bad spot.
That’s why accounting and bookkeeping are crucial for your company’s success.