Business owners are in trouble. Income property owners, too. The demands of running a business or managing investment properties has reached an all-time high and banks are demanding more detailed financial statements than ever before. And therein lies a side gig opportunity with high income potential.

Every tax season my office sees hundreds of financial statements prepared by the client or their staff. You can’t imagine the mess most are in.

The client always thinks they are doing an awesome job of keeping their books. . . until they need a loan and the bank is less willing to decipher their books than the accountant.

The ability to read a financial statement is a powerful wealth building skill. You can detect fraud, analyse an investment and manage business liquidity. 

Banks will not spend time trying to figure out a mess. It is easier to pass. If the funding required is significant pristine records are not an option.

In short, reading a financial statement is a requirement for wealth building and business management. The financial statements tells you how the business is doing and the direction it is heading. Often, the financials will indicate problems before they are apparent in the real world. These festering problems are easier to fix when they are still small.

Reading financial statements are a good opportunity for you to generate extra income. It can even be a high-paying full-time business. Understanding how money works requires you to understand how money is recorded and that means financial statements. The number of business owners looking for help in securing a loan is a business opportunity that starts with the ability to read financial statements.

Buyers of a business are investing serious money and definitely need help understanding the value of the investment. Real estate buyers the same.

Accountants and attorneys are an obvious choice. However, many do not handle this kind of work. As a specialist, you can solve a business owner’s financing problems while earning an excellent income.

We will now review the three most common financial statements: the balance sheet, income statement and cash flow statement. The examples used are filled with errors I see in my office frequently. You can find more errors than I discuss as I added plenty.

By understanding common mistakes business owners make you can become familiar with the issues and become a value added service. Good financial statements (good records) are not an expense! Clients seeking help improving their records will be more profitable and therefore, a long-term client.

 

The Difference Between an Income Statement and the Balance Sheet

This may come as a surprise to you, but very few people know the difference between an income statement and a balance sheet. And don’t get me started on the cash flow statement.

I see clients recording entire loan payments as an expense on the income statement. For some reason they know loan proceeds are not income because they don’t want to be taxed on that money. However, when it comes time to pay the loan they think the whole payment is an expense (and deductible). It isn’t!

Loan proceeds go on the balance sheet, of course, as a long- and/or short-term liability. If you require detailed records for a business sale, purchase or bank loan, you will need to separate a loan into long-term (amounts due in over one year) and short-term (principle due in one year or less). If the business is small the owner may not want to separate the loan into long- and short-term. In those instances the loan should be recorded as a long-term liability. (The correct way is to list long- and short-term. In no way do I feel the shortcut of listing all loans as long-term acceptable.)

Loan payments have three entries in a general journal: cash out of checking (balance sheet), principle portion of the payment (balance sheet) and interest payment (income statement). As all accountants know, only the interest is an expense. 

If you can clean up this one issue you will save more businesses than you can imagine. If your client is making this mistake you may need to junk the entire set of books and start over. The books are a mess and in no condition for a banker or the tax accountant. (Tax accountants deal with this all the time and if the books are bad enough and the client unclear in explaining what they are doing, taxes can be wrong as well. If you give your tax accountant clean records she will save you money in taxes versus wasting time trying to ferret out what your numbers really are.)

 

QuickBooks Does Not Make You an Accountant

The biggest mistake business owners make is thinking QuickBooks makes them a good bookkeeper or accountant. This is about as true as saying TurboTax makes you a tax professional. If you believe that I have some cheap ocean front property to sell you in Montana.

The only thing QuickBooks lets you do is dig the hole faster unless you understand basic accounting. 

As we review the following financial statements you will see some of the crazy things tax professionals see every tax season: balance sheets with equipment and no accumulated depreciation and negative numbers where they don’t belong. (Yes, I know contra accounts happen. But negative petty cash?)

I gathered financial statement issues from multiple sources and introduced as many issues as I could in one set of financials. I started with a sample account QuickBooks provided in an older version to construct this monstrosity. I have seen worse unfortunately, but this will do for our needs. 

Do not focus only on the errors. Keep a keen eye on issues the financials expose. Getting the books in order before presenting to a bank is vital. Once the bank (or investors) start expressing concerns over the financials they start to lose confidence. Deal with the weaknesses of the financial statements before presenting. You still need to provide honest information and it must be clear. Having answers prepared in advance can make or break a deal.

The same rules apply from the other side. As a buyer of an income property or business you will be looking with the same jaundiced eye at the financials. If the books have errors it becomes difficult to trust the investment is solid.

 

Balance Sheet

You can click all financial statements in this post to open in a second, larger window.

Novices always want to start with the income statement. The income statement is too easily doctored to give a false picture. Assets and liabilities are the place you want to start, especially if concerned with the value of the business..

The above balance sheet has the head-scratcher of a negative petty cash account. In effect, this means the petty cash account is overdrawn. Someone will need to explain that one to me. 

The other account issues that make no sense is a negative loan to John Doe, a negative bank loan for equipment, negative accounts payable and receivable, and negative payroll taxes due. You might be amused by this, but half or more of all business financial statements I see each tax season have these types of errors.

To be fair, QuickBooks (QBs) is a disaster when it comes to payroll. Payroll taxes payable need to be adjusted periodically for some reason on the balance sheet. QBs even has a neat tool to make the adjustments. The rest of the payroll module is accurate, just the balance sheet has this slowly roaming error that needs periodic correction.

I’m not sure how you get a negative accounts receivable and payable. 

This balance sheet has too many loans to friends. Don’t loan money to your girlfriend from the business. Take a distribution (if allowed) and give a personal loan to your girlfriend. Better yet, don’t be your girlfriend’s banker. It never works. I see that in the office, too.

Under fixed assets we have office equipment listed without any accumulated depreciation. Land isn’t depreciated, just about everything else is. Was depreciation expense missed, too? Yup.

All these errors are the result of incorrect accounting entries. The loan to John Doe shows up as a liability because I treated it as paid from a payroll deduction. John is an employee. It takes fancy footwork to get the books this bad in QBs.

Financial records this bad are unsalvageable. You will need to start over. Fixing this mess would take more time than building a whole new QBs file. You could have a full-time business just setting up QBs files for businesses. If you never turned a client away you would have an army of employees hired to keep up. There is that much to do. Almost all records kept internally by the client are in need of attention. And if you think this balance sheet example is bad, you are wrong. This is typical. The only matter is the degree of issues involved.

I intentionally excluded the equity accounts to save time. 

 

Income Statement

You can click all financial statements in this post to open in a second, larger window.

There are plenty of concerns on the income statement, sometimes referred to as the profit & loss statement. 

There is a large amount of non-taxable revenue listed. This should be clarified and listed below sales for aesthetic reasons. I’m concerned this could be “other income” or a refund of some sort that should be listed under Other Income at the bottom of the statement or treated as an adjustment to an expense. 

Auto expense requires explaining. Was the IRS mileage rate or actual expenses used. If the mileage rate was used there is an opportunity to add the depreciation portion of the mileage rate back into income for lending purposes. (What condition is the vehicle log for tax purposes? Were personal miles mixed in?)

Contributions were really donations to charity. Sometimes a business can deduct donations as a sponsorship. Personal donations to church are not a business expense and should not come from the business account. 

Miscellaneous expenses are high and need to be accurately classified. 

Payroll and payroll expenses should utilize sub accounts. The officer’s wage looks fine (if this is an S corporation) compared to net income, but the type of business may change that determination. Removing contributions and a few other items from the expense column could leave the reasonable owner’s wage requirement a bit light (for corporations only).

The SEP/IRA is a concern. Is this a retirement account run through payroll or an IRA contribution for an owner paid out of business funds? It needs to be cleaned up or clarified. Payroll with sub accounts would be ideal to address the lack of clarity.

The business portion of Social Security is listed, but is the wrong percentage. The Social Security portion of FICA is 12.4%; half paid by the employee, half by the employer. The Social Security expense of $5,562.26 is more than 10% of the officer’s wage of $53,800. The employer’s portion is only 6.2% and there are no other wages listed on the income statement!

Payroll expenses are listed as $18,909.25. Is this employee wages? It would explain the FICA issue. This would need to be cleaned up/clarified before presenting to a bank or buyers.

Finally, utilities are not an “other expense”. This needs to be moved up with the regular expenses. The sales tax adjustment also needs addressing.

 

Cash Flow Statement

You can click all financial statements in this post to open in a second, larger window.

The cash flow statement is my favorite. I want to see where the money is coming in and going out. This includes loan proceeds and retirement of debt. If the statement is accurate it can tell you a lot about the health of a company. As you can see, this is not an ordinary business.

If the balance sheet and income statement were clean I would have confidence in this cash flow statement. However. . . 

We discussed several issues on the income statement and balance sheet which reflect here. The item I want to point out is the shareholder distributions. Added to the officer’s wage, we get the total cash the owner received from the enterprise in 2018. 

Even with terrible books we are still able to get a vague idea how much the business is disbursing to the owner. The odds are pretty good the owner received a $53,800 wage and $35,950 in distributions. Cash was negative at the beginning of the period (unbelievable) and around $34,000 higher at year-end (believable if the rest of the books were not a mess). Messy books means the business probably throws off close to $90,000 in cash to the owner, more if contributions are not really a business expense. If the books were clean we could add the $34,000 increase in cash for the year since I don’t see any lending activity.

 

Analysis and Opportunity

Obviously this was an extraordinary mess used to illustrate multiple recordkeeping issues. Many businesses have books this bad, if they have any records at all. A thriving business can fail due to mismanagement of recordkeeping. Poor records can cause a business to over-pay taxes, lose bank funding and result in a lower sale price of the business at the end of the owner’s career.

Warren Buffett has said many times Accounting classes were the most important he attended in college. I agree. Without a fundamental knowledge of accounting it is difficult to build serious wealth and almost impossible to run a successful business. With a sound understanding of accounting and financial statements you are qualified to manage most businesses and investments, including finding the true value of the asset.

You don’t have to be a banker or financial analyst to use financial statements. Investing in a stock is investing in a company and should be treated the same way as buying an entire smaller local firm. Buying income property successfully requires understanding financial statements to make a sound decision. You want to know the rent history and expenses, plus required deferred maintenance, before making a decision to buy or pass.

Since most roofers are good at roofing and poor at keeping accurate records, you have a powerful side gig opportunity to make a difference in your community while earning above average income. 

All business eventually need funding. Your ability to read financial statements allows you to consult with clients at a higher level and to gain desired result. You can handle the raw data entry if you want or farm it out to a bookkeeper. Regardless, you lead and give directions. 

Done right, you and your clients will profit.

 

Coda

So how can you start reading financial statements as a side gig or person use if you don’t know how already? You could always take a college or technical school course. Or, you can self-study. Here is a good book to get you started. It will cover 99% of what most people will ever need. Note you will still look things up from time to time. It is the nature of the skill. The linked book is a good reference source. 

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Commingling of funds (mixing business and personal funds) is one of the riskiest things you can do, causing serious legal and tax problems. 

The issue is less acute from a legal standpoint if you are a non-LLC sole proprietor. There are still plenty of tax issues, however.

LLCs and corporations are at extraordinary risk when funds are commingled. Treating your business as a personal fiefdom instead of a separate entity—which it is—can cause serious legal and tax issues down the road. We will deal with both issues in this post.

 

Legal Issues When Commingling

The real reason you should incorporate or organize an LLC is for legal purposes. Taxes come along for the ride. 

The tax code treats certain incorporated businesses punitively: notably attorneys, accountants and doctors. When people in these professions want the liability protection of a corporation they are considered a personal service corporation (PSC). 

Commingling money can cost you big in taxes. The best tax professionals refuse to work with clients who commingle. Don't overpay your taxes. Never commingle! #commingling #comingling #taxes #taxplanning #IRS #sidehustle #smallbusiness #businessA PSC is not entitled to the graduated tax rates of regular corporations and therefore pay tax at the top corporate rate on all profits. New tax laws lessen the tax issues a bit now that the top corporate tax rate is a flat 21%, but other issues still abound. 

For these reasons we saw large partnerships form for doctors, attorneys and accountants. (Making partner is something every CPA and attorney aspired to.) 

The problem with large partnerships is that legal liability can be massive in these professions. The tax hit was so large that insurance was a cheaper route than the higher taxes of a corporation, However, it was a serious disadvantage.

And with attorneys taking the hit it was only a matter of time before a solution was devised. (The first LLC was allowed in 1977 in Wyoming when the state passed legislation allowing limited liability companies.) The limited liability corporation (or partnership) was created. 

The good news is that LLCs are superior to corporations in many respects. Organizing as an LLC and then electing to be treated as a regular or S corporation is quite common. 

Before I outline how dangerous commingling of business and personal funds are, let me first outline the legal difference between an LLC and corporation.

Legal Difference Between an LLC and Corporation

LLCs and corporations are organized at the state level so the rules can vary between state. I practice as a tax professional (enrolled agent) so what I am about to share is how I understand the difference between LLCs and corporations as told to me by attorneys. Always consult a competent legal professional prior to organizing a legal entity (LLC or corporation).

This is the one difference, of many, between the LLC and corporation I consider the most important. It is best illustrated by using two almost identical firms facing a legal challenge.

Example

Two groups of twenty doctors join together to start a practice. The first group of doctors organizes as a corporation. It does not matter if they are a regular or S corporation as those are tax designations and we are only considering legal protection in this example. The second groups of doctors organizes as an LLC. They can elect to be treated as an S corporation, but they are still legally an LLC.

A doctor from each practice face a lawsuit. In the corporation practice all doctors are liable for the acts of each other doctor (all-acts). The doctor sued in the LLC is the only doctor liable; the other doctors are not liable for the acts of other doctors in the LLC (own-acts).

 

This is a huge advantage to businesses with multiple owners. Not only is there a legal wall between your business and personal wealth; there is a wall between you and the other LLC members and their actions!

Serve yourself a big, juicy tax cut by never commingling. Lower your taxes and reach financial independence sooner by following this one simple rule. #taxcut #commingling #financial #financialindependence #retirement #business #smallbusinessEach state has their own laws governing how this will work in their state. The state you organize in is the state laws you follow. (You can organize an entity in any state even if you don’t do business there.) 

Limited liability, whether from an LLC or corporation, can be pierced. You may have heard the term “piercing the corporate veil”. What that means is certain actions can cause your personal belongings and wealth to be at risk even though you have the protective entity structure.

 

I don’t know if I can shout this loud enough. If you commingle personal and business funds you almost certainly lose all the asset legal protections provided by the LLC or corporation!

 

So, when you commingle you lose the single greatest advantage to having the entity structure.

Here are two simple rules to consider when contemplating commingling:

Rule 1. Commingling invalidates your LLC and all your personal assets are at risk: lake house, mountain retreat, boat, kids college fund etc are at risk in a lawsuit or asset seizure. 

Rule 2. No commingling. If confused, see rule 1.

But it gets worse!

 

Tax Issues When Commingling

Losing all your legal protection is a disaster, but then you face tax issues.

Commingling is the bane of every tax professional. Poor recordkeeping is time consuming to fix when time is at a premium during tax season. Bad records are so common virtually all accountants charge more to deal with poor, incomplete or missing records when preparing a tax return.

An informal survey on social media shows many tax professionals refuse to take clients with poor records and even break the engagement if poor records are turned in more than a few years. (It’s low margin work with lots of stress when time is in short supply. Top level tax professionals don’t have time for this foolishness.) The author has disengaged many clients over the years due to commingling.

Cathy Bryant, a former IRS revenue agent told me, “The fastest way to get into tax and money problems is to commingle funds.”

What does Bryant mean by this? Well, when you commingle funds you really have no idea what your real income and expenses are. The mixing of business and personal funds means the IRS can run over you, causing you to pay more taxes, and you have no recourse because you have no idea what your numbers really are. 

If you are a corporation or partnership (or LLC treated as such) you have the added issue of basis. There is no room in this post for a detailed review of basis, but know this: If you don’t know your basis there can be some very nasty tax surprises in your future.

Also, the IRS can revoke your S election if you commingle funds because you are not treating the S corporation like a separate entity. This means you could face serious additional taxes in an audit without recourse. Re-read this paragraph again S corp owners until this sinks in. If the IRS discovers commingling in an audit it could bankrupt you!

 

Avoiding Commingling

I hope I put the fear of God in you with the warnings above. Every tax professional should keep this post and show it to clients who commingle or are contemplating it. Remind the client the next step is ending the engagement. (Most tax professionals require an engagement letter be signed prior to working on an account. The engagement letter outlines the services provided and fees.)

Your legal protection is gone when you commingle. 

The IRS has you when you commingle. The IRS auditor will assess more tax and get away with it due to your poor records and commingling of personal and business funds. Revocation of your S election will be a financial disaster.

Avoiding commingling is actually very easy. If you don’t want to handle the bookkeeping yourself, hire it out. It is cheaper than overpaying your taxes and losing legal protections

Here are the rules you should follow when you have a business, no matter how small. Even a side hustle treated as a sole proprietorship should follow these rules.

 

Rule 1: Use separate bank accounts and records. The easiest way to keep personal and business monies separate is to have separate bank accounts for business use only and records dedicated to the business. Use any bookkeeping software you want, even an Excel file works.

When the business needs money you can invest money into your company by moving money from your personal account to the business account. This will show on your Balance Sheet equity accounts as a contribution or investment. It will add to equity basis for tax purposes; a good thing, especially for S corporations.

Once your business is profitable you can distribute money to the owner: you. Record the transaction as a distribution. You may also have a wage from your business if you are an S corporation. The distribution is the profits paid you (think of it as a dividend on your invested capital) after your wage is paid.

 

Rule 2: Treat the business like the separate entity it is. If you were the CEO of Apple you would not mix your personal funds with the corporations. I know, I know! You are not Apple. But you should still treat the business, even if 100% owned by you, as a separate entity (which it is).

There is no problem with you investing in your business or distributing excess funds. To do this you just transfer money into or out of the business account. The transaction is recorded on the books of the business accordingly.

Never deposit a business check to your personal account! The business should never pay your personal bills, either! (Transfer the money from the business to your personal account if you need business funds for personal expenses. This will leave a clean paper trail sure to please your tax professional and thwart a zealous IRS auditor.)

 

Rule 3: Consider a loan to/from shareholder account.  You can also lend money to and from your business.

When you have a small business it is hard to always separate all expenses. For example: you might have one mobile phone for business and personal. Having two phone would not make sense for such a small business. Since the phone is in your name you can pay the bill and have your business reimburse you for the business portion, currently a 60% safe harbor.

The same applies to mileage, meals or any other hard to separate business expenses. Your business can reimburse you for personal payment of business expenses. This is called an accountable plan and acceptable to the IRS (and distinguished tax professionals everywhere).  

Don't let the IRS tax your credit card rewards. If you commingle business or side hustle money with personal funds the IRS can tax some or all of your credit card rewards. #creditcardrewards #rewards #creditcard #taxes #IRS #comminglingI understand many small businesses frequently transact funds with an owner. Rather than record each of these transfers in an equity account, consider using a loan to or from shareholder account. If you take many distributions during the year treat it as a loan to shareholder. On the last day of the year convert the loan to a distribution. It is cleaner than running numerous transactions through equity accounts.

Credit card rewards also cause many business owners to commingle funds. I understand you want the most cash back so you want to run personal and business on one card. 

This isn’t a problem as long as it is one card and not credit card churning. If you want to churn, don’t involve the business; it becomes a mess really fast with the legal and tax consequences listed above.

However, you can have one credit card for business and personal. Reconcile the business portion of expenses on the card. If you pay with a business check make sure you list the personal spending as a loan to shareholder. If you pay the credit card bill with a personal check either get a reimbursement from the business or record as a loan from shareholder.

 

Commingling is the bane of the accounting, bookkeeping and tax preparation businesses of the world. Keep business accounts and spending separate. 

Good tax professionals will either charge for fixing your books during tax season and are likely to disengage. Then you are left with a second tier professional, if you can even find one willing to deal with such a mess.

In a tax audit you don’t want a revenue agent to see you commingled funds. They will have a field day with you if you have. 

Most of all, you want clean books so you know where your business stands financially and can make better business decisions. 

And if your tax professional asked you to read this it means you either comply or are gone. Life is too short and tax professionals are under a lot of stress. Help them help you pay less tax. Never commingle funds.

Ever!

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here.