The well-known and elementary method of determining a profit (or loss) is a simple method of deducting expenses from income. This is how accounting students are taught in Accounting 101, or at school.
To tamper with taxable income, adjusting sales reduces businesses profits. Or alternatively to impress stockholders, profits are artificially boosted by either tampering with expenses or accruing for sales, not realized. (Remember the accounting scandals and corporate failures a few years ago?)
Drawing up an Income Statement is considered easy, since the income less expenses exercise can be performed by anyone. The oversight of many aspects of accounting, such as double entry, accruals and book entries such as depreciation, has created many problems for novices, with Tax Authorities.
The simplistic Profit and Loss statements drawn up mostly by sole owners are grossly out of balance, since the asset component of accounts could be overlooked, or the expenses on a roughly drafted Income Statement could include assets purchased.
Reports would thus not be an accurate reflection of the true state of the business.
The services of an expert accountant should always be budgeted for. If business owners lack the skills, don’t avoid procuring the services of an accountant. In the same way as an attorney is indispensable, so an accountant is necessary to draw up a proper set of accounts!
Whatever means you use as a business owner to record business transactions, Tax Authorities don’t need your Income Statement, to determine true profits. Even without a physical audit, they will determine your true profits, using advanced information technology, as well as advanced accounting methods.
Tax auditors will build an asset base from all data that they can reasonably access, such as properties, vehicles, stocks and bonds, bank accounts and information from your suppliers and customers tax information.
As soon as a picture has been constructed of your assets and liabilities, liabilities are then deducted from assets, and an EQUITY BALANCE, is determined! Using the equity total, less Capital advanced, and previous years profits, an almost accurate figure of profits is arrived at! If this profit is way above the declared profit (Income Statement), the business will be in serious trouble, with the tax authorities.
This method is the simple, but overlooked accounting equation. (Assets-Liabilities=Equity). By just analyzing your balance sheet in this fashion, anyone can double-check the profits in relation to the income statement profits.
For the business owner it is important to bear in mind that the Balance Sheet method can be used for his internal accounts evaluation as well. More so, in an incomplete accounting environment.
In conjunction with an accountant, a balance sheet “profit” can be determined and reconciled back to an income statement profit. The trial balance is not always sufficient for proper balancing and profit determination. Assets beyond trial balances may exist that are not properly accounted for.