# Profitable business showing paper loss?



## indexxx (Oct 31, 2011)

I have a convoluted question. It it possible for a business (not a home-based freelancer, but a normal brick-and-mortar affair like retail or restaurant) to have a yearly net loss on their profit and loss statement, yet at the same time, the owners are actually making good money? I'm looking into a business, and the P&L statement show a loss on paper, mainly due to a lot of expenses deducted from the gross profit after COGS. But the owner's Revenue and Expense statement for the same period shows a salary and net income totalling $60,000. 

Is there a tax benefit to showing a business loss? I'm thinking that the accountant could have found ways to pad the expense side to show a paper loss, while the owners are actually doing well. Would this make sense?


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## Potato (Apr 3, 2009)

In all the cases I can think of, salary is a legitimate expense, so it's possible the owners are getting paid via a salary even if the business is losing money... but you have to ask yourself if that's sustainable. What would the salary be to make the business break-even?

For some businesses, net income can be negative due to non-cash expenses (depreciation in particular), yet cashflow can be good. This is the business model for many REITs and income trusts. Say you have a building that in reality is holding its value or appreciating, yet the tax code lets you depreciate some percentage (I think 4%) of the value each year as an expense. If you had an operating profit (revenue - operating expenses) you could send some of that out to the owners while showing a net loss once the depreciation is added on. With some other equipment with high depreciation rates you can get temporary effects similarly. For instance, not so long ago you could depreciate 100% of a computer in the first year. If you were just starting up and needed a bunch of computer equipment, you could show a loss that year, even if you expect the computers to last 5. 

But at some point reality will set in: either the building will actually start to depreciate because the cash flow is not being used to maintain it, or you'll sell it and have a massive taxable capital gain. In the case of rapid expansion, eventually that phase stops and you coast on the equipment you have; with much of the depreciation expense consumed your reported profits shoot up and you pay more in taxes through that part of the cycle (in that case I'd be wary of buying a business that looked too good, because there might be another round of capital investment in the future). The CRA doesn't go in for truly fictional expenses, so expect that either the business truly is losing money and the owners are paying themselves more salary than they should be, or assume that at some point the non-cash expenses like depreciation will be used up and tax liability will increase.


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## Four Pillars (Apr 5, 2009)

Indexxx, I have to be honest with you - you don't seem to have some of the basic financial skills necessary to evaluate a business. Are you going to be able to run the business side of things if you end up buying it? Do you want to?

If you are buying a small business for yourself, you are the business. If there is extra cash being made from the business then you can take it all as salary and the business will have zero profit. Or you can take more money and the business shows a loss or you can take nothing and the business will be very profitable.

As Potato said - depreciation charges can be quite significant for some businesses.


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## Homerhomer (Oct 18, 2010)

Have an accountant look at details however in a nutshell if you are looking at the restaurant that doesn't own the building (ei you are buying just the business not the building), your amortization expenses shouldn't be that big in a big picture, we will also need to assume that all sales are reported ( yeah right) and all expenses are legit.
You will now have to look at wages, of all wages which are paid to non related employees, and which are paid to shareholders and relatives. Are the relatives doing actual work or are just there to spread the profit (which is not legal either if they don't do the actual work), if they are actually working than in your case you will actually have to hire employees and pay them, if they don't work just collect the paycheque than the business is actually doing better than it shows..... you get the jest?


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## Four Pillars (Apr 5, 2009)

Homerhomer said:


> you get the jest?


You mean "gist"? Or was that a joke (that might have gone over my head)?


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## Homerhomer (Oct 18, 2010)

Four Pillars said:


> You mean "gist"? Or was that a joke (that might have gone over my head)?


sorry, English is not my first language and sometimes I mix things up ;-), I was in a very serious mood ;-)


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## Four Pillars (Apr 5, 2009)

Homerhomer said:


> sorry, English is not my first language


Really? I never would have guessed. Your English is perfect as far as I can tell.


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## indexxx (Oct 31, 2011)

Four Pillars said:


> Indexxx, I have to be honest with you - you don't seem to have some of the basic financial skills necessary to evaluate a business. Are you going to be able to run the business side of things if you end up buying it? Do you want to?
> 
> If you are buying a small business for yourself, you are the business. If there is extra cash being made from the business then you can take it all as salary and the business will have zero profit. Or you can take more money and the business shows a loss or you can take nothing and the business will be very profitable.
> 
> As Potato said - depreciation charges can be quite significant for some businesses.


Hi FP- Yes, I do have the skills to run the business in question, as I recently turned around a similar business that was doing triple the gross yet had never had one month of profit. I took over as the GM after they had lost money for a year and a half, and tweaked all aspects of operations to finally make it a profitable venture for the owner. What I do lack is in-depth accounting knowledge, meaning I do not know what can or cannot be done by an accountant to make a business look unprofitable, or, as my question asks, lose money on paper while the owners are actually taking decent money out. The crux of the issue is their expenses after COGS- I am going to meet with their accountant in the next while here and ask what exactly had been expensed under different categories, as it seems likely to me that there were many things that would not apply to me. Some of the expense is depreciation, but there are many categories of expenses deducted on their P&L that are not itemized.

Given that the current owners had no prior experience in this industry, it seems possible to me that they made a few large errors at startup that they needed to recoup; they have admitted as much to me and I'm thinking it could have been done through creative accounting, hence my question here. I have my own accountant that I am going to speak with as well.

As you say, you can take more money out and the business will show a loss- which is why I asked this in 'Taxation'- is there a benefit to showing a business loss?


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## Charlie (May 20, 2011)

If the loss is slight, they may be recognizing enough salary to offset taxable income in the corporation. 

But there are no complicated accountant tricks to make a business unprofitable. If they are cheating in the restaurant biz, they're probably underreporting revenue. Cash sales are a lot easier to fudge then expenses. (and if they're being dodgy with the tax man and you buy shares -- you buy the exposure). There may be a bit of auto, cell phone, home office, or fees and wages to owners and family that are discretionary, but overall, the operating expenses tend to be what they're listed at. Have the accountant back out 'owner related' items to see what the business is making.

And don't automatically disregard depreciation. Figure out what items you'll have to replace. Equipment buys show up on the income statement as depreciation (over time). So figure a replacement budget for stuff and leaseholds.

If you proceed with this, find an accountant or bookkeeper who is familiar with restaurants and make sure you review the statements no less then monthly. Track your sales daily.


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## Charlie (May 20, 2011)

the other reason they might be drawing more salary then income (thus creating this corporate loss) is if they've financed the business with loans and have drawn those funds out for personal living expenses.

if the cash has left the company, it has to either be salary (or dividends) or a loan to the shareholder. The shareholder cannot owe the company over two fiscal yrs, so, in time, what you take out often has to be reflected as salary -- even if the corporate tax deduction doesn't have any immediate benefit.


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## indexxx (Oct 31, 2011)

Charlie said:


> If the loss is slight, they may be recognizing enough salary to offset taxable income in the corporation.
> 
> But there are no complicated accountant tricks to make a business unprofitable. If they are cheating in the restaurant biz, they're probably underreporting revenue. Cash sales are a lot easier to fudge then expenses. (and if they're being dodgy with the tax man and you buy shares -- you buy the exposure). There may be a bit of auto, cell phone, home office, or fees and wages to owners and family that are discretionary, but overall, the operating expenses tend to be what they're listed at. Have the accountant back out 'owner related' items to see what the business is making.
> 
> ...


Thanks Charlie- you're correct, that's exactly what I am going to ask of their accountant. There are definitely some personal things expensed to the company- I know the husband bought a car and it's been deducted, for example, as well as phone etc.


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## indexxx (Oct 31, 2011)

Charlie said:


> the other reason they might be drawing more salary then income (thus creating this corporate loss) is if they've financed the business with loans and have drawn those funds out for personal living expenses.
> 
> if the cash has left the company, it has to either be salary (or dividends) or a loan to the shareholder. The shareholder cannot owe the company over two fiscal yrs, so, in time, what you take out often has to be reflected as salary -- even if the corporate tax deduction doesn't have any immediate benefit.


OK, that's also what I was thinking. I know they made some large kitchen equipment purchases and that they did take a personal loan to finance the startup. As I say, the company's P&L shows a yearly net loss of $24K, but their Revenue statement shows an Owner Salary of $32K and Net Income of $27k.


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## Cal (Jun 17, 2009)

You would be amazed at some of the things that a good accountant can decipher from the numbers for you.


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