As April beckons, thoughts of tax returns are common, not just in accounting firms, but for every person who has to file a return. Many people only think about their returns when they are due and when the topic of tax returns is in the news. The most prevalent time that tax returns make headlines is in the period up to a significant election.
It has become common practice for candidates to consider releasing their returns as a form of transparency, but a personal tax return is somewhat limited in what information it provides to a reader.
The main purpose of a tax return is to report the amount of income earned in a year, applicable deductions and credits, and the amount of tax liability. Plenty of other information about a person’s wealth is unattainable through the perusal of a Form 1040.
The two most basic financial statements are a balance sheet and an income statement. A balance sheet shows the assets and liabilities of the reporting entity, and the difference is the net worth (or equity) of that entity. An income statement shows the activity for the most recent period or year, from an income and expense standpoint.
For many entities, an income statement is very valuable. It shows a picture of operations for a period of time. When a business analyzes its results, the first thing it generally looks at is its income statement. It wants to see how much revenue it earned in a period and how much it spent, leading to the bottom line of net income for the period. Based on how the company views those results, it will make decisions for the future to improve or maintain financial outcomes.
Individuals, on the other hand, may look at their personal income statement from a budgetary standpoint, but they are often more focused on their personal balance sheet, i.e. what they own and what they owe. An individual’s balance sheet gives a much clearer picture of one’s financial health.
For example, a credit score is used by lending companies, and they focus on aspects of a balance sheet and not on an income statement. Similarly, investing in certain businesses (for instance, a restaurant franchise) requires a set amount of personal net worth, which is a balance sheet metric.
In applying for a home purchase, the mortgage company will probably ask for a tax return because they want to see income levels to ensure that the debt service will be covered by monthly income from the borrower.
So, if you have filed your return for 2016 or are about to, realize that there is a benefit of that return to the taxing authorities and to some potential lenders, but that, otherwise, the use of the information from a Form 1040 is limited to those purposes and little else.
By Dan Massey, CPA, Manager