By Peter Cuttini, CPA, CA, CPA (US-Illinois)
Your financial statements are more than just a set of documents that your accountant prepares for you each year. They are key tools in your real estate investing toolkit. Understanding the key parts of the financial statements, and what they mean, is critical to understanding your business and how it has performed.
What Is The Purpose Of Your Financial Statements?
The main purpose of financial statements is to provide information on your company and real estate business by determining:
- how well you did for the year,
- the financial health of the company at year end,
- and the cash flow of the company.
Different people you deal with as part of your real estate investing business use these financial statements for their own purposes:
- A lender will look at the financial statements to determine if they should lend you money or not.
- A purchaser may look at the financial statements to determine the health of the company and a fair purchase price for the company.
- Co-venturers will look at financial statements to determine if they want to enter a joint venture with you.
- Last but not least, governments will look at the financial statements to determine the amount of taxes you owe for the year.
What Is The Difference Between Bookkeeping And Formal Financial Statements?
Bookkeeping is the entering of daily business transactions (e.g. property taxes, mortgage amounts, expenses, etc.).
Formal financial statements are the result of reporting, summarizing and organizing the information provided by the bookkeeping. The formal financial statements help you interpret and analyze the results of your company for the year.
What Is Included In Financial Statements?
Most financial statements that we prepare will have two different statements:
- The Statement of Operations (also called an Income Statement) outlines the profitability of the company for the year. Most people feel that this is an easier statement to read.
- The Balance Sheet will give you a snap shot of the assets and liabilities of the company at the end of the year.
What is Amortization?
Amortization is the write down of the cost of a capital asset over a fixed period of time or rate. What you will see on the Balance Sheet for your property purchase is the historical cost basis of the property (what you paid for it) less the accumulated amortization that is taken. The fixed period of time or rate will vary depending on the type of capital and its useful life. For example, a computer has a much shorter useful life than a building. Thus the fixed period of time or rate on a computer can be as short as two years, while a building can have an amortization period of 40 years. We typically take the Canada Revenue Agency tax rates as our amortization. This does not cause a difference between accounting and taxable income.
Why Is My Cash Flow Different Than My Accounting Profit?
We often hear from clients that the income for the year is different from the cash they have in the bank. This happens for many reasons. The most common for real estate investors is the fact that amortization is a yearly non-cash expense and that mortgage principal repayments are not a deduction on the income statement. These two items sometimes do come close to approximating one another, but there are times when these two numbers can be significantly different. One of these times is when you refinance a property to purchase another property. On the financial statement, the mortgage payable will be the new mortgage on the property while the corresponding capital asset will be at historic cost less amortization, not the fair market value of the property.
How Do Historic Cost and Fair Market Value Compare?
We often hear from clients that the current fair market values of their properties are not reflected on the Balance Sheet. This is true. According to General Accepted Accounting Principles, you are not allowed to write up an asset to its current market value, it must remain at the price you paid for it. The main reason for this is that you have not realized the gain and, as accountants, we preach conservatism.
Educating yourself about your financial statements makes dealing with refinancing, property purchases, new investment opportunities, and so on much easier, which will make you a more effective investor.
Peter Cuttini is a Partner at BDO Canada LLP who focuses on real estate investors and their businesses. Peter is an investor himself, who is also part of the REIN faculty.