Often small business income statements misrepresent profit as compensation expense or misrepresent compensation expense as profit. Distinguishing between profit and compensation expense can be problematic.
In many, if not most, small firms the owners are actively engaged in operating the business. These owners contribute investment dollars and many hours of full time service to their businesses. Cash payments from a firm to its owners can be considered as either returns on owner investment or compensation for services provided. Unfortunately, GAAP provides no reliable means to distinguish between returns on investment versus compensation for owner labor. Only the former constitutes economic profits. The latter constitutes wages.
Under GAAP, payments made to owners of unincorporated firms are never classified as wages. Such payments are always recorded as owner or partner draws in the equity section of the balance sheet. This is the case, even if the cash withdrawals are in substance payments for services the owner renders to the business. Such payments should be considered wages, because if the owner did not provide the services the business would have to pay an employee wages to do so. An example will clarify this point.
Example. Consider two law firms. Steve Stickum Law Office operates as a sole proprietorship and, hence, is unincorporated. Charles Churnum SC operates as a corporation. Both firms have $300,000 of revenue and $175,000 of expenses not related to payments for owner labor. In each firm, the owner is an attorney who works 3,000 hours per year and is responsible for virtually all revenue generated. Cash withdrawals paid to Steve Stickum are classified as owner withdrawals that reduce equity and are not reflected in the income statement. Cash payments made to Charles Churnum are classified as wages and are reflected on the income statement. Here is a side by side comparison of the two income statements:
It appears that Stickum is significantly more profitable than Churnum SC, but from an economic point of view both firms perform identically. For Stickhum, form is trumping substance. GAAP does not require firms to reflect payments for owner labor as an expense, because management would have to decide how much of the cash withdrawals reflect a wage payment and how much reflects a return on investment. Such allocations often are subjective and difficult to make.
Another problem is that often there is not enough cash generated by a business to adequately compensate an owner for his or her services. Consider this example.
Example. Two retail companies in the same product line have $500,000 of sales, $250,000 cost of goods sold, and $250,000 of non-owner expenses. The owner of the Eke Company contributes no significant services to the business. On the other hand, the owner of the Squeak Company works 3,500 hours a year in the business. Since neither company had sufficient cash to pay the owners, neither owner received any cash. This is what the income statements look like side by side.
It appears from the income statements that both companies had the same lackluster, break-even performance. But the economic performance of Squeak was much worse than Eke’s, because Squeak required significant services from its owner, simply to break even. Eke broke even without such services. Even if GAAP required firms to distinguish payments to owners as either wages or profit, economic distortions like these would continue to exist.
Direct cash payments to owners are not the only source of problems in assessing the profitability of small businesses. Frequently, small business owners pay themselves lavish fringe benefits in the form of travel, automobile, entertainment, and meal expenses. These payments may greatly exceed the amounts that would be paid to non-owner employees. In this way, profits may be understated.
Another important aspect of small business performance that is not reflected in the income statements concerns the extent of satisfaction the owner derives from running the business. In most small firms the owner spends many hours working in the business. This work experience may be largely positive or largely negative. However, the overall level of satisfaction the owner derives from owning and operating the business may not be directly related to the cash compensation received. In many cases, the relationship may be inverse. Consider this example.
Example. Greg Grind, CPA, has a client Larry Laidback, a professional folk guitarist. Every year at tax time, Greg reviews Larry’s income statement. Very rarely has Larry’s net income exceeded $20,000 per year. One year Greg asked Larry how many hours he works per year. Larry estimated that promotional activities, rehearsals, song writing and performances account for about 60 hour a week, or about 3,000 hours per year. Greg quickly calculated that Larry makes about $6.70 per hour. Greg smugly thought to himself that he nets about $120,000 per year working, only about 2,000 hours. This translates to $60 per hour, approaching ten times the hourly compensation of Larry. Greg asked Larry if he ever thought about how much he makes per hour. Larry laughed and said “No, because I have enough to live on and I am doing exactly what I want to be doing in life.” As Larry’s answer sunk in, Greg’s smugness turned to sadness because he could never say that his work represented exactly what he wanted to do with his life.
In this example, Larry’s business offers him personal satisfactions that are not reflected on his income statement. Greg’s business related dissatisfactions are not reflected on his income statement. For small business owners, the satisfactions or dissatisfactions derived from operating their firms constitutes important positive or negative returns that income statements are incapable of quantifying.