Basis? Variance? What Do These Words Mean?

July 1, 2014

Understanding accounting and tax terms is crucial to your financial success. Yet the language of money management can be confusing to investors, business people and taxpayers alike.

Sometimes even simple words have more than one meaning. For example, you know that a credit is the red-ink side of an accounting journal entry. You also know credit is a way of spreading out payments for goods. But you might not be aware that credit has a third meaning – as a tax term that can save you money.

Here are brief definitions of some commonly used terms:

• Above-the-line deductions – A tax term for subtractions from gross income. For maximum tax savings, make sure your accountant is informed of your retirement plan contributions, moving expenses and self-employed health insurance costs.
• Accrual basis of accounting – The recognition of income and expense when incurred instead of when cash is exchanged. Accrual accounting presents a realistic financial picture by recording income and expense in the period when they are actually incurred.
• Acid test – An investing ratio. Business owners and investors divide cash by current liabilities to measure a firm’s ability to pay current debt. A higher ratio indicates less risk of default.
• Basis – A tax term for the dollar amount of your investment in property. Because your basis directly affects your gain, keeping accurate records of asset purchases is essential.
• Credit – In addition to being a bookkeeping term, credit is also a valuable tax concept. Credits, such as those for childcare and education, generally reduce your tax by the amount of the credit or dollar for dollar.
• Defer – Reporting income or expenses at a later date. This technique can be useful for tax planning, especially if your bracket will change in a future year.
• Defalcation – Embezzlement, or the theft of assets by falsifying accounting records. Though it may be little consolation to business owners, embezzlement income is taxable to the embezzler.
• Footnotes – Explanatory statements at the end of financial statements. Investors tend to overlook footnotes, but they offer “plain English” information about the company’s financial story.
• Itemized deductions – Expenses that can be deducted in computing taxable income. Medical expenses, property taxes, mortgage and investment interest, and charitable contributions fall into this category. Itemized deductions are generally less valuable than credits because they reduce taxable income instead of taxes.
• Retained earnings – Profits that a company keeps to invest in its own growth. Many startup companies retain their earnings instead of paying dividends to shareholders.
• Subchapter S corporation – A corporation that chooses to have its income taxed to the individual owners. An “S” corporation combines the flexibility of a partnership with the limited liability of a corporation. The corporation must qualify for this status under the rules of Subchapter S of the Internal Revenue Code.
• Variance – The difference between actual income and expenses and budgeted amounts. It’s a useful tool for investors who want to compare current year and prior year amounts in financial statements to detect trends.
• Wash sale – A tax term describing the sale of stock or securities and the purchase of identical securities within 30 days before or after the sale. Investors who want to balance their gains and losses should be careful not to run afoul of wash sale rules. For tax purposes, losses on wash transactions are disregarded.
• Window dressing – Attempting to make a balance sheet or income statement look better than reality. Examples include recording sales before they are earned and not accounting for all expenses. Window dressing could indicate fraudulent activity.
• Unlimited liability – A drawback of the sole proprietorship and general partnership form of business. In the event of a lawsuit, if there are not enough business assets to settle creditor claims, the personal assets of the business owner are at risk.

Business, investing and tax issues are complicated enough without the added confusion of unfamiliar vocabulary. Understanding the terminology helps.