Managing your Profit Level – Tips & TricksFirst Published: March 2021 | Available in: Property Articles Your Property Network
The profit that a business shows is obviously a visible indictor of its financial success and performance. Not surprisingly, lenders and other third parties will usually look at the profitability of a business, plus there may be tax reasons why it may be desirable for profits to be higher or lower in a particular year.
This article looks at how profit is calculated, and what factors can increase or reduce profits, plus why it may be beneficial for profits to be managed, legitimately.
For the purposes of this article, the business in question is a simple property investment company i.e. a company that owns properties that are rented (although many of the points will apply to other types of company, and ‘sole trader’ landlords).
What is profit, exactly, and how is it calculated?
“Profit” is simply income less expenses, however ‘GAAP’ (‘Generally Accepted Accounting Practice’) dictates how both income is included in accounts, and how expenses are shown.
Generally, the start point in calculating ‘profit’ is income received less expenses paid.
However, as accounts cover a defined period of time (e.g. 1st April 2020 to 31 March 2021), funds that are received or paid may not always be treated as income or expenses in that accounts period – for example:
Income – a company receives rent for April 2021 on 31st March 2021 – so, including this money in the bank as income for the year ended 31st March 2021 wouldn’t be correct, since the income actually relates to after the year-end – therefore this amount would be ‘accrued’ onto the balance sheet of the company, and so not included as income in year ended 31st March 2021.
Expenses – a company pays it’s annual insurance on 31st March 2021, which covers the period 1st April 2021 onwards – so, including this as an expense in the year ended 31st March 2021 would mean showing profits lower than they really are for that year. The insurance has been paid in advance and so should be put onto the balance sheet as ‘prepayment’.
OK, I get it, but what ways could profits be changed?
A company’s ‘accounting policies’ dictates how income and expenses are shown in the company’s accounts – however, subject to what is allowed by GAAP – a company has flexibility to set it’s own accounting policies – such as:
1. Amortising repairs
Most landlords and property rental companies will choose to include repairs in the year they are incurred. But, given that many types of repair costs will benefit the property and business over a number of years, such costs can be ‘amortised’ (spread out) over a number of years.
e.g. a new bathroom costing £2,000 may last (say) 5 years typically before more spending is required. If the accounting policy is to amortise repairs over 5 years, the business would include the cost over 5 years, so £400 per year. The remaining £1,600 of “unamortised” cost is added to the balance sheet, and so the cost is spread evenly over 5 years rather than the full cost included in year 1. In this example, year 1 profits would therefore be £1,600 higher if repairs are amortised in this way.
2. Amortising finance costs
Most mortgages incur set-up costs such as valuation fees, arrangement fees, solicitor costs etc. As with repair costs, these costs can be spread out over the life of the loan, if required (whereas, interest incurred would only be included in the relevant year).
e.g. a new 25-year mortgage incurs an arrangement fee of £2,500. If the accounting policy is to amortise finance costs over the mortgage term, £100 per year would be included in the accounts. The remaining £2,400 of “unamortised” cost in year 1 is added to the balance sheet, and so the cost is included at £100 per year over the life of the mortgage. In this example, year 1 profits would therefore be £2,400 higher if finance costs are amortised in this way. (Note: if the mortgage is re-financed before the 25-year term, any ‘unamortised’ cost would just be taken as an expense in the year the mortgage is renewed).
3. Management fees
Many business owners have more than one company, in which case their management efforts for each company can be reflected by charging management fees from one company to another. Care is required to ensure that VAT doesn’t need to be charged on the fees, if VAT is relevant.
This can be beneficial if a company owner is trying to move profits from one company to another, perhaps to boost profits in one company or to re-allocate costs more fairly, or to utilise tax losses that if incurred in a previous year can’t be transferred between companies.
4. Depreciation rates
Most companies will have some non-property assets that need to be depreciated e.g. computers, IT equipment, vehicles etc. These can be depreciated over the life of the asset, but the number of years is a judgement area e.g. computers and similar could be expensed fully in the year of purchase, or amortised over (say) 5 years.
5. Income ‘recognition’
Income may be received before a year-end that should be ‘deferred’ and included in the following year of accounts, or vice versa. Similarly, management fees and other income that has been earned (i.e. the work has been done) can be included in the current year accounts, even if the cash itself hasn’t been received.
Of course, for most property businesses, rental income is received because it is due, and so effectively the income is accounted for on a ‘cash received’ basis. However at either end of an accounts year there may be scope to include or exclude income from that year.
6. ‘Hard’ costs vs ‘soft’ costs
Accountants sometimes refer to costs as being ‘hard’ costs or ‘soft’ costs. Hard costs are actual expenses incurred (e.g. mortgage payments, utility bills), whereas soft costs are expenses that can be claimed, but don’t have to be.
Hard costs have to be included in accounts, as not to do so wouldn’t be correct as the cost has actually been incurred.
Soft costs however are more discretionary, and a business could choose not to claim for such costs if increasing profit were the objective. Examples of soft costs could be home office allowances, business mileage, travel, etc.
Similarly, discretionary salaries paid to family may be included as a year-end accrual if required – as long as actually for work done and paid within 9 months of the year-end – however many landlords and company owners choose not to pay their family, to improve the business’s profits (many do the opposite!).
7. Capital vs revenue repairs
Most landlords are familiar with the concept of ‘capital’ repair costs (improvements) versus ‘revenue’ repair costs (maintenance), and the rules are fairly well-defined.
However there is still significant judgement involved in assessing the split of costs between these categories, and some property business owners will err more towards a more conservative capital allocation, whereas others may err more towards repairs being expensed.
For many property business, a typical refurb may genuinely involve a mix of capital and revenue repairs, and so there is an element of judgement and estimating required – rather than there being a “correct” figure – it may very well be that one landlords and accountant would see a project split as being 50-50 capital / revenue, whereas another landlord and accountant would see the split as 25-75% – the point being, this isn’t an exact science.
8. Using provisions and accruals
An accrual is a ‘reserve’ for a cost (usually) that has been incurred, but which the bill hasn’t yet been received – it’s very common for a company to ‘accrue’ for a cost (e.g. an accountant’s bill!) that has been incurred (if the services or good have been provided by the year-end), but the bill hasn’t been received.
Similarly a ‘provision’ is a type of reserve but for something that hasn’t yet happened, but might e.g. an amount owed (a ‘debtor’ or ‘receivable’), but which there is doubt about whether it will be paid, in which a provision could be made for the likely unpaid amount.
Accruals and provisions for costs are an expense, and so reduce profits.
Accruals and provisions may also apply to income, for example, it is now fairly common for a property company’s funds to be used to provide private loan finance to other property people. Generally the interest would be paid at the back end when the loan is repaid, but the lender company can ‘accrue’ the income it has earned each year, thereby increasing each years income, even though the total (loan + interest) maybe received at the back-end.
9. Changing the year-end
Many businesses, including property, are seasonal in nature and so income and profits don’t accumulate evenly through the year. And, sometimes events happen that mean a year-end change could make a big difference to a particular year’s profits.
For example, a student HMO property rental company could see most of it’s rental income received between September and May – so, shortening the year-end to 31 May would increase profits, all things being equal, as the costs incurred in June and July would be included in the following year’s accounts.
Similarly, it is quite common for property developers to want to extend a year-end if there are extra sales made just after an accounts year-end, so that the extra sales can be included in the current year of accounts.
Many property businesses will have a stock of materials (paint, tiles, carpets, tools & equipment, white goods etc), that rather than being included as a cost when incurred, could instead be treated as stock, and so included on the balance sheet as an asset, rather than as an expense (the item would become an expense only when actually put into use).
The point of this article is to demonstrate that “profit” from an accounting view is not a fixed number, as in most accounts there are judgements and estimates required, and decisions about how to account for income, expenses, assets and liabilities.
While there are rules in many areas, and expectations / norms in other areas, there is still plenty of scope for profits to be legitimately made higher or lower, depending on the business owner’s view and objective.
Of course, lenders use financial information in different ways, and some ask more questions than others (not that there is a right or wrong number or type of questions to ask!), so any borrower should answer questions truthfully, and not try to deliberately mis-state their position, beyond what are normal estimates and judgements in any set of accounts.
Similarly, many judgements, estimates and decisions when producing accounts will have a knock-on tax impact – sometimes there is a trade-off between wanting to show a high profit but not wanting to pay too much tax – although often it is more a case of when the tax relief is achieved (sometimes known as a ‘timing difference’). HMRC would certainly expect accounts – which are the start point for tax calculation – to be produced using commonly used accounts principles GAAP … albeit business owners have more freedom than they might imagine when calculating what their ‘profit’ is.