As a self-employed individual, you may not have considered the need to prepare financial statements for your small business. However, there is one financial statement you may be required to prepare for tax purposes, and that is the profit and loss statement the IRS requires from sole proprietors.
Each year when you complete your trusty Schedule C as a self-employed individual, you are in effect creating a year-to-date profit and loss statement of your self-employed activities. You will need to fill out and file the form in a timely manner in order to satisfy IRS profit and loss reporting requirements for sole proprietors.
If you're self-employed, you may also find it beneficial to prepare a profit and loss, or P&L, statement for purposes other than compliance with taxation requirements. For example, if you intend to approach a lender to negotiate financing for your business, you may be asked to provide various financial statements along with your application, including a profit and loss statement.
Profit or loss from business (sole proprietorship): Schedule C (Form 1040)
The IRS requires sole proprietors to use Profit or Loss From Business (Sole Proprietorship) (Schedule C (Form 1040)), to report either income or loss from their businesses. How do you know if the activity in which you're engaged qualifies as a business? According to the IRS, it's a business if:
- Your main reason for engaging in the activity was to generate income or make a profit; and
- You participated in the activity on an ongoing, continuous basis.
Preparing the profit and loss statement for small business
If you answered "yes" to points 1. and 2. above, you'll be required to file Schedule C (Form 1040) with the IRS. The form can be found on the IRS's website, along with detailed instructions for properly completing and filing it.
In general, the IRS permits Schedule C (Form 1040) to be completed using either the cash method of accounting or the accrual method. However, the rules currently require the accrual method to be used for sales and purchases of inventory.
With the cash method, you report income you've actually received during the year, and your deductible expenses are amounts you actually paid during the year. The accrual method requires you to report income in the period in which you've earned it, regardless of when you receive the income. Under the accrual method, expenses are deducted when you incur the expense, even if you don't end up paying the expense during the current tax year.
Change of accounting method
Once you've filed a P&L statement using a particular accounting method, if you want to change the method (regardless of whether you've been using the cash method or the accrual method) you'll need to file an Application for Change in Accounting Method (Form 3115) in order to change to a different accounting method. An IRC 481(a) adjustment also may be required, in order to ensure that income or expenses are not duplicated or omitted.
Profit and loss statement analysis
In addition to being required by the IRS, as a self-employed individual, you may also find it useful to prepare a profit and loss statement for your business if you've applied for financing.
Potential creditors can use your P&L statement to conduct a profit and loss statement analysis. This analysis uses the numbers you provide to aid a creditor in the assessment of the viability and financial health of your business. This is an important assessment, as the result can have an impact not only on whether a creditor will extend credit to your business but also on the amount of credit and the types of payment terms the creditor will offer you.