The Accrual Basis of VAT and Other Hardships of Entrepreneurs

I’ve become a bit of a fan of Pauli Vahtera. If you don’t know him, he’s an accountant, auditor, politician and author who is probably best known as a defender of entrepreneurs and for being against bureaucracy, taxation and wasteful public spending. He writes a column for Iltalehti and Tilisanomat.

I’ve been reading his book Yrittäminen on kaunein tapa ottaa vastuu omasta elämästä (“Entrepreneurship is the most beautiful way of taking responsibility of your own life” [suggestions for better translation are welcome]). In spite of its inspiring title it’s mostly full of complaints about bureaucratic idiocy and downright oppression of entrepreneurs in Finland. Usually people are this bleeding heart about entirely other things so it is rather refreshing to see someone write with such emotional intensity in this context. What he says is, however, obviously grounded on solid facts.

So what is he on about? Oh so many things. The one that inspired me to write this post was his views on VAT and other taxation. The core of the issue in Vahtera’s opinion is the unfair way in which companies have to pay taxes, that is, before actual income arrives on its bank account.

This is all related to the very basic principle of accrual basis. In accounting practice, income is considered earned when goods or services are delivered and expenses are incurred when goods are (or the bill is) received. The actual payment may come later. This being the standard accounting method, the tax man demands its use, of course. That is why a company is considered to owe the state VAT from turnover before actual payment is received. This means that a company needs to have more working capital to be able to pay taxes in advance of having the customer’s payment in hand. For a small business already teetering on the edge of profitability, these kinds of demands for cash in advance from the government may mean the toll of death knells. Vahtera’s idea is that small businesses should be exempt from accrual basis and be allowed to report and pay taxes on a cash basis.

In Finland a cash basis for VAT is in use, but it is only for “Private sole traders” (The Finnish term yksityinen elinkeinonharjoittaja, translation from official forms). So not even for small limited liability companies or any other types operations involving more than one owner may use cash basis. This means really only artisans and other comparable professionals whose business really consists of self-employment without any notable capital expenditures.

With income tax, Vahtera is also proposing a transition to cash basis for small businesses. This would mean e.g. forgetting the idea of yearly amortizing in favor of expensing entire investments the year they are bought.

A highly successful business will of course survive any kind of tax climate and will even voluntarily pay more taxes than it needs (looking at you, SuperCell). Not every business makes millions overnight, however, nor should it be expected to. I agree with Vahtera in that we need to give a break to businesses that might need a bit of a push to get themselves off the ground. In my opinion Finns in general are not too keen on employing themselves and harsh regulations may scare off many of the few who are brave enough to take a chance. Vahtera himself is very passionate about his position and even claims the current regulations destroy businesses (and by proxy entrepreneurs’ lives due to unfair bankruptcy legislation). Part of his hyperbole is probably just a stylistic choice (which works as he did at least grab my attention in a big way).

I took a bit of a browse to see other views on cash-based taxation, but this issue doesn’t seem to be widely discussed, at least publicly. Suomen yrittäjät ry (Finnish Entrepreneurs’ Association ) released a statement in 2009 saying that a cash basis in taxation is a feasible option only if it is applied to both VAT and income tax at the same time. Otherwise businesses would almost have to do their accounting twice if they wanted to apply a cash basis.

Also for fun, I looked to a couple of other countries to compare. Apparently, in the UK, cash-based taxation for income tax is in use for small businesses up to £77,000 in receipts (according to this technical note from HMRC, the British tax agency). British small businesses (up to £1,35 million in turnover) are also allowed to use cash-basis for VAT. The limits for being VAT exempt entirely are also significantly higher in e.g. the UK (£77,000 vs. 8500 € in Finland). In Sweden a business with less than 3 million kronor of turnover may use a cash-based method for accounting for their VAT (also sprach Skatteverket, p. 21).

What really fascinates me with Vahtera’s views is being against accrual basis so much. All through my studies in accountancy I’ve been trying to absorb the whole model of accrual basis, which is in itself completely contrary to most people’s conventional everyday thinking, and IMO one of the biggest singular concept to learn and understand in an Accounting 101 type course. And here’s Vahtera (and others) telling that yes, you were right when you got confused in class. Accrual basis is sometimes crazy and unnecessary.

Vahtera also proposes an exemption from preparing financial statements and merely having small businesses give cash-based tax returns (= no income statement, no balance sheet). I understand his position well. Small businesses don’t have investors and analysts who are actively interested in traditional balance sheets for their decision making (for a small business the only ones making an equity investment are the same people who run the day-to-day operations). The financial statements are really prepared only for taxation purposes, and when in at least the Finnish system, the profit in financial statements (prepared according to the Finnish Accounting Act) is not accepted directly as basis for determining tax, it really makes the whole business not worth anyone’s while. Therefore allowing small businesses to just prepare tax returns and nothing else (and on cash-basis) would be the only logical solution.

One comment does pop to one’s mind though. Small businesses need to be financed, most often by lending from a bank. If we were to go to a system where small businesses do not prepare balance sheets, the whole banking system may need to overhaul their decision making processes and think things over quite a bit.

IFRS for SMEs is another thing Vahtera worries about (“the bureaucracy is expanding to meet the demands of the expanding bureaucracy” [quote source is in dispute: 1, 2] ). While I agree that IFRS standards are quite extensive, according to these CliffsNotes, the IFRS-SME brings things rather close to the statutes of our Accounting Act. So I don’t agree with everything Vahtera says!

I suppose there’s opposition to this, and Vahtera himself claims it comes from accountants and auditors, who benefit because more bureaucracy means more business for them. I think some of the opposition is due to just stubbornness and being comfortable with the status quo. I have my own doubts about these radical views and I can only imagine how doubtful the people who have worked in the field for decades would be. I also talked to one of my professors the other day, and according to him, the Finnish Tax Administration is not in actuality that strict about paying VAT in due time and there is room to negotiate a payment plan.

Part of the problem is indubitably that not all business owners are in the know about these things and wouldn’t when they would need to e.g. apply for a payment plan for VAT. A system that forgives mistakes and ignorance would be fairest, and could produce more tax revenue in total. If setting up a business is known to include legislative tricks and traps, it means it is a riskier endeavor to undertake for anyone, and we are all at least somewhat risk aversive. Thus more bureaucracy = less people doing business = less tax revenue.

All in all, I am personally still quite inexperienced in accountancy, and becoming too enamored with anyone’s hyperbolic complaints of an evil tax bureaucracy should probably be avoided. And it’s hard to say if these things are really the latest trends in Accounting per se, since Vahtera’s book was released in 2011 and I understand he and others have proposed changes mentioned in this post at least early as the 1990s. It is new to me, though, and I hope not entirely obvious and boring to everyone else involved in the field. 😉

Disclaimer: I am not a fan of the Finns Party, nor do I plan to vote for them. If Vahtera was in pretty much any other party, I’d probably vote for him.

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