Tax planning vs. preparation:Darrell W. Cain of Cain, Watters & Associates explains.

This month, Dr. John Jameson discusses a few of the primary factors involved in financial decision making with Cain, Watters & Associates President Darrell W. Cain. Cain, Watters & Associates, PC, is a fee-only certified public accounting firm in Dallas.

by Dr. John Jameson

Dr. Jameson: We often hear doctors talk about having good CPAs who prepare their tax returns and give them monthly profit-and-loss statements, but the doctors don't understand what they're looking at or which numbers are useful. What are some of the most common errors dentists make while looking at their financial statements?

Darrell Cain: Well, John, after dealing with dentists for around 20 years, I think the first error dentists make is looking at statements from accountants and deriving certain answers to questions. One of my great shocks is finding that, after a while, they just have a whole bunch of statements in a drawer, still in the envelopes, and they haven't ever opened them.

Dr. Jameson: We've seen that. That's the truth.

Darrell Cain: After a while, they think, "Why should I look at this — I don't understand it. I run my business by looking at how much money is in my checking account. If I have money, I must be good. That's my understanding of my practice's financial situation." You see, after a while, they quit using the data as a management tool.

Dr. Jameson: So what you're saying is that even the business structure of the doctor visualizing the practice has some basic flaws before he or she even gets to the P&L?

Darrell Cain: Right. Probably because they were never trained to read it in the first place. One of the common errors is their tendency to look at the profit that's left over on the bottom of the financial statement and correlating that to how much money is left over in their checkbooks.

And they don't understand, "Well, I might have a profit of $30,000, but I only have $10,000 in the checkbook."

This intuitively leads them to question the integrity of the financial statements. What they forget is that when they make payments on debt service — or on a number of other items — they may not be deductible as expenses to show on the profit-and-loss statement, but are, in fact, things that utilize their cash.

So, one of the problems they have is that they'll see a profit, and they'll think, "Hmm, I'm running a big profit. There must be money here to spend," and then they go out and obligate themselves to spend more money.

Dr. Jameson: Right. "I have checks in the checkbook, therefore I must have money to spend."

Darrell Cain: Sure. "I have profit until I run out of cash." Or, they have used up all the cash and know not to write a check, but they look at the financial statement to see a profit and forget that the profit is primarily being kept by the accountant for the purpose of measuring how much tax liability they're going to owe. So, the cash is gone. There's still income on the financial statement, and now they're going to owe a bunch of tax and there's no cash left to pay the tax with. That's probably the most common error dentists make when looking at their financial statements.

Another one is looking at the financial statement and adding up how much money they took out of the salary, and then they compare that as a percentage of their overall growth and assume, "Well, that's my profit margin." So, for example, "If my practice is doing $500,000 a year and I took out a salary of $150,000, I must be clearing about 35 percent, so that's my profit margin." That's a common error because that's really not the profit margin. The profit margin is disguised by the fact that they may still be servicing debt; they may have a number of perks and benefits being run through the business that are really part of their profit.

Another common error is a tendency to staff their businesses for their busiest days, not their slowest days. They look at the percentages they're spending on various costs and think these percentages should fall into absolute numbers. I've had dentists who tell me their facility costs are 8 percent, and that's "too much." That's a mistake because that percentage doesn't really mean anything. When they obligated themselves for their rent, that's a fixed cost. It's a sum of money they're going to have to pay, so that percentage really doesn't mean anything to them, except when it comes into calculating their true profit margin.

Dr. Jameson: Doesn't it go back, in many ways, to what we were talking about — when they look at their P&Ls and they misconstrue the numbers, thinking they have money available that may actually be held aside, as you say, for taxes to be paid? Here we have a breakdown in communication between them — the doctor or client or both — and the CPA or tax-preparation organization before they really understand what's happening. So, what they're doing is having a tax preparer, rather than someone in their practice — in their lives — who's helping them do tax planning. And that's a huge difference, isn't it?

Darrell Cain: Oh, very much so, and you'll remember, having spent 30,000 hours with dentists counseling, that also comes from the accounting profession. The thought process of the accountant (who's very much a technician like a dentist) assumes that you have a business background and you understand our language and what we're thinking. Come to find out, when you spend a lot of time with a dentist, there is no education in this area of the business environment, so there's a giant miscommunication. Most people who prepare books and records will actually assume that you know what you're looking at and how it is derived. And therefore, the accountant also thinks that you know how to interpret this.

Likewise, the dentist thinks, "Well, this process is really easy. I can just do it myself."

Dr. Jameson: Yeah, then they begin to think that way: "This is a snap! A bunch of numbers ought to show up in a very useful form right out of my management software. I think I'll just go do my own books and begin using money-managing software, and think that I can be secure in what I'm doing." But, there's a huge difference, isn't there, between having your accounting done monthly by a CPA or tax-planning organization, rather than using one of these programs?

Darrell Cain: There sure is. I'll tell you a personal story. You know, my wife's a dentist and she uses Quicken. She had an accountant who would drop by her office, sit for a couple of hours, reconcile her bank statements and books, and then be on his way. When I started dating her, I went in and did her books. It was just one of many times I'd go into a practice, get Quicken's books, and fix them. People said, "I've been doing this. I don't want to pay your monthly accounting fee just to fix what I've been doing." They, along with my wife, were shocked when I actually started to get in there and find out on a monthly basis, not only did they not have their cash balanced correctly, but in the reconciliation of their bank accounts and the classification of that reconciliation, they regularly distorted profit. Then the amount of money that QuickBooks kept track of was just cash in, cash out.

In other words, we enter deposits and write out all the checks. Well, unknown to many people, some of the checks we write — whether toward principal on a debt or a nondeductible item with the Internal Revenue Service, or the reconciliation of payroll taxes dentists pay on behalf of employees when they record payroll checks — can distort profit by as much as 10 percent to 20 percent a month. This is a large difference compared to when it's reconciled and done properly by an accountant. This creates a total mismanaged situation in which the dentist becomes confused.

Some dentists are so detailed — I have clients who want us to reconcile their financial statements off QuickBooks and what we in accounting call "timing differences." A timing difference — and you know the nomenclature or thought process of an accountant — is an item you expend cash for, and you either deduct the item you purchased early or you deduct it later on your tax return.

An example of this is buying equipment. We're all familiar with the 179 deduction — you borrow $100,000 to buy this piece of equipment, purchase it, and then on your tax return, you write it off and it becomes a deduction. Nevertheless, on the financial statement of your QuickBooks, it shows up as an asset. You get to write it off on your tax return. The accountant writes it off, but doesn't give you the adjusting journal entry to actually record what's called "accumulated depreciation." Then, you write a check every month to the leasing company or the bank. All the principal payments in the current period of income are made (i.e., earned $5,000 and pay down $5,000 note on the equipment), so you don't have any more cash, but you still owe the tax on that $5,000. We now call it "phantom income." So, one of the big problems — to go around the whole loop here — is that you're not trained as an accountant; you don't know how to reconcile the books; you don't know which items to categorize as deductible or nondeductible on your tax return; and you don't understand the concept of a timing difference and how that affects planning your cash flow.

What happens to most dentists who do their own books is they add to the problem of no one understanding their records. At least when the accountant did the books, he understood them, but maybe just didn't take the time to explain them to the dentist. But now you produce a set of books out of QuickBooks, hand them to your tax preparer and say, "Here, here's what I did." The tax preparer looks at them and knows they're wrong, but doesn't know why unless he retraces the steps of every transaction, item by item, which effectively is the same as completely redoing the books.

Dr. Jameson: This is an example of how we see so many different things in the practice that lead to a dysfunctional type of understanding for the doctor when looking at his or her own books. There are two terms, one being "direct costs" and one being "fixed costs." Between the two, there's a tremendous misunderstanding among practitioners. What is the significance in that misunderstanding?

Darrell Cain: Well, direct costs are those costs that vary up and down, directly proportional to the amount of dentistry or volume of money involved in doing dentistry. To say it a different way, we try to keep it simple and think of direct cost as labor and materials. Employee costs, lab fees, dental supplies, office supplies, and so forth would all be direct costs. This is truly your cost that should go up and down as you do dentistry. So, if you do another $10,000 of dentistry in a month, hypothetically, you're going to need more labor, more lab work, dental supplies, and office supplies.

There's a certain elasticity or variance you have as a practitioner, where you've got enough chairsides and can do more per day without hiring more people. But, as you get to a certain point, you've got certain expenses associated with the number of tray setups, turning the room, and getting all the volume through the office, so you can go in and actually incur more direct cost.

On top of that, you have fixed costs. Fixed costs are different. They're pretty much set. Whether you have a $50,000 month or an $80,000 month, the rent to your landlord is still $3,000 per month. Your telephone bill is still pretty much the same. Those costs don't vary up and down. The significance of understanding the difference is your real profit margin. If you do a dollar of dentistry and your direct costs are 40 cents, then you're going to have a profit margin of 60 cents on each incremental dollar of dentistry done. That 60 cents is then used to pay the fixed costs and, after the fixed costs are paid, the amount of money that's left over is the percentage you clear from your business. The amount that you clear, though, is not a direct dollar relationship. For every additional dollar you do — and let's say right now you're looking at your financial statement and you think, "Well, I net 35 cents." When you do an additional dollar of dentistry, you're not going to net another 35 cents; you're actually going to net a dollar less your direct cost — in this example, let's make it 40 cents. Your actual profit margin on the next dollar is 60 cents. That 60 cents will then go into the overall fraction and you'll find that the overall percent you cleared in the business went from 35 cents to maybe 37 cents overall.

That's where people get confused. They're making incremental decisions: "I'm going to buy this new room of equipment or hire this new employee." They don't understand how much money it really takes or how much it could make them while running their businesses and making decisions about expenditures.

Dr. Jameson: So, looking at that bottom-line profit situation, you use a "break-even analysis" when you're assisting clients in making these business decisions. What is a "break-even analysis" and how is it used?

Darrell Cain: Well, a break-even analysis is a mathematical computation that measures the doctor's direct costs and computes accurately the real profit margin, then calculates how much dentistry must be done to cover fixed costs. That's where the word "break-even" comes in. For each dollar of dentistry done above the break-even point, we forecast how much profit they will earn for each dollar.

Here's an example to explain how we use it: If I were going to bring an associate into the practice and pay him or her a $6,000-a-month salary, the break-even analysis can calculate the exact monthly goal I have to reach so I don't lose money.

Keeping it simple, John, take the $6,000 salary, a direct cost of 40 cents, and a profit margin of 60 cents. Then, $6,000 divided by 60 cents would mean the break-even point this associate would have to pay his or her salary is $10,000. This allows you to structure appropriate financial arrangements with the people you work with.

Likewise, if you were to buy a new piece of equipment for $1,000 a month, you could calculate and ask, "Will I generate enough dentistry to not only cover the $1,000 payment, but also the cost of doing the next $1,000 of dentistry?" This allows incremental decision making. It allows you to calculate and establish a daily goal of how much dentistry you need to do each day. It allows you to create a bonus plan for your employees — to come up with something fair and accurate so your team shares in the increase, but you don't go broke offering a plan that doesn't really work for you. The break-even analysis measures all incremental financial decision making.

Dr. John Jameson is chairman of the Board for Jameson Management, Inc., an international dental consulting firm. Representing JMI, he writes for numerous dental publications and provides research for manufacturers and marketing companies, as well as lecturing worldwide on the integration of technology into the dental practice, and leadership. He also manages the technology phase of the consulting program carried out by JMI consultants in the United States, Canada, and Europe. He may be reached at (877) 369-5558 or by visiting www.jamesonmanagement.com.

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