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Instructor Blog - Covenants

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Covenant Use in Controlling Cash Outflows


  • admin

  • 1/27/2021 1:20:00 PM

  • 125

  • Covenants
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Q: Did we have enough information to determine actual cash flow was negative in 2018?

A: We can construct and use a UCA cash flow statement from the accrual financial statements and identify the negative cash flow amounts. In addition, the FASB 95 Statement of Cash Flows points to negative cash flow at Net Cash Provided by Operating Activities. Finally, with some laborious adjustments, we can convert Schedule 1120S to an accrual income statement and, along with Schedule L, construct a UCA cash flow statement.

The messages from the Performance Ratios and Selected Results suggest negative business cash flow because of the huge jump in the Financing Gap. The above methods and analysis confirm our initial suspicions about negative business cash flow in 2018.

Q: For state taxes, can't you just go to schedule A (if available)?

A: Usually Schedule A should provide this information, but we need a separate Statement to identify the purpose of state taxes paid, e.g.., withholding for the current year only, the current year and the last year, and so on. In the case of Douglas McPherson, the large state tax payments likely reflect payments of back taxes, i.e., taxes due before 2018 but paid in 2018 along with those state taxes withheld against 2018 income.

Q: What's the best way to determine the % of distributions that are distributed for tax purposes and % that is discretionary for a pass-through entity?

A: The most accurate way is to add up the amount of taxable company income that is passed to the owner and then assume, or calculate, an effective tax rate. From the PITR for Douglas McPherson, we can identify the effective tax rate by dividing Total Tax at Line 15 by Adjusted Gross Income at Line 7 on his Form 1040. For McPherson, the effective tax rate in 2018 was 20.45%. His taxable income from Sandover Contractors was $344,011 – ordinary business income of $608,995 less the Section 179 deduction of $264,984. 20.45% of $344,011 is $70,350. Given distributions of $251,575, $181,225 of that amount represents additional compensation.

Course overview: Covenant Use in Controlling Cash Outflows

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