In the Question and Answer segment of Webcast on Incomplete Information on November 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Please elaborate on liar loans.

A: Liar loans is a term used to describe residential mortgages granted to borrowers in the overheated residential housing market that led up to the housing collapse in 2007.  The loans were granted under the implicit understanding that the lender would not attempt to verify information about income, employment, personal assets, or personal liabilities submitted by the borrower in support of the loan application.  In other words, the borrower could lie about his or her employment and financial status with impunity.
The term NINJA loans applies as well, where NINJA refers to no income, no job, and no assets – yet lenders would provided residential home financing to such borrowers.

Q: Why do we reclassify loans to shareholders to distribution?

A: A company or a company’s outside accountant will usually convert, or reclassify, loans to owners throughout the year to distributions at the end of the year as a clean-up exercise to reflect the purpose of the loans.  Under usual circumstances, the owners of non-Subchapter C corporations, i.e., owners of Subchapter S corporations, partnerships, limited liability companies, and sole proprietorships, take cash from the company on a quarterly basis in order to pay quarterly estimated income tax payments on company profit.  (Recall that the income tax obligation falls on the owners of non-Subchapter C corporations and not on the corporation itself.)  If the sum of loans and distributions exceed the amount required to satisfy the income tax obligation, the excess represents compensation to the owners.

Keep in mind that neither loans nor distributions are taxable revenue to the owners.  That is, owners do not report loans and distributions as revenue on their personal income tax Form 1040.  In addition, loans from the company and distributions from the company are not recorded as expenses on the income statement. 

Q: What if the principal put money in the company?

A: If an owner puts money back into a company, it usually represents emergency financing unless the cash injection was used to reduce the balance of loans to owners.  In the case of Sierra Products, the owners did provide cash to the company in 2008 since the Due to Shareholders account increased from $57,931 to $202,397 – a cash inflow to the company of $144,466.  Had the owners intended this cash inflow to repay prior amounts borrowed by the owners from the company, we would have seen a decrease in the Due from Shareholders account by $144,466 – in addition to the $92,469 decreased explained by the conversion of loans to distributions.  But the owners decided to record the cash inflow as loan to Sierra Products, which means that they expect to get repaid at some future point.

In this instance, it is very likely that Sierra Products could not raise all the outside funding it needed for a variety of purposes in 2008.  As a result, the owners were compelled to put money back into the company to meet a financing gap that they could not cover by other means.

In the Question and Answer segment of Webcast on Fund Accounting Part II on November 12th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: What if a government entity doesn't prepare financials under GAAP reporting?

A: The first footnote should provide information about the financial statement preparation process, which will usually state that the enterprise-wide and business-type activities are prepared in accordance with GAAP but that the individual statements for the governmental entities are prepared in accordance with modified accrual accounting, i.e., fund accounting.  Some exceptions may exist (exceptions always exist, it seems) but all governmental entities must provide audited statements as the best assurance to the taxpayer that his or her tax dollars are used appropriately.

If a municipality violates a) the audit requirement or b) the specific accrual and fund accounting applications, a prudent lender may readily pass on a lending opportunity with such an organization.  However, if the lender has funds outstanding to a governmental entity that violates one or both of these two conditions, the lender’s only recourse for understanding the financial conditions of a municipality is to approach it directly with a range of information requests – beginning with a request for the necessary adjustments to conform the existing financial statements to the relevant accrual or fund accounting statements.

Q: What is our recourse if a municipality files bankruptcy?

A: In most instances, there is little if any real recourse other than to let events play out under the provisions of Chapter 9.  Most state laws prohibit an encumbrance on public assets, which means that most credits provided by the private sector to the public sector are unsecured, although that will depend on the provision spelled out in a loan agreement.   The claims of an unsecured private sector lender will be addressed by a bankruptcy judge along with all other claims, some of which would likely reflect municipal employee claims and claims by other government entities.  The latter normally take precedent over private sector claims.  The same would likely apply to private sector claims that carry some form of security.  Public sector claims would again have priority in most instances if they were coupled with security or collateral conditions.

Q: In the state of Ohio, do Tax Anticipation Notes carry a true pledge of future tax revenues, even though a lien is not filed?

A:  Tax Anticipation Notes generally pledge specific future tax receipts as the source of repayment for the Notes.  If the tax receipts are sufficient, the Notes will be repaid as scheduled.  If they are not, the lender has no other recourse than to depend on the best efforts of the governmental entity to find additional sources of revenue in satisfying its repayment obligations.

Q: How do you calculate debt per capita if not shown in financial statements?

A: The total amount of interest-bearing debt obligations will invariably be reported in a municipality’s comprehensive financial statements.  If the population of the municipality is not listed, it will be available from Census Bureau information or from information provided on the municipality’s website.  In fact, don’t underestimate the array of information that is usually available from municipality websites.  In general, it can be quite extensive and very useful.

Q: At what point would a municipality consider the taxes due as uncollectible?

A:  As with a commercial business, management determines if and when an account is considered uncollectible, where management in this instance refers to the treasurer or chief financial officer of a municipality.  Over time, municipalities develop their own rules of thumb about the time span of delinquency that generally reflects an uncollectible tax assessment.  Therefore, the point at which a municipality considers a tax assessment as uncollectible will vary between municipalities, just as the time period varies among commercial businesses reflecting the specifics of their client base.

Q: If taxes are determined to be uncollectable are these written down against revenues for the year?

A: Once taxes are considered uncollectible they are written off.  Municipalities use one of two methods – the allowance method or the direct write-off method – in their enterprise-wide accrual statements, which matches the approach used by business enterprises.  For example, the City of West Linn, Oregon uses the allowance method.  The City of Calistoga, California uses the direct write-off method.

However, the fund accounting statements generally do not include provision for uncollectible assessments in the “income statement” – either directly or indirectly – since fund accounting considers revenue as either cash in hand or the virtually certainty of cash in hand.  Therefore, the revenue numbers for all governmental entities in theory reflect an accurate estimate of cash revenue, in which uncollectible amounts are excluded.  If those estimates prove invalid, the revenue amounts are adjusted by a negative revenue or bad debt expense in the monthly statements that roll up to annual statements.  The bad debt expense is usually buried in the funds – or near cash – amount recorded for revenue.

Note that amounts not due with 60 days, for example, are booked as deferred revenue on the liability side of the balance sheet with an offsetting entry to receivables on the asset side of the balance sheet.  If an account becomes uncollectible, the deferred revenue and receivables balances are reduced accordingly.  Nothing hits the “income” statement.

Q: How do I confirm the "total system net revenue" number in the footnotes to the statement of revenues, expenses, and changes in net assets schedule?

A:  The total revenue number for a governmental enterprise is determined by the application of accrual accounting, which includes revenue for all governmental entities and business-type entities within the municipality. 

• On an individual basis, all governmental entities, such as the general fund, report their operating results according to fund accounting. 
• On an individual basis, all business-type activities report their operating results in accordance with accrual accounting.
  

With respect to the City of Calistoga, the Statement of Revenues, Expenses, and Changes in Fund Net Assets for the business-type or proprietary funds reproduces the same information included in Statement of Activities – the accrual enterprise-wide “income statement” for the City of Calistoga.   The Statement of Activities on page 13 of the comprehensive financial statements for the City of Calistoga records a negative $247,776 change in net assets for business-type activities.  That identical amount is reported on page 18 in the Statement of Revenues, Expenses, and Changes in Fund Net Assets for proprietary funds, i.e., for business-type activities.

However, the revenue and expense amounts reported for governmental funds on an individual basis will differ from the amounts included in the enterprise-wide “income statement”, since governmental funds report results individually according to fund accounting while the operating results of governmental funds included in the enterprise-wide “income statement” are reported according to accrual accounting.  Note the information on page 16 in the comprehensive financial statements for the City of Calistoga.  That information guides us through a reconciliation of the net changes in all governmental funds balances for 2008 – determined in accordance with fund accounting – with the change in net assets for all governmental funds determined in accordance with accrual accounting.  As you see, there are numerous adjustments the explain the differences between a fund accounting change in net assets or fund balances of $3,483,565 and an accrual change in net assets for all governmental funds of $1,149,676.

In the Question and Answer segment of Webcast on the UCA Cash Flow Statement on November 5th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: I have a real estate company that uses a modified cash basis of accounting where revenues (rent) are recognized when received and expenses when cash is disbursed - and then on the income statement has rental income as well as unrealized gains and losses on the RE portfolio.  Does this negate use of the UCA format? 

A: In most instances, a modified cash basis means that the income statement is virtually all cash amounts, i.e., the revenues are cash revenues and the expenses are cash expenses.  Any unrealized gains or losses would, of course, be non-cash amounts.  Therefore, to construct a UCA cash flow statement, you might follow these steps:

• Remove unrealized gains or losses from the income statement.
• Adjust the resulting income statement for any changes in operating asset or operating liability accounts, if any such accounts exist on the balance sheet.  Under a modified cash basis, there may be no amounts recorded for receivables, inventory, payables, or accruals.  But there may be amounts recorded for tax obligations of one sort or another.
• Adjust the resulting income statement for the sum of distributions and loans to owners.
  

These adjustments should bring you to Net Cash Income on the UCA cash flow statement.  At this point, make the following adjustments:

• Reduce Net Cash Income by the prior period current maturities of long-term debt to arrive at Cash after Debt Repayment.
• Adjust Cash after Debt Repayment by a) fixed asset spending and investment (be sure to adjust assets for an unrealized gain or loss before computing the resulting change in those assets), b) intangible spending, c) related party cash inflows or outflows, d) debt repayments to owners, or e) new debt provided by owners.  These adjustments should bring you to the Financing Requirement or Surplus for the year.
• Calculate a) the increase or decrease in short-term debt, b) the amount of new long-term debt, and c) the amount of any capital injections from owners to estimate the amount of financing for the period.
  

The difference between the Financing Requirement and Financing should be equal to the change in the cash balance over the year.

Q: Please explain the bottom line of cash flow statement, i.e., the financing requirement / surplus.

A: The Financing Requirement/Surplus line is the summation of all cash flows from a) operating activities, b) interest-bearing debt service (payment of interest expense and repayment of long-term debt as scheduled), c) fixed asset spending, d) long-term investments, e) intangible spending, and f) related party cash flows.  If the sum of all these events is positive, the company generated enough business cash flow to cover all its cash outflows for the period.  It needs no additional outside debt or equity to fund operations.

However, if the sum of all these events is negative, the company must seek and secure additional cash resources to meet all cash expenses.  There are four options – short-term interest-bearing debt, long-term interest-bearing debt, capital injections, and use of existing cash balances.  If there is a Financing Requirement and the sum of a) short-term debt, b) new long-term debt, and c) capital injections exceeds the Financing Requirement, cash balances increase.  If the reverse occurs, cash balances decrease and the company is compelled to use some of its cash balances to meet the Financing Requirement.

Q: We are consistently asked for quantitative measurements of cash flow from regulators and have been using a coverage ratio using EBITA/(Interest expense + CPLTD) to calculate coverage.  Is there any way to get a UCA coverage ratio?  If so, what do you use?

A: There is no simple coverage ratio, but there are two covenants that work in tandem to assure sufficient business cash flow to service interest-bearing debt absent the cash impact of sales growth. 

The first is Business Profit Coverage, which is defined as follows:

• [reported net income – (distributions + loans to owners) + interest expense] / [interest expense + current maturities long-term debt] > 1.00

The greater the risk that not all reported profit will be converted to cash, the greater the factor above 1.00, e.g., 1.25.

The second is the Financing Gap Ratio, which is defined as follows:

• [operating assets (last historical period) – operating liabilities (last historical period)] / [sales (last historical period)]

If the Business Profit Coverage is met and if the Financing Gap Ratio does not increase, a company will have sufficient business cash flow, absent the cash impact of sales growth, to fully service its interest-bearing debt.  If the Financing Gap Ratio is honored and the company grows, the growth will drain cash because operating assets, e.g., receivables and inventory, invariably exceed operating liabilities, e.g., payables and accruals.  But no further cash will escape the company caused by an increase in receivable days, for example, or by a decrease in accounts payable days. 

Business owners can readily understand these two measures, which is always a major consideration in establishing covenants or performance standards.

Q: When you have distributions from other entities in which you are invested, should that be added to the UCA cash flow?

A: It depends on the party receiving the distributions.  If the distributions, or cash flows from other entities, flow to your specific borrower, then they must be included in the company UCA cash flow statement.  By the same token, if your borrower provides cash to other entities, those cash outflows must be included in the company UCA cash flow statement.

However, if distributions from other entities flow to the owner of your specific borrower, then they bypass your company and its cash flow.  In this instance, the distributions play a role in determining the owner’s personal cash flow and associated personal liquid assets and, as such, would be instrumental in determining the value of the owner’s personal guarantee.

Q: Why was it necessary to reclassify the conversion of debt to equity in your spread? Why not show an increase in LTD of $3MM and equity of $4MM?

A: As Footnote 4 to the Sequoia Properties’ financial statement indicates, there was no cash inflow from an equity injection.  The company simply reclassified in 2007 a loan from the owner, made in prior years, in the amount of $4,112,432 to equity.  The reclassification had no cash impact.  The decrease in the long-term debt balance to reflect this classification had no cash impact.  The increase in the equity balance to reflect this classification had no cash impact. 

Once we know that the 2006 long-term debt balance was decreased by $4,112,432 via a reclassification of long-term debt to equity, we can then calculate the amount of new long-term debt raised by the company in 2007.  That amount turns out to be $7,176,975.  As a result, we know that the source of cash to meet the Financing Requirement in 2007 was new long-term debt and not a combination of new long-term debt and equity.

Q: You showed no change in equity, which contradicts the answer you just provided. 

A: There was no cash change in equity but there was a book or accrual change in equity reflecting the reclassification of $4,112,432 of long-term debt to equity in 2007.