Incomplete Information Questions and Answers
In the Question and Answer segment of Webcast on Incomplete Information on July 23rd, 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: Because the company prepared financial statements contain so many differences from the compiled statement, wouldn't that cause a lender to check the quality of inventory, accounts receivable, prepaid expenses and fixed assets in order to ensure that even more errors exist in the quality of financial statements especially when an accountant does not thoroughly check a compiled statement?
A: You would certainly want to verify the account balances. It seems, however, that the best way of doing so is to require that an outside accountant “touch” the numbers, e.g., require compiled statements at a minimum. This might be the cheapest and most efficient way to get at the issue. That is, you either require the company to verify the numbers via use of an outside accountant or you, the lender, would have the option of doing so – but by using third party experts such as internal audit personnel.
Q: Maybe we should remind lenders to also "kick the tires" with an on-sight visit?
A: It’s always a very good idea to kick the tires, simply because no one knows as much as company management and company personnel about the business and all of its nuances. In fact, a 30 minute conversation with the bookkeeper or chief financial officer can provide invaluable information about the company, the competence of the accounting department, and the integrity and approach of company management to preparing and using quality financial information.
Q: Shouldn't we record the cash received in the asset sale (regardless of tax loss) and note that it is non-recurring?
A: Absolutely. It’s the cash that counts, regardless of a gain or loss recorded for income tax purposes. Usually, it is indeed a non-recurring event – something we would not depend on to be repeated in the future.
Q: Do you count the capital loss if it is a carryover since it really isn't a use of cash in 2008?
A: No. The issue is, first, whether it is a cash gain or loss in the period in question and, second, the amount of the asset sale, which represents the cash amount associated with the gain or loss. A tax loss carryover tells us the event occurred in a prior period, rather than the present period, and that the cash dimension of that event occurred in the prior period as well.
Q: Why were dividends kept in personal cash flow as we don't know if they are automatically reinvested or pass-through from another S Corp, LLC or partnership? Also, we would need to know the amount of the shareholder loan change due from Joe Robie to subtract from his distributions from the company that he actually received.
A: Distributions take place for two purposes – to provide cash to the owners of non Subchapter C corporations to a) pay personal income tax on company profit and b) provide compensation to owners if the amount of the distributions exceed the income tax obligation. How the owners use the money is a separate issue, very similar to the issue of how employees use salaries. Distributions, if they exceed the amount needed for income tax payments, may be used for virtually any purpose from paying daily living expenses to investing in solar energy partnerships – and everything in between.
To determine the actual amount of cash received by Joe Robie, in this instance, we would need to know if the reduction in the Due from Shareholder account reflected a reduction in company loans to Joe Robie alone. The balance decreased by $92,469 while the amount of distributions to Joe Robie in 2008 was $308,376. The net cash amount distributed to Robie would then be $308,376 - $92,469 = $215,907.
Note that the UCA cash flow shows cash distributions at $474,425 - $92,469 = $381,956. Of that amount, $215,907 went to Robie under the assumption that the reduction in the Due from Shareholder account applied only to loans made by the company to its majority owner.
Q: Regarding capital gains, shouldn't we ask if the funds were re-invested?
A: This really raises a larger issue about getting more complete information from the guarantor so we can piece together a full personal cash flow statement. If we have information about investment activity, along with information about changes in personal debt obligations, we could make rough estimates of a full personal cash flow statement.
But progressing as far as we have can be very revealing. For example, let’s assume that we know the amount of cash provided the guarantor from the sale of an asset that resulted in a capital loss. If we were to include that amount of cash in the stream of personal cash revenue and found that there was no surplus cash available to help support debt service on company debt, we would know that the proceeds from the asset sale were not reinvested. They were consumed in covering an array of living expense, cash taxes, and personal debt obligations.
Q: Do you subtract from personal cash flow if they have contributed money to the business?
A: I keep them separate. I consider distributions as operating expenses that, given the tax code, pass through the balance sheet instead of through the income statement. Distributions satisfy two needs. They provide cash for income tax payments on company profit, an operating expense. If the amount of distributions exceeds the income tax obligation, that excess amount provides compensation to the owner, an operating expense.
Loans from an owner or guarantor, on the other hand, is a financing activity and, generally, emergency financing at that. Owners put money back into the company if they cannot acquire the financing the company needs from other sources.
Joe Robie took money out of the company in 2008 to pay income tax on company profit and to provide himself with additional, and tax-free, compensation. He likely put money back into the company at some point during the year when he couldn’t arrange the additional financing the company required to meet pressing needs. Those are two separate events with very different objectives.
Q: Do you consider CSVLI a liquid asset?
A: Yes, but it usually requires a bit more time to request and receive the cash value of the policy than it does to arrange a sale of marketable securities. Nonetheless, I would consider the cash surrender value of a life insurance policy to be a liquid asset.
Q: If you had a company prepared tax return and a co-prep statement for the same period, which one would you use generally?
A: I would be inclined to use the company prepared financial statement since the company prepared income tax return would be prepared from the financial statement information. In other words, the financial statement information represents the source document.
In addition, the company prepared financial statement would be prepared, generally, in accordance with generally accepted accounting principles, where the business income tax return would be prepared according to the tax code. The differences in revenue, expense, and profit amounts can be considerable. It’s usually easier to sort through the company prepared financial statements than it is to fully understand the necessary adjustment to conform business income tax returns to accrual financial statements.
Q: Because the company prepared financial statements contain so many differences from the compiled statement, wouldn't that cause a lender to check the quality of inventory, accounts receivable, prepaid expenses and fixed assets in order to ensure that even more errors exist in the quality of financial statements especially when an accountant does not thoroughly check a compiled statement?
A: You would certainly want to verify the account balances. It seems, however, that the best way of doing so is to require that an outside accountant “touch” the numbers, e.g., require compiled statements at a minimum. This might be the cheapest and most efficient way to get at the issue. That is, you either require the company to verify the numbers via use of an outside accountant or you, the lender, would have the option of doing so – but by using third party experts such as internal audit personnel.
Q: Maybe we should remind lenders to also "kick the tires" with an on-sight visit?
A: It’s always a very good idea to kick the tires, simply because no one knows as much as company management and company personnel about the business and all of its nuances. In fact, a 30 minute conversation with the bookkeeper or chief financial officer can provide invaluable information about the company, the competence of the accounting department, and the integrity and approach of company management to preparing and using quality financial information.
Q: Shouldn't we record the cash received in the asset sale (regardless of tax loss) and note that it is non-recurring?
A: Absolutely. It’s the cash that counts, regardless of a gain or loss recorded for income tax purposes. Usually, it is indeed a non-recurring event – something we would not depend on to be repeated in the future.
Q: Do you count the capital loss if it is a carryover since it really isn't a use of cash in 2008?
A: No. The issue is, first, whether it is a cash gain or loss in the period in question and, second, the amount of the asset sale, which represents the cash amount associated with the gain or loss. A tax loss carryover tells us the event occurred in a prior period, rather than the present period, and that the cash dimension of that event occurred in the prior period as well.
Q: Why were dividends kept in personal cash flow as we don't know if they are automatically reinvested or pass-through from another S Corp, LLC or partnership? Also, we would need to know the amount of the shareholder loan change due from Joe Robie to subtract from his distributions from the company that he actually received.
A: Distributions take place for two purposes – to provide cash to the owners of non Subchapter C corporations to a) pay personal income tax on company profit and b) provide compensation to owners if the amount of the distributions exceed the income tax obligation. How the owners use the money is a separate issue, very similar to the issue of how employees use salaries. Distributions, if they exceed the amount needed for income tax payments, may be used for virtually any purpose from paying daily living expenses to investing in solar energy partnerships – and everything in between.
To determine the actual amount of cash received by Joe Robie, in this instance, we would need to know if the reduction in the Due from Shareholder account reflected a reduction in company loans to Joe Robie alone. The balance decreased by $92,469 while the amount of distributions to Joe Robie in 2008 was $308,376. The net cash amount distributed to Robie would then be $308,376 - $92,469 = $215,907.
Note that the UCA cash flow shows cash distributions at $474,425 - $92,469 = $381,956. Of that amount, $215,907 went to Robie under the assumption that the reduction in the Due from Shareholder account applied only to loans made by the company to its majority owner.
Q: Regarding capital gains, shouldn't we ask if the funds were re-invested?
A: This really raises a larger issue about getting more complete information from the guarantor so we can piece together a full personal cash flow statement. If we have information about investment activity, along with information about changes in personal debt obligations, we could make rough estimates of a full personal cash flow statement.
But progressing as far as we have can be very revealing. For example, let’s assume that we know the amount of cash provided the guarantor from the sale of an asset that resulted in a capital loss. If we were to include that amount of cash in the stream of personal cash revenue and found that there was no surplus cash available to help support debt service on company debt, we would know that the proceeds from the asset sale were not reinvested. They were consumed in covering an array of living expense, cash taxes, and personal debt obligations.
Q: Do you subtract from personal cash flow if they have contributed money to the business?
A: I keep them separate. I consider distributions as operating expenses that, given the tax code, pass through the balance sheet instead of through the income statement. Distributions satisfy two needs. They provide cash for income tax payments on company profit, an operating expense. If the amount of distributions exceeds the income tax obligation, that excess amount provides compensation to the owner, an operating expense.
Loans from an owner or guarantor, on the other hand, is a financing activity and, generally, emergency financing at that. Owners put money back into the company if they cannot acquire the financing the company needs from other sources.
Joe Robie took money out of the company in 2008 to pay income tax on company profit and to provide himself with additional, and tax-free, compensation. He likely put money back into the company at some point during the year when he couldn’t arrange the additional financing the company required to meet pressing needs. Those are two separate events with very different objectives.
Q: Do you consider CSVLI a liquid asset?
A: Yes, but it usually requires a bit more time to request and receive the cash value of the policy than it does to arrange a sale of marketable securities. Nonetheless, I would consider the cash surrender value of a life insurance policy to be a liquid asset.
Q: If you had a company prepared tax return and a co-prep statement for the same period, which one would you use generally?
A: I would be inclined to use the company prepared financial statement since the company prepared income tax return would be prepared from the financial statement information. In other words, the financial statement information represents the source document.
In addition, the company prepared financial statement would be prepared, generally, in accordance with generally accepted accounting principles, where the business income tax return would be prepared according to the tax code. The differences in revenue, expense, and profit amounts can be considerable. It’s usually easier to sort through the company prepared financial statements than it is to fully understand the necessary adjustment to conform business income tax returns to accrual financial statements.
