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- 9/2023
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September 2023 Comments
In this issue:
Retainage and A/R Days for Contractors
If the financial statements for a contractor fail to include a retainage account for accounts receivable from clients, the resulting computation for accounts receivable days may be misleading.
Recall that a retention is intended to encourage, or compel, contractors and subcontractors to complete a project on time and on budget. To that end, the client will frequently hold back - or retain - a percent of the total contract that is due and payable on completion of the project to the client's satisfaction. Both parties agree to the retention provision in the contract.
As a contractor invoices a client for project progress payments, it classifies a percent of the invoice as a retention posted to an "A/R - Retention" account on its balance sheet. The invoice to the client does not include any reference to the percentage of the invoice designated as retention. The client customarily withholds payment of invoices from the contractor until the billings equal the agreed upon retention amount. From that point on, the client is obligated to honor the periodic billings from the contractor.
Upon completion of the project, the contractor bills the client for the final time and states the amount within the invoice necessary to fully pay the retention. The amount due could be the full amount of the retention or some portion of it, depending on the cumulative payments made by the client up to receiving the final invoice.
The are a couple of points to keep in mind:
It is common for contractors to forego use of a retention account even though the contract provides for it. In such circumstances, there is no "A/R - Retention" balance to use in computing A/R Days. It is hidden in the general "A/R - Contracts" balance, and the full balance is used in computing A/R Days for contractors.
Note, however, that a few contractors will set up a current asset account, such as "Retentions Held" and a current liability account, such as "Liability for Defects" and bill the client over the life of the project for the total contract amount less the retention. Upon completion of the project, the contractor will debit the balance in the "Liability for Defects" account (eliminate the balance) and credit the "Retentions Held" account by the same amount (eliminate the balance). As part of this transaction, the contractor will also credit (increase) "Revenue" on its income statement and debit (increase) "Accounts Receivable - Contracts" by the same amounts. Retentions are now recognized as revenue and included in "Accounts Receivable - Contracts" in computing A/R Days for contractors.
To summarize, "A/R - Retention" should be included in the A/R Days computation since the amount posted to that account has been recognized by the contractor as revenue under the percentage of completion method of accounting. To exclude it would result in an underestimate of A/R Days.
However, never include a "Retentions Held" balance - if such an account exists on the asset side of the balance sheet - in the A/R Days computation since no amount of that balance has yet been recognized as revenue.
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Data Issues and Implications for Future Cash Flow
Contractor financial statements frequently include an asset retainage account and a liability retainage account. The asset accounts report the amount of billings from the contractor that are retained by the client in agreement with the contractor until completion of the project or contract in question. If the finished product meets the terms and conditions of the contract, the client is obligated to pay the amount of retainage to the contractor.
The liability retainage account reports the amount of billings from subcontractors to the contractor that it withholds from payment in agreement with the subcontractors until the project in question is completed according to the terms and conditions of the contract.
Recall that working capital is the difference between current assets scheduled for conversion to cash in the next operating period measured against current liabilities scheduled for payment in cash in the next operating period. The greater the difference - expressed primarily by the current ratio - the greater the prospects that a borrower will have sufficient cash flow in the next period to meet its operating expenses as well as its debt service obligations.
It follows, therefore, that the balance in an account such as "Accounts Receivable - Retainage" under current assets and "Accounts Payable - Retainage" under current liabilities should be excluded from the computation of working capital. Until all projects are completed that give rise to the balances in these accounts, the contractor cannot depend on cash revenue in the next period from retainage accounts nor can it expect to pay out cash to satisfy pending obligations to subcontractors. There is considerable uncertainty in both instances that argue for removing these account balances from the working capital computations.
Note, too, that many contractor financial statements may fail to include retainage accounts on the balance sheet but, rather, include the retainage accounts under such accounts as "Accounts Receivable - Contracts" and "Accounts Payable - Contracts." To the extent retainage balances are included in either or both sets of accounts, the resulting working capital and current ratio computations may differ significantly from the computations excluding both sets of retainage balances.
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More Closely Tracking Shareholder Basis
In December 2022, Form 7203 and its instructions were developed, revised, and entitled "S Corporation Shareholder Stock and Debt Basis Limitation". It replaces the three-part worksheet for figuring a shareholder's stock and debt basis, which was previously included in the IRS instructions for completion of Schedule K-1 (Form 1120S).
The intent of Form 7203 is to provide greater precision for the amounts reported in Part II and Part III on Schedule K-1 (Form 1120S).
A shareholder who a) sells shares, b) receives a payout, or c) receives a loan repayment during the financial year from the Subchapter S corporation must submit Form 7203. The IRS recommends shareholders complete and save Form 7203 in years where none of the above reporting requirements apply in order to better establish their Subchapter S corporation stock basis at any future date.
For a lender, Form 7203 should provide better information to quickly estimate a shareholder's "basis" in a Subchapter S corporation and, therefore, the maximum amount of distributions he or she may receive on a tax-free basis. (Recall that distributions are not taxable revenue for owners of a Subchapter S corporation unless they exceed "basis.")
With respect to Part III, Form 7203 should have little relevance since the dollar amounts of taxable revenue flowing to the shareholder's personal tax returns will remain clearly stated as will the dollar amount of distributions.
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Subchapter C and the Others
Dividends, distributions, and withdrawals are similar in nature in that they are generally cash payments from a business organization to its owners or partners. Yet the recipient of a dividend must report the dividend as taxable revenue on his or her personal income tax returns. However, recipients of distributions or withdrawals do not report distributions or withdrawals as taxable income on their personal income tax returns.
Dividends are taxed twice by the IRS, in effect. The profit of a Subchapter C corporation is taxed at the applicable corporate income tax rate. The dividends it issues to shareholders are taxed at the applicable personal income tax rate for each shareholder.
Distributions to owners or partners of a Subchapter S corporation, partnership, or LLC are not reported as taxable revenue on their personal federal income tax returns. However, several states assess a minor franchise tax on such distributions. Further both the state and federal government tax at the applicable capital gains tax rate should distributions to owners or partners exceed their "basis" in the company, partnership, or LLC. The definition of "basis" varies by business organization. "Basis" includes loans from owners of a Subchapter S corporation but excludes loans from partners for a partnership or LLC.
Withdrawals - which is a different term for "distributions" but means the same thing - are not reported as taxable revenue by the sole proprietor.
It is tempting to assume dividends, distributions, and withdrawals are all discretionary expenditures. Dividends certainly may be since a publicly traded Subchapter C corporation frequently issues dividends to benefit its stock price. A privately held Subchapter C corporation has no need to issue dividends to owners who are usually active officers in the company and, as such, receive salaries and bonuses.
The same applies to owners of a Subchapter S corporation. The principal owners are generally active officers in the company and receive salaries and bonuses. Yet distributions are necessary to provide cash to the owners to pay their personal income tax on taxable company income the owners must report on their personal income tax returns.
For partnerships and LLCs, distributions are frequently the only sources of cash for a) payment of personal income tax on taxable company revenue reported on the partner's or member's income tax returns and b) compensation as a substitute for salaries and bonuses. The IRS does not allow salaries and bonuses for partners or members as a tax-deductible expense on business income tax returns. One way around this restriction is for the partnership or LLC to provide guaranteed payments for partners or members. But if it does so, the partners and members must pay all FICA and Medicare withholding taxes themselves as well as pay estimated quarterly income tax payments on the guaranteed payment amount.
For a sole proprietorship, the IRS does not allow salaries and bonuses for the sole proprietor on his or her Schedule A in the personal income tax returns. Withdrawals are the single source of cash from the sole proprietorship to its owner for payment of income taxes on taxable company revenue and for the sole proprietor's compensation.
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The Language of Business
On Wednesday, October 4th, Shockproof! Training conducts the first of four live sessions in the Credit College Course on Accounting Essentials. The course is designed for analysts and lenders with little if any accounting knowledge as well as for more experienced personnel interested in an examination of accounting concepts, principles, and application.
Accounting Essentials explores the fundamental and essential concepts and principles of accrual accounting. At the end of the four online sessions, participants will understand:
If you would like more information about Accounting Essentials, about any of our 27 single-topic Webinars, or about any of our other five Credit College Courses, please call us at 1-866-237-7228 or send us an email at inquiry@shockproof.com. If you wish, you may review the description of all single-topic Webinars and Credit College Courses on our Products page.
Please note that all single topic Webinars and each session in the Credit College Courses are recorded and available for use and review, should participants prefer the flexibility of on-demand sessions and webinars.
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Please note, too, that Shockproof! Training recently incorporated a learning path function into its website that suggests single topic webinars and Credit College Courses that might be applicable for selected positions within financial institutions. The positions in question range from newly appointed credit analysts in commercial business and commercial real estate lending to experienced loan review officers, specialty lenders, and board members.