Instructor Blog

Q: Question on M-2 which may not apply. Are distributions on Schedules K-1s always noted as distributions or withdrawals on Schedule M-2?

A: Yes. In general, distributions reported on Schedule K in the business income tax returns are reported on Schedule M-2. However, it is not uncommon to find distributions reported on Schedule M-2 limited to the amount of taxable revenue for the year, which may be less than distributions for the year. Consequently, it is always prudent to identify distributions for a Subchapter S Corporation or for a Partnership by reference to Schedules K-1. If there is more than one owner or partner, the amounts reported on the individual Schedules K-1 will add up to the total amount of distributions reported on Schedule K in the business income tax returns.

Q: How did you arrive at $31,101 in Depreciation? If I take the depreciation of $197,289 from the 1065 tax return less the depreciation of $172,911 under depreciation on the cash flow statement and "other costs" then I come up with $24,378.

A: The $31,101 is the difference between $197,289 reported on the tax return at Line 16c and depreciation expense reported in Footnote 1 on the financial statement as $166,188. The difference between depreciation expenses of $197,289 reported on the tax return and $166,188 reported on the accrual financial statement is $31,101.

Other Costs of $172,911 on the accrual income statement match the $172,911 of Depreciation and Amortization of $172,911 reported on the Statement of Cash Flows. This implies a 2018 amortization expense of $6,723 that is not specifically identified in the accrual financial statements. Note that Schedule L in the business tax returns shows a $6,723 accumulated depreciation amount at Line 12b, which is likely amortization expense for the single year 2018.

Course overview: Schedule M-1 and the Accrual Income Statement

Q: I have come across several CPA-prepared statements where a comment was included that basically said, "we have not included some financial information because it might change your mind about the company." I would take that as a huge red flag. Is that common practice?

A: This is not a common practice but one that is very welcome and reflects highly on the CPA. Such a comment is indeed a red flag and needs to be thoroughly pursued by the lender or potential lender.

On occasion such a comment may be no more serious than a contested issue about classifying accounts that would impact a ratio calculation. But in other instances, such a comment might point to contested issues between the borrower and the accountant that raise questions about the viability of the business itself.

Course overview: Non-Financial Red Flags and Performance Implications

Q: Will Mr. Schumacher need to pay taxes on any portion of the base or excess distributions he received in 2018? Would any portion be included in the “passthrough” taxable income?

A: No and No. Distributions from “passthrough” entities in any amount are tax-free to the receiving owner or partner. Even when the distribution exceeds the estimated taxes due, owners like Mr. Schumacher do not report any portion of the distributions as taxable income on their 1040.

Further, the distributions from any of the “passthrough” entities cannot be reported as a tax-deductible expense for the paying business entity in preparing their business information-only income tax returns. Distribution, in effect, fall outside the tax arena. Schumacher is taxed only on the taxable income generated by the each of the passthrough entities in which he has an ownership stake. Owners do not report the cash distributions from those organizations as taxable income, as we noted above.

There can be an exception to this general rule. If accumulated distributions are greater than a partner's or owner’s "basis" in the Partnership, LLC or Subchapter S corporation, the amount in excess of the “basis” is taxed as a long-term capital gain. Note that “basis” for partners in a partnership is generally defined as each partner’s pro-rata accrual net worth in the partnership plus each partner’s “share” of partnership liability obligations. This exception occurs infrequently.

Q: What about the $4,112,432 capital contributions reported on Sequoia's 2018 Schedule K-1 as part of the Partner’s capital account analysis? Is it considered a cash inflow or outflow?

A: Neither. During 2018 Mr. Schumacher converted $4,112,432 of personal loans he made to Sequoia to a capital contribution as described in Note 4 on page 10 of Sequoia’s financial statements. Since the cash inflow to Sequoia occurred earlier when the long-term loan was originated, the conversion to equity is a non-cash event in 2018. In the absence of the conversion, however, the capital contribution would be a cash inflow, and the loan from Mr. Schumacher would remain on the Sequoia balance sheet as part of the Note Payable liability account.

The net effect of this capital contribution is accounted for as a $4,112,432 decrease in the long term Note Payable, which include loans from partners, and an identical increase to Partner’s Capital. From an accounting standpoint, the conversion transaction occurred before Sequoia arranged any new long-term debt and contributes to the $1,979,974 net decline in the Note Payable account. The Partners' Capital account was further increased by 2018 net profit of $166,505 and reduced by distributions of $86,346. The net effect of this combination of transactions increased 2018 year end Partners' Capital to $4,415,990.

Q: If we are consolidating Mr. Schumacher’s cash "support" with business cashflow from operations in defining Global Cash Flow, could an argument be made about the liquidity positions of each respective company as a mitigating factor?

A: Yes, indeed. We would look to the highly liquid assets – or ready cash – available from each related company controlled by Schumacher as a potential cash source available to service debt. In doing so, it is very difficult to predict which 2018 year end cash or liquid asset amounts might be available throughout 2019 to support debt service problems at Sequoia.

Each company’s cash available to support a related party would depend on the internal cash needs the companies encounter as they go through 2019. For example, only Modesto Services has significant cash balances at the end of 2018 at $350,442. That could be gone early in 2019 if the company encountered unexpected cash flow problems. On the other hand, Clovis Supply reports only $7,040 in its cash account at the end of 2018. If Clovis has a robust year in 2019, it may have excess cash resources it could lend to Sequoia for debt service support.

Bottom line? Very prudent to examine other likely ready cash resources among related companies but very risky to depend on their availability because of operating uncertainties in the forthcoming year.

Course overview: Guarantor Analysis, Global Cash Flow, and the Second Way Out

Q: Under UCA cash flow calculation, distributions and loans to partners are deducted from Cash after Operations. How are contributions from partners and / or loans from partners to the company treated? Are these adjustments recorded in the same section of the UCA cash flow statement?

A: Partner or owner capital contributions and loans to the company are not consolidated with distributions and / or loans to owners nor should they be reported as an operating activity on the UCA cash flow statement. Capital contributions should, instead, be treated and classified as a financing activity intended to strengthen the company’s overall financial position. Owner loans to the company should be recorded as a related party activity since they fall outside the core operating activities and traditional third party lending used by the company. Maintaining this separation in reporting these business activities and associated cash flow impact preserves the integrity of the nature and amount of each transaction type.

Consolidating or recording capital contributions and partner or owner loans to the business as operating activities would erroneously affect Net Cash after Operations and cash flow available to service debt. The net effect would be to distort our analysis and our view of the debt capacity of the borrower.

Course overview: Advanced UCA Cash Flow: Part I of II

Q: Would you repeat what you said about "Business Cash Income cannot state that cash from operations are..."

A: A negative Business Cash Income of $163,945 in 2018 indicates that after meeting all cash operating expenses, including interest expense of $59,062, Total Coverage, Inc. had a cash flow deficit of $163,945, which means that cash flow from operations was insufficient to service the debt. Instead, the company had to use either existing cash balances or additional third-party financing to cover this cash flow deficit. We can rule out existing cash balances as the primary source of cash to cover the deficit since the cash balance was only $20,339 at the beginning of the year. Total Coverage, Inc. used additional short-term debt to fund their debt service in 2018.

Q: Would one use the same last recorded value assumptions when creating projections for multiple years?

A: Yes. Begin with the last recorded value of sales growth, for example, and use it as the projected growth rate in the first projection period unless there is a compelling reason to change. If there is a compelling reason to change, use the revised projected sales growth value, which then becomes the basis for the second projection period. If there is a compelling reason to change the second projection period's sales growth rate, then do so. And on and on.

However, keep in mind that the key to any projection scenario is the first projection period, which we need to get as right as we possibly can. Projections are notoriously inaccurate and misleading, especially beyond the first projection period. The best source of information about likely projection variables, such as sales growth for the forthcoming year, is company management. If management is on top of its game, it will be very close to market events and developments. No one should have better insight into the likely course of events for the specific company in question.

Course overview: Management Assessment, Projected Cash Flow, and the First Way Out

Q: Can you discuss a Single Member LLC?

A: A Single Member Limited Liability Company has a single owner who has full control over the LLC. The LLC is a legal entity created by the state after the chartering process is completed and, as such, allows the single owner to avoid any liability for the entity's obligations unless that member guarantees that obligation. A Single Member LLC does not file federal tax returns in its own name. Rather, the Single Member reports the entity's taxable revenue as personal income on his or her Form 1040. Further, a husband and wife, if filing a joint return, may be considered a Single Member LLC.

In all other respects the single member LLC and a multi-member LLC are the same.

Q: Even with a personal guarantee, can a lender legally go after a personal guarantor's personal assets, e.g., liquidity in a bank, to cover the guarantor’s financial responsibility for a guaranteed loan?

A: Yes. Unless restricted in some way, a lender can pursue all of a guarantor’s personal assets to complete payment of a guaranteed loan.

Looking further, restrictions on this privilege may have been negotiated in originating the loan, so it depends on the precise language of the personal guarantee provided by the guarantor. As an example, the guarantee could include carve-outs that would prevent the lender from pursuing specific personal assets in seeking payment. In contrast, an unlimited guarantee is structured to allow the lender to pursue all guarantor personal assets. In the case of an unlimited guarantee, cash in a bank account or bank CDs would be subjected to attachment.

Course overview: The Credit Write-Up and the CRE Analytical Process

Q: Aren't unfunded pension obligations typically reflected on corporate financial statements as a liability?

A: Yes. You are correct. If a company reports its operations according to GAAP, it will record unfunded pension liabilities as a net liability on its balance sheet.

It would be good practice, however, to ensure that any unfunded pension obligations are included on the balance sheet for companies that have pension programs.

Course overview: Not for Profit Analysis

Q: Poll Question 4 stated Total Coverage needed less cash or less financing to buy and hold inventory in 2018 than in 2017. The answer was disagree. My question is if they are holding inventory for 15 more days in 2018 vs 2017 why would they need more cash or financing to buy inventory if they already have it on hand?

A: Poll Question 4 reads as follows:

“The change in inventory days indicates that Total Coverage, Inc. needed less cash or less financing to buy and hold inventory in 2018 than in 2017.

• Agree.
• Disagree.

The correct answer is Disagree.”

Inventory composition is constantly changing as is the value of the inventory held for sale. An underlying business assumption is that during 2018 all inventory on hand at year end 2017 was sold and replaced in the normal course of business. Total Coverage, Inc. inventory further expanded by $55,339 due to the sales increase and the increased inventory days. Both dynamics brought about an $55,319 expansion in inventory by year end 2018, i.e., 2018 inventory of $287,342 less 2017 inventory of $232,003 = $55,339.

The increase in inventory was not a surprise because the two business drivers caused inventory to increase by $55,339. The first driver was the 5.94% increase in 2018 sales that pushed a 5.94% increase in 2018 inventory to account for $13,781 of the 2018 inventory increase. The significant increase in Inventory Days from 60 days in 2017 to 75 days in 2018 caused an additional $41,558 inventory increase.

To fund the $55,339 incrementally increased investment in 2018 inventory, Total Coverage, Inc. needed to access more, not less, funding in the form of a like amount of company cash, financing, supplier credit, or additional equity investment to do so. By inspecting the 2017 and 2018 balance sheets and considering the funding options, we find that the company’s cash position increased in 2018. Short term Notes Payable to Bank, a line of credit, increased by $261,962. Trade credit in the form of Accounts Payable went down $255. We find no additional capital investment in the company.

Our conclusion is that Total Coverage, Inc. satisfied the need for more cash to support inventory, not less, by using the line of credit.

Course overview: Critical Ratios and The First Necessary Condition for Business Success

Q: Is there a limitation on the carry-over Section 179 Deduction?

A: There is no limitation on the carryover. However, it can be applied only up to the amount of Ordinary Business Income in a future period in which it is used?

Q: Do we know what the Other Income is comprised of?

A: Statement 1 to the business income tax returns reports that Other Income of $20,352 represents Referral Income.

Course overview: The Section 179 Deduction

Q: Please explain why we have two Notes Payable to Bank and Capital Lease Obligations under Liabilities. Thank you.

A: The first Notes Payable to Bank is a short-term line of credit. The second Notes Payable to Bank is a term loan that matures over multiple years. As a result, there is an annual amount due on the term loan, which is designated as Current Maturities LTD. The remaining long-term balance is reported as Notes Payable to the Bank.

Then there is the capital lease obligation, which is a form of long-term financing. As such, it, too, has an annual amount paid down against the capital lease total. Therefore, the capital lease is reported as Current Maturities Capital Leases, which are due and payable in the next year, and Capital Leases, which is the remaining long-term balance of the financing.

Course overview: Cash Flow Analysis and Borrowing Causes

Q: I was looking through the materials for today’s webinar and had a question: On schedule M-2, should the last line ($66,910) equal the capital level in Schedule L ($66,937).

A: Yes. The two amounts should be identical. There is a $27 difference because the accountant transposed the amount at Line 6 on Schedule M-2. The correct amount is $66,947 and not $66,974. When the proper amount is used, $66,910 at Line 9 on Schedule M-2 becomes $66,937, which matches the balance in the Partners' Capital Accounts of $66,937 at Line 21 on Schedule L.

Q: Regarding Poll Question 5, what does the inclusion of the net loss in the UCA cash flow statement mean? What amount is this net loss?

A: The net loss of $41,035 is the accrual net loss, which means that accrual revenue less accrual expenses, including depreciation, resulted in a negative amount of $41,035. This amount is repeated in Schedule M-1 in the business income tax returns at Line 1 on Schedule M-1. Note that, on an accrual basis, net income plus depreciation – traditional "cash flow" – is a negative $19,947, which is the sum of the first two amounts reported on the UCA cash flow statement and the starting point for constructing the statement.

Once we make adjustments for distributions, loans to partners, and changes in receivables, inventory, and payables, the company's net income on a cash basis is a negative $17,781. Therefore, it cannot service its debt from its actual cash flow.

Course overview: Cash Based Income Tax Returns

Q: Why pull cash out for distributions to stockholders if it means running out of operating cash flow?

A: Distributions are the means by which a pass-through company provides cash to its owners to pay the income obligation on the company’s taxable income. Recall that the owners of a pass-through company, and not the company itself, are responsible for paying the income tax obligation on taxable company income.

If a profitable pass-through company is short of cash and cannot provide distributions to owners in an amount sufficient to meet at least their income tax obligation on taxable company income, the owner or owners must then use their personal cash resources to pay the personal income tax obligation on taxable company income, an event they obviously wish to avoid if at all possible.

If the company can borrow to provide distributions when it is short of cash, it will invariably do so because of pressure from the owners, one or more of whom may be part of company management. In addition, the company, its owners, and its management may attribute the cash shortage to events other than distributions, such as a necessary build up in inventory or a slow down in collecting receivables.

Borrowing under such circumstances may also reflect the attraction for the owners of receiving tax-free income in the form of distributions. Unless distributions exceed an owner’s basis – basically his or her net worth in the company – they are not reported as taxable revenue on Form 1040. As a result, owners of this mindset seek to stretch the amount of the tax-free distribution for their personal benefit regardless of the impact on company cash flow.

The question is a very appropriate because it highlights the need to identify the borrowing cause correctly and completely. Frequently, the cash impact of distributions is overlooked in the analytical process, especially if the lender does not use the UCA cash flow statement to identify borrowing causes.

Course overview: The Five Cs of Credit

Q: Shouldn't leverage have increased with unfunded pension liabilities on the balance sheet?

A: The definition of leverage can cause a problem. For a commercial business, leverage is, in general, liabilities divided by net worth. Low leverage is desirable since there are more assets to cover the liabilities in the event of default and liquidation.

In this instance, leverage is defined as assets divided by liabilities. The higher the leverage ratio, the greater the asset coverage and the less the risk. If the leverage ratio decreases, it means less assets available to cover every dollar of liabilities. For Calistoga, reporting unfunded pension liabilities dropped the leverage ratio from 2.67 to 1.98, signaling greater risk, i.e., fewer assets to cover each dollar of liabilities.

Q: The last chart statement pointed out lower interest rate environment over the period and reduced principal which shows less need to borrow.

A: A very good observation.

In 2011, the 20-year municipal bond rates varied between 4.75% and 5.50%. In 2015, the rates had dropped to roughly 3.25% at the lower end of the range to 3.85% at the upper end - 150 to 165 basis points difference. This period would obviously translate to lower debt service per dollar of debt.

Course overview: Fund Accounting and Municipality Analysis: Part II of II

Q: If the Subchapter S corporation is not profitable and still distributing funds to owners, unless they have cash on the balance sheet, they may be borrowing to make those distributions. Should you include those distributions in cash flow if it is borrowed funds.

A: Yes. Include the cash distributions as a cash outflow in a cash flow statement since one of the major objectives of a cash flow statement, especially the UCA cash flow statement, is to identify the borrowing cause or causes. In the case you cite, one borrowing cause could well be distributions at a point in time when the company did not have the cash resources to make such distributions. It is very important to know this to assess the risk profile of the company and borrower and to correctly identify the source of cash used by the borrower to meet its debt service.

Course overview: Business Income Tax Returns

Q: I've seen distributions reported in equity as cumulative amounts. Why would this be done and is there an advantage in doing it that way?

A: This is an interesting approach. By reporting distributions as a cumulative balance within the equity section of the balance sheet as a negative amount, the financial statements clearly show the impact distributions have over time on retained earnings and net worth. It would be helpful if this practice were more common.

Course overview: Financial Statement Review and Ratio Analysis

Q: Is it correct to say that if debt service is met under fund analysis, it would be even stronger under enterprise analysis?

A: Not necessarily. Some of the fund amounts may be actually greater than their cash counterparts and could lead to an inflated estimate of cash available for debt service. But funds flow statements, if properly adjusted and assessed, can usually indicate whether sufficient cash flow is available to service debt.

The key question is whether the "near cash" amounts in any funds account will turn out to be actual cash, such as property taxes due in the near term that may not actually materialize.

Course overview: Fund Accounting and Municipality Analysis: Part I of II