The Credit Write-Up and the CRE Analytical Process (Session #1)
Q: Why are distributions to owners not reported as an expense?
A: IRS guidelines state that distributions made by “pass-through” entities to owners or partners may not be deducted as an expense on business income tax returns. In addition, distributions are not reported as taxable revenue to the recipient on his or her personal income tax returns.
The IRS disallows distributions as an expense and treats them, instead, as a reduction to the partners' capital account or as a reduction to corporate retained earnings. The accounting profession has adopted the same approach in establishing GAAP to guide preparation of accrual financial statements. Distributions are not recorded as an expense on an accrual income statement. Distributions are, instead, posted as a reduction to partners' capital or corporate retained earnings on the accrual balance sheet.
Considering distributions and withdrawals apart from IRS guidelines and practice by the accounting profession, it is clear that distributions are, indeed, an expense by their very nature. They are used to provide cash to owners or partners to pay taxes due on business earnings or if distributions exceed taxes due – which will frequently be the case – they become compensation to the owners. Since taxes and compensation are operating expenses, it is appropriate for lenders to adjust reported earnings by the amount of distributions in analyzing the company’s performance.
Q: Where are distributions reported on the balance sheet?
A: Distributions or withdrawals do not generally appear as a line item on the balance sheet.
Distributions are, instead, reported in reconciling the capital accounts or corporate retained earnings in the notes or in a supplement to the balance sheet. Annual distributions are reported as a line item in reconciling the Statement of Shareholders' Equity or Partnership Capital and in reconciling Retained Earnings. The Statement of Cash Flows, when included in the financial statement package, reports distributions as a line item in the Financing Activities section of the statement.
A fundamental resource for locating distributions in a typical submission is Schedule K or the summation of all distributions reported on individual Schedule K-1 statements.
In the absence of these sources of information, another option is to reconcile Retained Earnings or the Owners’ Capital Account as follows:
- Prior Year End Retained Earnings (or Capital) + Current Year's reported net income = Expected Year-End Retained Earnings (or Capital)
- Expected YE Retained Earnings (or Capital) – Actual Year-End Retained Earnings (or Capital). If the result of this step is zero, then no dividends were paid. If Actual Year=End Retained Earnings (Capital) is less than Expected Year-End Retained Earnings (or Capital) creating a negative numerical answer, then the company paid distributions during the current year in the amount of the calculated difference.