Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success (#4 in series)
Q: If a loan to an owner gets converted to distributions later via accounting entries, then how would we know? If this happens, then that distribution later should not be taken out of net income (because it would be hitting them twice)?
A: If a loan to an owner in the Due from Officers / Stockholders account on the balance sheet is converted to, or reclassified as, a distribution, it may be reported in a footnote if the event itself is sufficiently material. In this respect, it is always helpful to carefully read all the footnotes – or statements to business income tax returns – before spreading or attempting to analyze the financial statements. There is usually a footnote devoted to loans to or from related parties, e.g., loans to or from owners, and changes in such loans from one period to the next. But there is no assurance that the footnote will include information about a conversion of owner loans to distributions.
You are correct that if you have completed a UCA cash flow statement, the loans to owners should have been deducted from the cash flow during the year the loan proceeds were paid out in cash to the owner(s). Note that the $67,254 loan to Larry Crevin, a cash outflow, was properly accounted for in constructing the 2013 Cash Flow Snapshot Worksheet that resulted in negative Business Cash Income of $163,945.
Assume now that the $67,254 loan is converted to distributions in 2014 while the amount of distributions for 2014 is reported as $252,616, which is identical to 2013 distributions. The balance in the Due from Officers / Stockholders account would decrease from $132,732 back down to $65,478, presumably a cash inflow of $67,254. If we were to recast the Cash Flow Snapshot Worksheet, the “Change in Due from Loans to Shareholders” would report a cash inflow of $67,254 and “Distributions” would report a cash outflow of $252,616. The net of these two amounts is a cash outflow of $185,362. In effect, $67,254 of 2014 distributions represented the reclassification of a 2013 loan to Larry Crevin as a 2014 distribution. The actual amount of cash outflow to Larry Crevin in 2014 from the combination of loans and distributions would be $185,362.
In this example, 2013 distributions reduce retained earnings by $252,616 while the actual cash outflow from loans and distributions to Larry Crevin was $252,616 + $67,254 = $319,870. In 2014, distributions again reduce retained earnings by $252,616 while the cash outflow from loans and distributions to Larry Crevin would be $185,362. The sum of distributions in both years is $505,232. The sum of cash outflows from the company to Larry Crevin in both years from loans and distributions is $505,232 or $319,870 + $185,362.
So long as we always add distributions and loans to owners together in each year, regardless of whether we know that a conversion took place during the year, we will get it right in constructing the UCA cash flow statement.