Analytical Decision Tree and the Credit Write-Up
Q: How would we verify what portion of prepaid expenses should have been expensed?
A: To determine what portion of prepaid expenses should have been expensed requires a conversation with someone at the company who is knowledgeable about the account. We could ask the company accountant or bookkeeper a) to assure the lender that all prepaid expenses had been properly brought into the income statement or b) to provide a detailed breakout of the prepaid expenses account. If a proper prepaid expenses balance were the only issue, or one of only a few issues, we would do so. However, given all the other red flags for Sequoia Properties, it is probably not worth the time and effort to pursue this particular issue.
Q: Given that the $1,230,735 reduction in the Due to Clovis Supply balance represents a cash outflow, should we be looking to verify this in the cash flow statement?
A: The cash flow statement included with the accrual financial statements – the Statements of Cash Flows – should highlight the change in the Due to Clovis Supply account. In this case, the change in Due to Clovis Supply is not readily apparent from the Statements of Cash Flow in the accrual financial statement package. The change in the Due to Clovis Supply balance is not broken out separately, but is included in the Change in Long-Term Financing, which is not, to anyone’s surprise, calculated correctly.
The change in long-term debt should be the entire amount of long term debt outstanding at the end of 2014, which is the sum of the current and long-term portion, less the long-term portion of 2013 long-term debt at the end of 2013. The current portion of 2013 long-term debt was paid down in 2014, so the appropriate measure for new long-term debt is a) total 2014 long-term debt less b) 2013 long-term debt excluding the 2013 current portion. We will review the new long-term debt calculation in Session 3, which focuses on constructing and using the UCA cash flow statement.
The bookkeeper or accountant who prepared the Statements of Cash Flows calculated the change in long-term debt using both the current and long-term portion at the end of 2013 and comparing that to the current and long-term portion at the end of 2014. To that change, he or she added the cash outflow of $1,230,735 from the reduction in the Due to Clovis Supply balance. This is all perfectly proper in accordance to guidelines for preparing a FASB 95 statement of cash flows, which is what we have in the Sequoia Properties’ financial statements. But the change in long-term debt from one period to the next is not the same as new long-term debt, which is the real issue we want to address.
The calculations for Long-Term Financing in the Sequoia Properties’ Statements of Cash Flows – a FASB 95 indirect cash flow statement – are as follows:
- 2014 CPLTD of $1,084,569 plus long-term portion of $20,910,939 = $21,995,508
- 2013 CPLTD of $70,418 plus long-term portion of $18.930,965 = $19,001,383
The difference is a cash inflow of $2,994,125. Combining that inflow with the $1,230,735 outflow from the change in Due to Clovis Supply results in the reported cash inflow from Long Term Financing reflected in the Sequoia Properties’ 2014 Statements of Cash flows of $1,763,390.
Again, the $70,418 CPLTD in 2013 should not have been included in the calculation of the change in long-term debt if the objective were to determine the amount of new long-term debt for 2014 because that $70,418 was paid down during the year. The proper calculation for 2014 new long-term debt should be:
- 2014 CPLTD of $1,084,569 plus long-term portion of $20,910,939 = $21,995,508.
- $21,995,508 minus the 2013 long-term portion of $18,930,965 = $3,064,543 of new Long-Term debt.
If the $1,230,735 change in the Due to Clovis Supply balance were included, the number would be $1,833,808.
The calculation of new long-term debt is complicated by the conversion of Schumacher’s $4,112,432 of personal loans from long-term debt to equity in 2014. That $4,112,432 was included in long-term debt at the end of 2013, but not included in long-term debt at the end of 2014. The conversion was a non-cash event, and so the true amount of new long-term debt acquired by Sequoia Properties is $4,112,432 higher, i.e., $3,064,543 plus $4,112,432 = $7,176,975 of new long-term debt in 2014.
Course overview: Analytical Decision Tree and the Credit Write-Up