Q: On Schedule K at Line 1, what does the $201,887 represent?
A: The $201,887 is the company's ordinary business income reported at Line 22 on Schedule 1065, which is the quasi-income statement on the first page of Form 1065.
Q: Why are the costs on uncompleted contracts categorized under depreciation?
A: Schedule M-1 is a fixed format schedule. The accountant has little flexibility in entering data. In this case, the Cost of Uncompleted Contracts must be recorded at Line 4 on Schedule M-1. If the accountant's software package had allowed it, he or she should have typed in a Statement that would be included in the set of Statements following the tax return schedules. We discovered this only by checking all the Statements and identifying this amount reported in the Federal Supporting Detail set of information.
Q: How do the adjustments to Schedule M-1 affect cash flow when calculating a DSCR for a borrower?
A: It depends on which income statement a lender uses. If it uses Schedule 1065, the quasi-income statement on the first page of Form 1065, then these adjustments play no role in computing traditional cash flow, i.e., in computing net income plus non-cash charges, and a DSCR using only income statement information.
However, if the lender uses these adjustments – as we'll see in Sessions 6 and 7 – to construct an accrual income statement, then the amounts for net income and for depreciation expense will change, which changes the computation of traditional cash flow and the computation of an associated DSCR. Further, traditional cash flow and debt service coverage ratios based on income statement information can only be computed properly from an accrual income statement and not from the quasi-income statement in the business income tax returns. This is a point we explore and clarify in Sessions 6 and 7.
Note, too, that with an accrual income statement, Schedule L, and information from various Statements can we construct a full UCA cash flow statement – an issue we explore in Sessions 6 and 7 – which then allows us to identify actual debt service coverage for a period in question.
Q: When we are calculating global cash flow where we include the shareholders personal income, do we add back the Section 179 expense?
A: Adding back the Section 179 Deductions is a common error. The Section 179 Deduction does not play any role in determining net income or depreciation expense for a pass-through organization such as an S Corp, a partnership, or an LLC. Further, a shareholder's personal cash flow statement is not touched by the Section 179 Deduction. It plays no role in determining a guarantor's personal cash flow surplus or deficit.
However, if one of the related parties in a global cash flow scenario is a C Corp, the Section 179 Deduction is bundled with depreciation expense on the business income tax returns and must be removed in computing business "cash flow'. On an S Corp's accrual income statement, however, there is no Section 179 Deduction reported in any expense category. An accrual income statement is free from the Section 179 Deduction.
Course overview: Schedule M-1 and the Accrual Income Statement