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Instructor Blog - Credit College - Credit Basics

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Session #4: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success


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  • 8/2/2023 1:38:34 PM

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Q: Please confirm that the company's reported accrual profit is not impacted by distributions.

A: Confirmed. Accrual profit does not include distributions, and taxable profit does not include distributions. According to GAAP and the IRS, distributions are neither a recognized accrual expense nor are they a tax-deductible expense. In addition, distributions are not taxable income to the owner or partner who receives them from the business.

Apart from accounting and IRS definitions, distributions are by their nature very clearly operating expenses. They provide cash to the owner or partner to pay his or her share of taxes on the company's taxable income. To the extent that distributions exceed taxes to be paid by the receiving owner, they are another form of owner compensation. Both tax expense and compensation expense are operating expenses.

Q: Please confirm that distributions are never taxed unless they cumulatively exceed the capital contributions the receiving owner has made to the company.

A: Confirmed. Distributions are tax free cash income to the owner or partner until total distributions to that owner or partner exceed that owner's or partner’s “basis” in the company. Distributions in excess of basis are taxed as long term capital gains.

The definition of "basis" varies. For a Subchapter S corporation, “basis” is the owner's equity in the company plus loans from the owner to the company. For a partnership, “basis” is the partner's equity or net worth in the partnership plus his or her share of partnership debt obligations.

Q: Please clarify the partial UCA cash flow.

A: Our discussion of the UCA Cash Flow Statement centered on the Modified UCA with brief references to the Full UCA. A partial UCA presents only one section or an excerpt from the completed Modified or Full report as is the case with the Modified Operating Section displayed on page 2 in the Session 4 Exercise page.  

The Modified UCA version is sometimes referred to as an Indirect UCA cash flow statement. The Modified UCA starts with Net Income which is then adjusted upward by adding back non-cash expenses to become Traditional Cash Flow. The net change in each operating asset and liability account for the period is then displayed and used to adjust Traditional Cash Flow in a “bundled” approach. The sequence culminates in defining Business Cash Income available to service debt. The operating section is completed by identifying Cash after Debt Repayment.

The Full UCA version, also known as the Direct UCA cash flow statement, begins with Sales and then proceeds to adjust each individual income statement line item by the change in its counterpart operating asset or liability account. An example is the adjustment made to accrual sales for the change in accounts receivable, its counterpart account, in arriving at Cash Sales.

In effect, each major income statement account, such as Sales, Cost of Goods Sold, and Operating Expenses, is adjusted by the change in its counterpart account(s) to identify the cash equivalent for each of these accounts. The process culminates with the same calculation of Business Cash Income reached in the Modified UCA format.

The Modified and Full UCA versions then are identical in their method and format for reporting investing, related party, and financing activity for the period.

Course overview: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success

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