Category: Accounting

Cash Flow and Investors

~ C.O.R.E. Beliefs ~ Leave a comment

I am occasionally asked to provide guidance to developers on how best to structure cash flows and how to present the information so that their investors can see what is happening.  Unfortunately, GAAP is somewhat weak in this area so we fall back on good old fashioned sources and uses statements.

Of course, these become a little more challenging when the project has multiple classes of ownership, each with their own return on investment (ROI) expectation.  And they become really hard when the cash flows are no where near expectations.

Naturally, developers don’t turn to the accountant when things are going well – invariably we are asked to weigh in when things are not working as expected.  In the most recent case, the investors are bothered by cash being paid to the developer and they think it should be paid to them.  This is a pretty common theme.

Changing the facts and circumstances a little, lets say you developed a commercial building.  To keep it somewhat simple there are 3 investors and a lender, A, B Developer and Bank.

  • A invested $5,000,000 with a guaranteed 10% return and is supposed to receive the first $500,000 in cash annually after debt service
  • B invested 5,000,000 with a guaranteed 15% return and is scheduled to receive their payment after a $100,000 developer payment to Developer
  • Developer receives their $100,000 payment and then can receive any residual cash
  • The developer predicted about $1.5 Million in annual cash flow after debt service

Cash flow after debt service is $900,000.   Obviously this is somewhat disappointing, especially for B.  According to the accounting,

  • A receives their $500,000
  • Developer receives their $300,000
  • B only receives $250,000 out of their $750,000

B thinks that developer is taking more money than allowed for.  From B’s perspective, Developer received $300K when they should have only received $100K and the other $200,000 belongs to B.

In the course of trying to explain this, we had to dig a little deeper.  We identified that Developer also invoiced for maintenance – $200,000.  The bookkeeper inadvertently recorded it to the wrong account but the damage is done.  B is threatening to sue for failure to perform.

This is where a good sources and uses statement comes in handy.  We were able to lay out how funds came in and how funds went out.  We started from the accrual basis  and created columns to eliminate the various transactions to get to the pure cash in and out.

By identifying how first funds, and then cash, were handled, B was able to understand that the transaction was first recorded incorrectly and second was not a cash transaction.  We actually pointed out that the invoicing for the maintenance was agreed to by the members and could have been paid out as an ordinary business expense but Developer felt it best to try and satisfy B first to the extent possible.  The remaining cash was actually being held onto as a reserve for some defects that were noticed

As powerful as full GAAP statements can be, sometimes it is the simplest statements, like a sources and uses that can make people understand what is actually going on.  Yes, had B read the full financial statement they might have seen what was going on, and yes B could have handled it better than assuming improper behavior on the part of Developer, but the truth is, when you think you are not received your due one tends to see only things from your own perspective.

So the next time you are facing a question over how money and value are coming and going from your activity try a sources and uses statement.  I think you will be surprised how well it might help the situation.

Have a great day.  If you have any questions about this topic or anything else related to business or management, feel free to contact us through our website.  We are here to be of service to you.

Impairment and the Balance Sheet

~ C.O.R.E. Beliefs ~ Leave a comment

Typically it goes like this, “I googled this accounting term and it says that I am not required to do what you are saying.”  Ugh

Do not put your google search up against my accounting degree and constant hours of study of accounting principles.  Kubae actually saw that on a coffee cup and I thought it was pretty awesome.  Clichéd but awesome.

As I wrote on my other blog today GAAP is an accounting model that is selected by the organization.  If you elected to follow GAAP then, when a situation arises that GAAP covers, you are required to comply.

Or not.  Remember it is a choice.

We have worked with a few businesses recently who needed their financial statements reviewed.  They each have bank loans with covenants that require their financial statements to be prepared in accordance with GAAP.  And have those financial statements reviewed.

In each instance revenues are down year over year.  In each instance the companies have substantial non-cash assets: inventory, property, facilities and equipment, goodwill.  And we have asked each of them if they determined that their assets are impaired in value.

Sorry but this is a necessary question in a review.  GAAP requires that assets be tested for impairment, that is, loss of value.   And since you have a loan covenant requiring GAAP financial statements you have to follow the steps called for by GAAP.

Or you can say you are not going to follow GAAP.

By the way, you should be worried about value impairment in the situation where revenues are dropping and profits are slipping.  It is a sign that perhaps you have surplus inventory, desks that are not being used, expensive plant equipment that is sitting idle, shop space unused.  Why wait until the CPA says something?

That was a rhetorical question.  At this stage businesses have bigger problems than if their assets no longer have value.  Your bank moving you to special assets is chief among them.  You are focused on profitability because you think that is what the bank is concerned with.  And slamming more expenses into your fragile profit and loss statement is the last thing you want to happen.

Testing for impairment doesn’t necessarily lead to a write-off of value.  But if it does, so what?  If you are carrying inventory that you haven’t moved in a year then maybe adjusting its value to what you can get for it is a good move.  Think about it, you are trying to correct for past decisions and return to profitability.  Your inventory, and other assets, were a reflection of those past decisions and not dealing with them will actually hamper your turnaround.

Capitalized leasehold improvements has been a big issue for us on review.  What we find is that the accountant (even us) records the depreciation/amortization over 39 years.  Why?  because it fits with MACRS.  But it isn’t disclosed properly.  And then the problem is compounded by the fact that the company has a 5 year lease with one 5-year extension.

There are three years left on the extension.  Revenues and profits are down and management is looking for smaller, more affordable space.  And the company is sitting on $350,000 net book value of leasehold improvements.  It is painfully obvious isn’t it?

The value is impaired like it or not.  You don’t have a $350,000 asset, you have a huge rock tied to your ankles while you plummet the depth of the ocean.   Ignoring the problem isn’t going to help.  When it is time to move to the new facility the business will have to take a $300,000 write off for the inaccurate reporting of the economic life.  And that is the year your line of credit renews.

We know this isn’t an easy subject but you elected to follow GAAP.  Look at your assets and ask if it is still worth it.  You should do this even if you are vastly profitable since it is highly likely that there are assets or asset classes that you are no longer utilizing.

Or don’t follow GAAP.  The choice is yours.  Just don’t get mad at the CPA because she questions your balance sheet.

Have a great weekend.  If you would like more information about impairment or any other GAAP issue, feel free to contact us through our website.  We look forward to being of service to you.

 

Understanding risk

~ C.O.R.E. Beliefs ~ Leave a comment

We were asked to propose on a review engagement about 10 days ago.  This is for a commercial business doing about $20 million in revenue.  Their prior accountant got out of doing attest work – it seems the peer review burden and trying to stay in compliance with the standards was more than he wanted to undertake.

We asked for and received copies of their past two year financial statements as well as their interim statements.

  • Significant losses in 2015
  • Significant losses in 2016
  • Significant profits in 2017

We started asking some high level questions of the controller and her response bothered us.  She started by asking if we were accusing her of “cooking the books”.

If you own a business, or are the responsible accounting person, you need to understand how this goes.  It is all about risk and from the independent accountant’s perspective, the risk is based on who reads your financial statement – so our job (in a review) is to make sure that nothing comes to our attention to make us think the financial statements are not correct.

When we see a pattern like this, we are skeptical.  Believe it or not, skepticism is a job requirement.  The code of professional conduct requires us to be skeptical.  But skepticism is not cynicism and automatically assuming the worse, it is thinking that maybe something is overlooked.

Imagine your teen brings home 2 progress reports in a row which say that homework is not being turned in.  You walk into his room while he is playing video games and ask if he completed his homework.  He says “Yeah of course.”

It isn’t that you don’t believe him.  But lets face it, history isn’t kind and he does have a track record of not doing it.  So what do you do?

Ask if you can see it of course.  You are skeptical.  You are not accusing him of not doing it, you are simply verifying that it is complete and ready to be turned in.

If it is done, great!  Pat on the head and maybe even a hint on how to beat the level.  If it isn’t, well I wouldn’t say he lied, I would say that no doubt the game is interfering with his memory and say that perhaps it is better off in your closet.  Until his memory improves and the homework is done.

It’s a silly analogy but true.  As the independent accountant, we are concerned with risk.  Risk to ourselves naturally, but also the risk that might be taken by the reader of the financial statement if it turns out it isn’t accurate.  We are proud of our independence and objectivity.  And this requires us to ask questions which make people uncomfortable.

Keep in mind, most of us who still perform attest services have seen a thing or two, so we know a thing or two. (Sorry Farmers, I owe you two cents) We realize that the bank is probably paying very close attention to your numbers.  We are pretty certain that another year of losses could end up with you in special assets.  We know that some peoples jobs are potentially on the hook if profits don’t improve.

We have seen it before.  But it isn’t cynicism, it is skepticism.  The patterns are there so we have to reduce the risk that the pattern is real.  And we do this by asking questions.  Sometimes painful questions.

We have to learn your business, your processes.  We have to understand the industry you compete in and sometimes the multiple industries you try to make a profit in.  We have to know what others in your industry do when it comes to capitalizing assets and recording liabilities.  We have to understand your motivation and tolerance for risky behavior.

Keep this in mind when your independent accountant starts asking questions.  And, if your accountant isn’t asking questions, maybe it is time for you to get another accountant.

Have a great day.  If you have a need for an audit or review in Washington or Oregon, feel free to learn more about us on our website and contact us for more information.  We are here to be of service to you.

Accounting for Bond Investments

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Auditing condo and homeowner associations is a very rewarding activity for us.  Between Doug and me, we have many years of experience auditing HOA’s and condominium associations.  For the most part, our role is helping the board and the manager create better, more accountable processes so that the owners can feel comfortable knowing their assessments are working hard for them.

There are several areas however, that toss a wrinkle into the audit process.  And it all revolves around the reserve – specifically having enough on hand or not having enough.  When there is enough in the reserve, the quest becomes making that reserve work more effectively for the association by having it take on perceptively more risk.  When there isn’t enough the owners have to agree to a special assessment and oftentimes bank loans to fund the projects.

Both have their accounting complexity and both have add complexity to the audit.  Today we are going to discuss the accounting and audit issues around having sufficient reserves to allow for some greater returns than money market savings.

The first foray into reserve investing is typically bonds.  These are likely long-term bonds with interest of 3% to 5%.  And the accounting complexity begins almost immediately.

Lets say you buy a $1,000 bond that pays 5% interest.  It had an original maturity of 20 years and matures in 10 years.  And lets say you paid $1,020 for it.  How should you record this transaction?

The simple answer is not the correct one.  It would be so simple to record it as

Bond investment     $1,020
Cash                                         $1,020

And then you record the $50 received each year by recording

Cash                         $50
Interest                             $50

Finally 10 years down the road you get $1,000 and turn in the bond but what happens with the $20 extra you paid?  It would be a loss on the redemption.

Cash                         $1,000
Bond investment                 $1,020
Loss on redemption   $20

But that is not the way GAAP works.  Since you know the price you will receive in the future you need to get rid of the difference between what you paid and what you will receive. You do this by amortizing the difference, the premium or discount, over the remaining life of the bond in your possession.

So, in this case, the easiest thing to do is amortize $2 every year on this bond to reduce the additional $20 you paid.

Interest                 $2
Bond investment        $2

By taking this step you will eliminate any gain or loss at the time of the bond redemption, assuming you hold it until it matures.

This seems simple and straightforward right?  And it is, until you get to 10, 20 or 30 bonds and then trying to keep it all straight becomes an accounting headache.  Then someone needs to manage the spreadsheet to make sure that the premiums and discounts are allocated correctly and guess what, no one really has that expertise.

There is a cost to seeking a higher return on your reserve fund.  Your accounting becomes more complex and because of that, your reporting and ultimately your auditing costs start to increase.  There are disclosure requirements for your financial statement and the auditor has to test the investments and then make sure the right information is gathered to put in the notes.  Having investments, even investments as straightforward as bonds, can easily increase your compliance costs by $1,000 or more.  You need to take that into consideration as you move away from CD’s and money market accounts into other investments.

Taking on additional risk in your reserve fund needs to be thought through.  These investments are not guaranteed by the FDIC or NCUA.  You could be locked into a low return and, if you are investing in non-US government securities, you might even lose your investment because of default.  This doesn’t mean to avoid investing but it does require a board to think about this clearly.  And most importantly, understand that your accounting, and the audit you rely upon, will increase in cost and complexity as you invest more.

Have a great day.  If you would like to discuss this further or would like information on how to work with us at C.O.R.E. please head to our website for more information and to contact us.  We are here to be of service to you.