Agreements Matter

I have been summoned to a meeting.

I was helping a developer client with a sticky problem.  Once of the LLC’s was showing unequal capital accounts and I was tasked with trying to figure out why and then work with the LLC’s tax advisor on getting it straight.  Now the members wanted to discuss the impact of the plan to correct the problem their not following the operating agreement created.

The capital accounts were all out of sorts with a low of about $4K and a high of $50K.  Now, it is important to realize that the LLC was owned equally, 20% each for five members.  Distributions were all over the place.  All distributions happened on the same day but for entirely different amounts.  There were no instructions in the operating agreement to allow for disparate distributions.

The LLC’s CPA and I set up a meeting to review what had been happening and why.  The concern is that at least one capital account will go negative in 2019 and there is a plan to sell the project in 2020.  Not surprisingly, there is no claw-back or capital restoration provision in the LLC operating agreement.  So, someone was getting a bunch of money upfront with no requirement to take less than their 20% of the net proceeds upon sale.

The stuff of lawsuits.

Here is the frustrating part.  The tax advisor knew what they were doing was going to cause a problem but what could he do?  It was why he had his team set up the first layer of reallocations – to try and address the shifting of cash without the shifting of income.  Clearly it wasn’t enough.

I give him credit, he had tried to address this matter repeatedly over the previous 3 years.  He shared with me all his emails and memos to the manager and members.  To the members, it wasn’t a problem, until it was; capital accounts are edging towards negative territory.  His efforts to get the Members to see reason wasn’t working and it was now becoming a serious problem as almost 20 individuals were involved in this LLC.

The basic issues:

82% of the space is occupied by tenants controlled by the members.  Each of these tenants pays the same lease rate / square foot.   This is so even though they do not occupy the same amount of space.  Tenant 1, which is controlled by Member A occupies 25% of the total SF while tenant 5, controlled by Member E occupies less than 8%.

This isn’t as irrational as it sounds.  I agree that the goal should be to charge market rates for the space being occupied.  The 5 controlled tenants are paying $32.00 / SF.  It is a class A office building in downtown.  Each of the controlled tenants is occupying and using all the space they are paying for.  Is $32/SF reasonable?

Or perhaps that is the wrong question.  If we determined that the rent was overpaid, wasn’t it logical to offer a rent rebate back to the tenant?  After all, the tenant is the one who paid the rent, not the member.  The ownership of the LLC members was not the same as the tenant.  And remember, none of the members actually leased space; their businesses did.

What the CPA and I agreed to was that none of the tenants were overpaying rent, even though they are controlled by a member.  A business with 20 employees (tenant A to a tee) would occupy 5,500 SF of class A space.  They would pay anywhere between $20 and $40 / SF.  A business with 6 employees (tenant E) would pay between $24 and $48 / SF.

What we want is the members to accept that certain tenants (the affiliated tenants) are occupying the space and paying the rate / SF they are, due to the superior negotiating strength of the respective Member.  In short, Tenant 1 management was convinced to pay fair rent in this building for the space occupied.  Neither tenant nor member used a leasing agent.  Tenant was unable to negotiate a lower rate due to the control.  If this is true, couldn’t the argument be that the Member who put the tenant into place should get the benefit of the premium paid to the LLC for the additional rents paid and costs avoided?

Naturally being accountant’s we had to make it a little more complex but we ran it by counsel and the lawyer felt it was reasonable.  We had economic substance – a rational reason to reallocate cash flows and we had a model which supported the calculation.  Our reasoning that larger spaces could command a discount is sound and the fact that the controlled tenant didn’t (or couldn’t) request lower rents was because of the control of the Member.

The calculation actually allowed us to document almost all the distributions.  Three tenants had been overdistributed during the prior 4 years and two received less than they should have.  The largest over distribution is about $37K and the Member with the largest deficit was only $27K.  These can be corrected in the last distribution of 2018.

The downfall of this plan is that we would be creating specific allocations of the revenue.  The only way to do this fairly was to treat the payments as guaranteed payments.  That means that the Members could potentially see a tax hit for the payments.  Naturally, no one is happy about that and this is the reason for the meeting next week.  Also, no one wants to amend the prior returns as the sheer number of returns involved amounts to almost 200 separate amended returns.

Since I don’t know the tax situation of any of the individual members I can’t say with certainty what the net effect would be when passed through to all the various owners.  My gut instinct is almost zero; which means the concern is overblown.  But people fear what they have been conditioned to fear; in this case, each Member has a different tax advisor who has considerable influence over the client and each tax advisor has a different take on taxes.  Me personally?  I think that taxes are an ordinary cost of being in business: Make money – pay taxes.  But like any business cost, there is no need to pay more than you should.

I happen to agree with the LLC’s tax advisor.  the net cash flow from the rents after debt service should be distributed only in relationship to the Members ownership, i.e. 20% each.  If they wanted it another way, the structure should have been different – that is, perhaps the tenants should have purchased their space similar to a condominium arrangement and then they could have redistributed the net back to the owners.  But, that isn’t the structure they wanted.  They wanted to keep it simple.

While I understand the argument from the Members, it doesn’t stand scrutiny.  The rents charged were within an expected range.  Yes, Member A has a point; in comparison to smaller spaces for the other tenants, his company is overpaying.  But in relationship to the rest of the market, the lease rate was reasonable.  I can see where the Member could say he was being forced to shift income and cash flow to the other members if they didn’t reallocate; so what? This could have been easily avoided by the Member owning a smaller building and leasing it to his business as the sole tenant.  That isn’t what they wanted.

All this simplicity created enormous complications.  So, it is extremely important to think through your organization and how you want to generate revenues and distribute profits because in many cases your options are limited by the structure of your agreement.   Agreements matter and trying to smash a complex arrangement into a simple business agreement will cause nothing but headaches.

 

Understanding Overhead

When I first start evaluating a financial statement, I try to group costs together logically.  It is far too typical for most businesses to rely upon the canned reports and these are almost always prepared in GL Number order.  But a clearer picture can be developed by grouping the costs of revenues separate from the overhead and the overhead into 4 main groups.

The overhead groups I prefer follow the Throughput model:

  • Labor Overhead
  • Marketing Overhead
  • Facilities Overhead
  • General

A little bit about the groupings:  Labor overhead includes not only those who are on payroll but also consultants and outsourced staffing.  So, for instance, if your company outsources janitorial services, this expense is reported in labor, not facilities.  My approach is to put all labor into labor overhead, including production labor, unless it is truly variable – which most is not these days.

General is the catch-all classification.  There are two services I typically would group into general – legal and auditing.  While both are still people performing services, these are services which your business typically cannot provide internally.  Otherwise, if it cannot clearly fit into one of the other three groups, put it in general for now.

Let’s say your business does $1.0 Million in sales monthly.  Your direct material costs are $350K and you have depreciation on equipment which manufactures the products you sell of $50K.  Throughput, which is the measure of how much money you generate to cover overhead and profit, is $600K.

Continuing our analysis:

  • Labor Overhead runs $400K  or 66.7% of throughput
  • Marketing Overhead is $50K  or 8.3% of throughput
  • Facilities Overhead is $50K or 8.3% of throughput
  • General Overhead is $30K or 5.0% of throughput

In total you are spending $530K to generate $600K of throughput.  88.3% of every dollar you bring in is consumed by your overhead, of which most is tied up in labor costs.  You see, when you separate out your labor into different categories, such as production labor, sales commissions, accounting and office staff, you can lose sight of the total amount you are spending to generate throughput.  It isn’t that these separate amounts are not important, but when you are looking at leveraging your business, having expenses scattered everywhere can lead to a misunderstanding.

Properly grouped, we can start analyzing.  There would be two points of reference to the analysis, average and best case.  Both of which can be found in the prior year’s records.  For the average, I would recommend taking the last 5-7 years of information and reformatting to match the groupings above.  You are looking for a trend and what you will likely find is that throughput has remained fairly steady but labor overhead has crept up.  It isn’t necessarily bad, but it does indicate that more money is being paid out for peoples time but the company is not getting much in return.

The comparison to best case can be a real eye opener though.  Here you find the year where there was the most profit and then compare where you are today with the overhead structure in place when the company made vast profits.  In almost all cases, you will find that the company increased spending across the board relative to that maximum profit year.

So, instead of giving a bonus to the employees and management, the company raised base compensation.  The company went from a 50,000 sf facility to 100,000.  When you study this great year you start realizing that perhaps it was luck and you were betting it would continue – only to find out it didn’t.

GAAP statements have their purpose.  But managing to GAAP can be dangerous to the bottom-line.  It is all too easy to want to capitalize everything into your inventory but that means that today’s costs are probably being buried and will be recovered in a later year.  But in the meantime, your costs are possibly growing out of control which is impacting your current cash flow picture and may even hurt you in the future if you have to reduce prices to be competitive.

Consider using the Throughput model for evaluating your internal financial statements.  I think you will be surprised at how much information it can provide you to help you make better business decisions.

If you would like more information or would like to discuss how effective analysis can help you understand your operations and profitability, feel free to contact mecontact me anytime.  I am here to help.

 

An Uncomfortable Moment

The other day I was speaking with another CPA firm’s leaders about opportunities to cross-refer – they don’t do audits or reviews and we don’t do taxes – and I was asked what one of my most uncomfortable professional issues was.  I dislike airing my dirty laundry but at the same time, I have found that being forthright about these things helps me heal as well as hopefully provide a lesson for other professionals.

In 2002 I was “interviewed” by a joint task force investigating abusive tax practices.  Even today I am upset with myself for having put myself in that position.

I was in my 7th year (2000) and was recently given responsibility for managing the tax team along with the accounting and auditing team.  Beyond knowing what was, and more importantly wasn’t, allowed, the owners felt I could apply some of our audit processes to tax.  It was fun redesigning the entire workflow to streamline the processes.  I was also part of the local chamber and about that time I was asked to give a presentation on tax planning for small businesses.

After my presentation, I was approached by two gentlemen who wanted to discuss an idea they had.  I am always game for a business conversation so I set an appointment with them.  They gave me some materials they put together and asked if I would read them to plan for the meeting.

As I read their stuff, I became concerned about what they were trying to do.  I made my notes, did lots of research and came to the conclusion that what they wanted to do wouldn’t fly.  But…

And this is where things went sideways for me.  I love a challenging problem.  So I decided to change the scenario, restructured how it should work, Identified potential pitfalls and even created the basic literature to help them with sales.  All told, I invested about 20 hours into this before we even met.  But I felt good – I took a problematic process and modified it to where it would work.

When we finally met, they appreciated the information but were disappointed that I felt their plan wouldn’t work as they had originally conceived it.  I walked them through my analysis and they seemed to have a response to every point.  This seemed odd, so I asked them about how they had come to so much knowledge about this… and they divulged that they had been to 3 other firms who each had found flaws in their plan: I was the only one to offer a full rebuttal and a new concept though.

They asked me how confident I was in my research and I told them very confident.  They then offered us $15,000 to help them formalize the documentation and issue a tax opinion on the plan.  That was a good sized engagement and I felt I had convinced them that my way was superior to theirs – even if they couldn’t offer a huge tax benefit to participants.

The next week I met with their in-house accountant and their attorney, along with the owners.  Once we got going they kept pushing to use their original plan as they felt it was bullet-proof.  I told them that if they felt it was bullet-proof then they didn’t need me.  I explained that their plan would never fly; they kept saying that it was being done by this firm on the east coast.  They got another lawyer on the phone from back east who allegedly represented the firm who was “killing it”. He agreed that it was a “gray area” but he was certain it could pass an IRS challenge.

I did a lot of soul searching on the matter.  They were certain they were right and I was certain they were too aggressive.  I felt our more conservative approach would survive a challenge, which was most likely to happen since they were targeting larger corporations with their plan.  In the end I wrote the opinion letter based upon the plan I outlined, not theirs.  I wrote them a separate letter stating why their plan would not work, quoting chapter and verse of the tax code.

They thanked me, paid our bill and I never heard from them again.  But I did hear from the task force about 2 years later in 2002.  It seemed they decided to use our tax opinion letter to support their more aggressive plan.  One of their customers used it to justify their participation, were audited, and showed the IRS auditor our opinion report who then pointed out that the plan they put in place was not the plan I wrote an opinion on.

Which led to my being interviewed.

I missed the warning signs.  I understood opinion shopping but hadn’t really faced it before.  I was quite proud of that research and how well we documented the situation.  It was complex and challenging.  But I failed to heed my own warning signs.  I saw the problem and thought they could see the elegance and superiority of my plan.  In the end they saw their greed and willingness to use people to get the results they wanted.

It was an uncomfortable experience and I don’t recommend it to any professional.  It did, however, give me great life, and business lessons that I still use to this day.

  • Go with your gut.  As a professional advisor, you have to trust your instincts.  Not every client is a perfect client and if you feel they are not a good fit, go with it.  There are other client opportunities out there.
  • Be wary when clients shop other advisors.  I think a client interviewing several potential firms is a smart move, especially for business clients.  I encourage it.  But it is entirely different when they seem to have paid several firms for advice they don’t seem interested in heeding.
  • If a client plans on using your work to stay out of trouble, make sure it is effectively documented.  We had an engagement letter and I kept copies of all our drafts and research.  We also kept all their correspondence which showed their thoughts and plans.
  • Finally – slow down.  I love a good juicy complex problem.  I enjoy research, writing and presenting.  But I jumped into it before I knew the client.  I inadvertently talked myself into this engagement by buying into the solution I presented.  Had I gotten to know them a little better, we would have likely turned down the work.  Yes, a good sized engagement is always hard to turn down, but having to sit for an interview with law enforcement is almost always going to be uncompensated.

Be selective.  I have come to understand me and my passion for problem solving.  But I have also learned that not everyone’s problem is worth the energy.  I like underdogs, I love winning.  I have learned to love learning (losing) by choosing the work I want to do for clients I am passionate about working with.  Having fewer, more engaging clients who value your input and expertise is much better than tons of clients who treat you as a commodity.  Quality over quantity every time will help you become healthy, wealthy, and wise.

 

Understanding Why Financial Reporting Exists

I was asked to answer a question on financial accounting concepts on Quora.   I felt that it is an issue worthy of sharing on my blog as well as we don’t often discuss why we have expectations when we prepare and audit financial statements – other than to say GAAP requires it.

The most basic concept underlying financial reporting (and the accounting procedures used to accumulate the data) is investment decision-making.  Everything Mahesh spoke to, and what I am going to elaborate on, is premised on the need for some information for investment decisions.

FASB and IASB have concept statements.  I am most familiar with US GAAP which is put out by FASB.  But I believe both standards setters agree overall on the concept of information necessary for decision making.

Ask yourself, if you were ready to make a decision to invest in a company, what information would you like to know?  Conceptually, the argument goes, you would like to know the business’ financial position – its balance sheet; its operations – profit and loss statement; and its cash flows.  These collectively make up the general purpose financial statements.
Oftentimes, the information presented on the face of one of those statements does not tell the whole story.  Take inventory as an example.  Lets say the statement of financial position says only that inventory is $1.0 Million.  As an investor, your decision to invest might change if you knew that the inventory was all finished goods: Or perhaps it is all work-in-process.  Knowing additional details which can impact an investment decision might still be necessary, the standards require additional disclosure – footnotes – to help investors put those statements into context and provide details that otherwise do not exist.
These statements do not exist in a vacuum.  They are the accumulation and summarization of thousands and millions of transactions.  And to ensure the necessary information is presented timely, is a faithful representation of what actually happened, and is relevant, the standard setters created accounting principles.

And to ensure that investors receive accurate information based on these guiding concepts, it is important that reported information be verifiable (can be audited successful) and comparable to others in similar situations.  This is why there are industry-specific principles and there is a focus on establishing an effective audit trail.  Investors should be wary where there is first, not an independent examination of the statements and second, where the underlying accounting is totally dissimilar to everyone else in the industry.  Sadly, it happens all too often.

If you are a small business and your bank requires you to prepare GAAP financial statements, it is important to understand that this is what they are looking for: Investment Decision information.  It doesn’t matter if the financial statements are prepared by your bookkeeper or audited by an independent CPA.  Your business is responsible for sharing financial information that the bank can use to make an investment (loan) decision.  You have an obligation to ensure it is accurate, tells the whole story, can be compared to other businesses that are in the same industry as you, and ensure that whatever is recorded can be independently verified.

You, management, are responsible for the accumulation, summarization and reporting of the information.  Management decides when to recognize revenues; or to have it be reported as unearned because the job isn’t done; Management decides if a product was actually sold; or was actually shipped to another warehouse across the country.  There is an undeniable tension between management sharing accurate accounting information and investors receivable actionable investment information.  You see this played out frequently in the press when you see a stock slide because a company missed its revenue target.

Accounting principles exist to put the concept into context.  Accounting principles are not complex or difficult to employ, business is moving farther and farther away from simple transactions of shifting values from producer to consumer.  Complex transactions make for challenging financial statements as investors cannot see where value begins and ends.  So ask yourself, do you really want to invest in a company where you can’t tell who owns what and who is owed what?  If not, demand that GAAP be followed; otherwise:

Caveat Emptor baby.