The Difference Your Method of Accounting Can Make #2Posted on March 21st, 2016
Outsourced Accounting Department, Inc.
In my first article on this topic (“The Difference Your Method of Accounting Can Make”), I talked about a private ambulance company that was able to obtain significant bank financing, improve receivable collections and cash flow, and solve an employee turnover problem while simultaneously reducing labor costs, all by simply using the proper accounting method to evaluate their true financial situation. In this article I will talk about what can happen when the wrong accounting method is used.
To provide a little background, over the past fifteen to twenty years, as banks have gotten bigger and bigger, the banking industry has gotten away from requiring financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), the underlying premise of which is to “match” revenues with their related costs (Accrual Accounting). Instead, for its own convenience, the banking industry has gone to using tax returns, credit scoring, and what’s called a “global, debt service coverage ratio” to measure a small business’ ability to repay a loan. Basically, this means that if the company’s and its owner’s combined tax returns show a lot of income, and the owner has a high credit score, you’re in! If not, you’re out!
The problem with this loan underwriting approach is that while a business owner can utilize legitimate tax methods to reduce his or her business income for tax purposes, using this same information may very well work against them when applying for a business loan. And since banks no longer require GAAP financial statements for “small” businesses, owners don’t request them from their CPA firm because they don’t understand why they need them, and they don’t want to pay for them.
A case in point: A while back, a client of ours found out what happens when your bank relies on your tax return to support your line of credit. As a matter of practice, our firm always prepares the company’s internal financial statements based on GAAP, and then at year-end, if our affiliated CPA firm also prepares their tax return, they also prepare GAAP financial statements to accompany them. However, in this case, the client used another CPA firm who simply took our financials and converted them to cash basis for tax purposes, and a tax return was all the bank required to support the company’s $500,000 line of credit.
For the record, we did strongly recommend to their CPA that he also prepare compiled financial statements in accordance with GAAP using our internal numbers. However, as his firm was strictly focused on tax preparation services, he told our mutual client that he knew the bank’s management, and that he didn’t need GAAP statements. Then the CPA made some major accounting adjustments for tax purposes that made it appear that the company had distributed a large amount of money to the owner all in one year, and paid off a stockholder loan that was subordinated to the bank’s loan. In fact neither of these were true, and compounding the problem, this was at a time when the company’s “taxable income” (cash basis) was already way down. The outcome? The bank panicked and terminated the company’s half million dollar line.
Sadly, the owner had already taken corrective action based on the internal numbers we provided to him, which painted a true picture of what was going on in his business and reflected the measures he had taken. Had the proper financial information also been provided by their CPA on an accrual basis, it might have instilled more confidence on the part of the bank’s management in the business owner, and perhaps the outcome would not have been quite so drastic. But instead, the bank had no idea what was really going on in the business, and this is what banks do when they don’t know what’s going on. Lesson learned – the hard way!