Fuzzy financials

Northwestern Financial Review, Feb 15-Feb 28, 2003 by Regan, Shawn

What's in your portfolio: Tax minimizers or Market-value maximizers?

With all the accounting scandals coming to the fore of late, and with fourth quarter/year-end financials about to land on their desks, bankers cannot be faulted for wondering if their commercial customers are stealing a page from the Enron playbook and attempting an end run to qualify for loans or keep their covenants.

Legitimate disagreements over accounting options will always exist, but bankers - perhaps now more than ever - need to be on the lookout for "aggressive accounting practices," a euphemism for mischaracterization, deceit and fraud.

In playing it too fast and loose with their financial statements, companies are pursuing one of two strategies. They are either minimizing profits so they can reduce income taxes, or they are increasing net income and/ or strengthening their balance sheets so they can impress investors, clients, vendors and bankers.

He's not my Uncle

"Most small businesses will do everything in their power to avoid paying taxes," said Mark Kuhne, vice president and commercial banker at the St. Michael, Minn., branch of Highland Bank. Kuhne's insight was sharpened by his 1980s experience as the controller and treasurer at an electronics manufacturer in the Twin Cities. "Owners want to get as much cash as possible out of their companies, and sometimes they get sort of creative," Kuhne said.

Misrepresenting capital costs as operational expenses tops the list of deceitful ways to reduce income and taxes. But this tactic also cuts a company's assets and equity. For example: Assume a $100,000 piece of equipment, with a five-year, straight-line depreciation, is purchased with $25,000 in cash and a $75,000 loan. When the equipment's capital cost is treated correctly, pretax income is reduced by $20,000 in depreciation. By applying a 40 percent tax rate - a combination of the federal rate and the average state rate - the depreciation deduction saves $8,000 in taxes. So it reduces net income by $12,000. After the $20,000 is added back on the cashflow statement, depreciation's de facto net effect is to improve the company's cash position by $8,000.

But when the capital cost is deceptively treated as an expense, then pretax income is reduced by $100,000 in operating costs. This saves $40,000 in taxes; net income and de facto cash are reduced by $60,000. So, to save an additional $32,000 in taxes, the company suffered an adverse effect of $48,000 to both its assets and its equity.

In addition, the company could mischaracterize capital costs as operational expenses by having the owner personally buy a long-term asset and rent it back to the business. Or the company could mischaracterize a capital lease with its fixed, buyout amount as an operational lease with a fair-market-value buyout provision.

"If you are seeing the company is buying or leasing lots of property or equipment each year, but fixed assets aren't going up, then you know it's not making it to the balance sheet because it's being totally expensed," Kuhne said. "That could be a warning signal of ignorance or deception."

Other common, questionable subtractions from income are:

* Salary and wages that include the owner's family members who have high rates of absenteeism;

General and administrative costs that include home computers and family educational expenses;

* Travel and entertainment expenses that include family vacations; a Premiums for salary continuation plans that can amount to highcost retirement plans for a select few employees;

* Depreciation that's been over-accelerated;

* Stock given to employees.

(Whether this is a problem depends upon the motivation of the owner and employees. They may both prefer stock in lieu of pay, or it may be indicative of a cash flow problem.)

Additionally, bankers should be alert for some really nasty instances of fraud, such as the creation of phony employees or vendors. Then there's always the red flag of burgeoning bad debt in accounts receivable. This signals some combination of several possibilities, none of them good: poor collections, non-delivery, shoddy products, or stolen receivables.

Pumping profits, nice assets

On the other side of the counterfeit coin, businesses may buff up their income statements and balance sheets to a glitter that betrays only fools' gold. Low and behold, the charade of choice to accomplish this is to misrepresent operational expenses as capital costs - just the opposite of the host popular tactic to reduce profits and taxes.

"The place to detect deceit is on the balance sheet, in the valuation of assets and liabilities" said Rick Burrock, CPA and managing partner at Boulay, Heutmaker, Zibell & Co. P.L.L.P, a regional accounting firm in Minneapolis. "When a company is trying to create profits, it usually means there is a corresponding asset that's over-valued. Management may try to push too much [operational] cost into inventory, property or equipment on the balance sheet." A couple examples illustrate how this might be done.