Author: Robert Wood, CPA, Principal
Make Your Clients’ Aware of DPAD – An Often Overlooked Tax Deduction
The end of the year is a great time to revisit certain tax-saving opportunities, especially Internal Revenue Code Section 199, involving the Domestic Production Activities Deduction (DPAD). If you are an asset based lender with clients who aren’t aware of the DPAD, or are simply intimidated by its perceived complexity, you can do a great service for them by raising awareness of the possibility that they might be leaving money on the table.
Production activities that qualify
Do you have clients in any of the following lines of business? They may qualify for the DPAD:
- U.S.-based construction services, including renovation and building of commercial and residential properties,
- U.S.-based manufacturing,
- Architectural and engineering services relating to a U.S.-based construction project,
- Leasing, selling or licensing items manufactured in the United States,
- Leasing, selling or licensing motion pictures or recordings that are produced in the United States, and
- Software, including all video game development in the United States.
In addition to the above list, mining, oil extraction and farming also qualify as domestic production activities. Moreover, businesses qualify even if their products are partially produced in the United States. Safe harbor rules allow businesses to take the DPAD if at least 20% of total costs result from direct labor and overhead costs incurred domestically.
Mind the limitations
The lines of business that are specifically excluded from claiming the DPAD include leasing or licensing activities to a related party, cosmetic construction services (such as decorating or painting ), and selling food or beverages prepared at a retail establishment.
The DPAD is generally equal to 9% of the lesser of a borrower’s qualified production activities income (known as QPAI) or its taxable income (or adjusted gross income for estates, individuals, and trusts). The DPAD generally can’t exceed 50% of W-2 wages paid to employees.
Understand the mechanics
If a client engages in only qualified domestic production activities, the QPAI will typically equal its taxable income. Companies that manufacture or produce partially outside the United States must implement cost accounting mechanisms to make sure their tax deduction is calculated accurately.
To show how the deduction works, suppose ABC manufactures widgets in the United States. The revenue from domestic widget manufacturing is $4 million, with $2 million of domestic manufacturing costs. ABC also reports $500,000 of income derived from repairing software, which doesn’t qualify as a domestic production activity. Total W-2 wages were $600,000, including $400,000 to provide needed repair services.
The QPAI thus equals $2 million ($4 million of software revenues - $2 million of manufacturing costs). ABC can deduct $180,000 under IRC Section 199 (9% × $2 million of QPAI), assuming ABC has at least $180,000 of taxable income. Moreover, the deduction would be limited to W-2 wages attributable to software production ($600,000 - $400,000 = $200,000).This is a simplified example. S corporations and other pass-through entities also qualify for the DPAD, which reduces their owners’ personal tax obligations. Eligible borrowers should revisit their calculations and consult a tax professional to ensure full compliance and adequate documentation.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in helping you show your clients ways to minimize their taxes.
For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.
Author: Robert Wood, CPA, Principal
Guidance on Factoring Timing into the Liquidity Equation
As you know, many loan covenants include a minimum liquidity threshold based on static metrics, such as the quick ratio or current ratio. Asset based lenders have learned the hard way that a large decline in liquidity can foreshadow bankruptcy. But few banks consider (or even know about) the cash conversion cycle (CCC), which factors timing into the liquidity equation.
The term “liquidity” refers to an asset’s nearness to cash. For instance, current assets (those that will be consumed or converted to cash within the next 12 months) determine a company’s liquidity. Marketable securities are generally more liquid than trade receivables, which in turn are typically more liquid than inventories.
Common liquidity metrics
Static liquidity measures tell whether a company’s current assets are sufficient to cover its current liabilities. A loan agreement, for example, may require a borrower to maintain a current ratio of 1.75. What this means is that, for every $1 of current liabilities, the client should have at least $1.75 of current assets.
The quick ratio (also known as the acid-test) is a more conservative static liquidity measure. It compares the most liquid current assets, such as cash, trade receivables and marketable securities, to current liabilities.
Pretend you’re comparing two borrowers. Borrower A has a current ratio of 2.5 and a quick ratio of 1.8. Borrower B, on the other hand, has a current ratio of 1.5 and a quick ratio of 1.0. Both borrowers have sufficient current assets to cover their current liabilities, but Borrower A seems to be more liquid and, thus, healthier. But, if you compute the CCC, you may very well come to a different conclusion.
The CCC difference
Current ratios assume that cash, inventories and receivables are all immediately available to pay off any debt. The CCC accounts for the timing of converting all current assets to cash and then paying off current liabilities. It’s really a function of three other ratios: CCC = Days in Inventory + Days in Receivables - Days in Payables.
As you can see, the CCC gauges how efficiently a client manages working capital. A positive CCC shows the number of days a company must borrow or tie up capital while waiting for payment from customers. A negative CCC, however, represents the number of days a business has received cash from customers before it has to pay its suppliers. A strong borrower will have a low or even negative CCC.
Who is more efficient now?
If we return to the example, let’s suppose that Borrower A maintains 60 days in inventory, 80 days in receivables and 30 days in payables, which generates a CCC of 110 days. But, let’s suppose Borrower B has 45 days in inventory, 45 days in receivables and 60 days in payables, which generates a CCC of 30 days. All of a sudden, Borrower B looks a lot more efficient. Why?
Borrower B is carrying less inventory and incurring lower carrying costs. It also collects from customers much faster than Company A is. Plus, it extends its payments to suppliers longer, therefore taking advantage of a form of interest-free financing.
So, based on our expanded liquidity analysis, Company B looks a lot stronger, so long as its inventories can meet customer demand, suppliers aren’t angry with the two-month lead time on payables, and collections are without excessive early bird discounts.
The bottom line
The CCC offers greater insight into a borrower’s liquidity position over time when used in conjunction with traditional static measures of liquidity. But before you make any credit decisions, make sure you evaluate other metrics, such as profitability, leverage and growth, and then compare the borrower to others in its industry.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your loan portfolio using CCC and other types of analyses.For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.
Author: Paul Muldoon, CPA, CIE, CFE, Senior Manager
Be the voice of reason when it comes to customer growth.
Whether a client’s business growth happens through internal expansion or external acquisition, they share certain denominators. Borrowers usually need more capital — either private equity or debt — to achieve their objectives. And these entrepreneurs tend to overestimate how they will perform while underestimating timing and financing constraints.
Asset based lenders often serve as the voice of reason by 1) reviewing expansion plans skeptically — that is, by asking key questions — before approving an expansion or acquisition loan, and 2) requiring borrowers to provide financial statement projections and other analyses.
Clients have several expansion strategies from which to choose. And lenders should analyze these tactics carefully.
Build from within
Clients can take the slow and steady path by stepping up sales themselves. Internal growth strategies might include building a new plant, developing a new product or service, purchasing new machinery or expanding into new markets.
But, building from within isn’t without its drawbacks. First, management must devote a lot of time to marketing and selling, which means there’s less time for normal operations. This scenario can be especially disruptive for a business that relies on just a few key individuals. Likewise, integrating new equipment or facilities can consume time at the expense of customer service and existing sales.
Moreover, new products may cannibalize existing ones, or a new target market might reject a product extension. Conducting preliminary tests via free trials, surveys and focus groups is an inexpensive way to avoid costly marketing miscalculations.
Consider an acquisition
Purchasing another business is the fast track for growth. An acquisition usually provides assets and an established track record, including a pre-existing client base, immediate cash flow, an assembled workforce and customer referrals.
Business combinations make the most sense so long as the value of the combined entity is greater than the sum of its parts. So, acquisitions should create value via operating synergies, economies of scale, and cross-selling opportunities. Your competitors will likely be the most obvious acquisition candidates.
Of course, acquisitions don’t always pan out. Some potential reasons for failure include seller misrepresentations and incongruent corporate cultures.
The most successful transitions require the seller’s ongoing efforts. In-depth due diligence can minimize acquisition risk.
Do it jointly
Joint ventures and other contractual relationships with other businesses, such as franchising and licensing, allow companies to grow with minimal capital infusion. By starting slowly, the two entities can test their congruence and, if they’re compatible, add incremental layers over time.
Clients face many growth opportunities but typically have limited resources to pursue all of their ideas. When you’re prioritizing and selecting expansion alternatives make sure you have projected financial statements.
Normally, projections begin with an expected percentage increase in sales. Then the growth rate flows through to other areas related to sales, such as variable expenses, inventory, receivables and payables. Thorough projections will depict all three financial statements: the balance sheet, income statement, and statement of cash flows.
CFOs and CPAs often use debt as a “plug” figure to balance projections. This figure is very helpful for lenders, because it shows how much, and when, the loan proceeds will be needed. Historic results offer an important frame of reference when reviewing the projections.
Don’t ignore the time value of money
One big problem with projections is that they often ignore the time value of money. That’s because they describe what’s likely to happen given a set of circumstances. Thus, it’s difficult to compare detailed projections against other investments that a business might be considering. As a result, other financial tools, such as internal rate of return calculations and a net present value analysis, generate comparative metrics.
Expect growing pains
Your clients’ expansions will likely come with growing pains. So, make sure their strategies are sound before issuing new loans.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the merit and integrity of borrowers’ requests for expansion strategy funding.For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.
Author: Robert Wood, CPA, Principal
FASB Eases Rules for Private Businesses
As you might know, the Financial Accounting Standards Board (FASB) has talked about easing its rules for small private firms for years. Fortunately, FASB recently proposed some revisions to Generally Accepted Accounting Principles (GAAP) to accommodate the needs of private businesses and their stakeholders.
These proposals may have an impact on the asset based lending industry.
4 areas targeted:
The FASB proposals target four specific areas: amortization and impairment of goodwill, intangible asset recognition, variable interest entities, and certain types of interest rate swaps. So, how might these proposals affect your private borrowers’ financial statements? Read on.
1. Intangible asset recognition
The current GAAP requires that companies recognize intangible assets acquired in business combinations at their fair value on the acquisition date. These intangibles need to be reported as separate line items if they meet either the contractual-legal criteria or the separable criteria.
Some examples of contractual-legal intangibles include domain names, trademarks and customer contracts. Some examples of separable intangibles include unpatented technology, customer lists and recipes.
FASB’s proposed change allows private companies to recognize only contractual-legal intangibles on the acquisition date, while other intangible assets would be combined with goodwill. This proposal might cause private companies to recognize more goodwill in business combinations and fewer intangible assets.
As you may know, goodwill is the residual intangible asset that’s recognized in a business combination after recognizing all other identifiable assets and liabilities assumed. As of now, GAAP requires businesses to record goodwill at its fair value on the acquisition date. Then it’s tested each year for impairment at the reporting unit level.
The reporting units may be based on product lines or geography. It may be necessary to employ interim impairment testing if a triggering event, such as the loss of a major customer or discontinued product line, takes place. Impairment occurs when the fair value of a reporting unit’s goodwill falls below its book value.
FASB proposes that private businesses amortize goodwill on a straight-line basis over a useful life of no more than 10 years. Private companies would test for goodwill impairment only when a triggering event occurs. The proposal simplifies impairment testing to apply at the entity level, not at the reporting unit level.
Under these proposed changes, private businesses would make fewer and less complicated computations to report goodwill in business combinations. Thus, goodwill would receive similar treatment as other finite-lived intangible assets, such as patents and copyrights.
3. Interest rate swaps
When clients can’t qualify for inexpensive fixed rate debt, they can instead obtain variable rate debt and then enter into an interest rate swap with another entity. This will help reverse their exposure to interest rate risk. Those that enter into an interest rate swap don’t trade debts. Instead, they agree to make each other’s interest payments as if they had swapped debts.
Generally speaking, GAAP requires businesses to use complex hedge accounting techniques to report interest rate swaps at fair value. Or they can measure debt at its amortized cost and make swaps separately at fair value. But, both methods can create income statement volatility over the life of the swap.
FASB has proposed two simpler methods for private businesses that use interest rate swaps: the simplified hedge approach and the combined instrument approach. The simplified hedge approach is quite similar to the current GAAP rules for reporting swaps, except that qualifying interest rate swaps are valued at settlement value, and not fair value.
With the combined instrument approach, qualifying interest rate swaps aren’t reported separately on the balance sheet. There is an exception for periodic accruals from interest rate settlements, however.
4. Variable interest entities
In the aftermath of the Enron scandal, FASB required consolidation of variable interest entities with their parent companies in order to prevent management from using them to disguise lackluster performance or fraud.
Consolidation has, indeed, been burdensome for small business owners who own buildings personally and then lease them to their companies. Under this proposal, private firms wouldn’t need to consolidate results from a lessor entity if they have a formal lease agreement, are under common control and substantially all of their interactions relate to leasing activities. The proposal, however, would require detailed disclosures of the leasing arrangements.
The debate rages on
This fall, FASB and the Private Company Council are supposed to discuss the comments received on the four proposals mentioned above. Keep your eyes and ears open for news later this year on whether FASB will enact the changes and when they’ll become effective.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. Contact us for any questions or concerns you may have on wither the FASB or AICPA proposals.For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.
Author: Mike Boeheim
Protect Your ABL’s Assets by Helping Your Clients Recognize and Stop Internet Fraud
As people flock to the Web to make purchases, they risk being snared by Internet fraud. Asset based lenders need to be aware of the latest scams that could affect your customers and impair debt service.
Popular Fraud Tactics
As you can imagine, cybercrime can take many forms, such as credit and debit card fraud, mobile phone transaction fraud, pay-per-click (PPC) scams, and, of course, identity theft.
Fraudsters can get very creative when “trolling” the Internet for opportunities. For instance, some might use malware to collect credit card information from unsecured merchant websites. PPC fraudsters also cause unsuspecting merchants to incur charges every time customers click on their ads. Then they redirect the customers to their website, thereby “stealing” the sale.
Help Your Clients Stop Internet Fraud
Determine whether your clients are taking appropriate steps to protect themselves against Internet fraud. Ask whether they’re analyzing transactions and identifying which are at a higher risk for cybercrime. Some examples of online order form red flags include customers who use drop shipment forwarding addresses, or post office boxes and payments split between multiple debit and credit cards. All of these can signal the use of stolen cards.
According to a survey by technology provider FIS’s ClearCommerce®, an e-payment processing and fraud prevention service;
other warning signs you need to be aware of include differences between billing and shipping addresses, the country of the billing and IP address, or the area code and the billing ZIP code. International shipping addresses — especially those in former Eastern Bloc countries or the Middle East may be suspect, Of course, just the existence of a red flag doesn’t mean that fraud has taken place. But it does mean that borrowers should take a closer look at the potentially high-risk order before processing it.
Asset Based Lenders Need to do Due Diligence too
As part of your due diligence, ask your clients whether they’ve taken steps to secure their IT against fraud. Transaction screening software can take a lot of the guesswork out of identifying these high-risk transactions. Another security measure you should pass along to your clients is to couple automated address verification services with card security code systems. This will not only verify the cardholder’s address, but also crosscheck the security code on the back of the card.
All borrowers should employ and maintain encryption codes, antivirus software, firewalls, and operating system and browser updates. By taking these measures, the client will be protected on the merchant side, as well as when ordering for its own materials, downloading, or sharing information with any supply chain partners.
Don’t go it alone
Of course, maintaining secure, efficient computer systems can be quite daunting and way outside the bailiwick of most entrepreneurs. So, if one of your borrowers simply can’t afford a dedicated IT professional, a CPA can help them tackle the cybercrime prevention tasks mentioned above on an as-needed basis.
Freed Maxick’ s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your customers’ collateral by performing pre-loan surveys and rotational collateral monitoring field examinations.
Freed Maxick also provide specialized forensic accounting services.
If you or your clients need assistance in fraud detection, prevention or remediation, contact us, or call me directly at 716-847-2651.
Author: Bob Abraham
Protecting Your Investment in a Client with Succession Planning Advice is Smart Business
You’ve likely heard the saying: “The only constant in life is change.” Most asset based lenders recognize this “reality” and they plan ahead with their clients to tackle future challenges, such as a change in management. The following fictitious tale shows how it’s done.
The Story of Susan and John
Some six years ago, Susan Matthews told her lender, John Deep-Pockets, that she wanted to retire at age 55 with her husband in Maui. She wanted to turn over Matthews Foods to her daughter, Abigail.
John was quite concerned about this move, since he knew firsthand how bad the failure rate was for second-generation owners. On top of that, Abigail, a young speech therapist, lacked the manufacturing experience, technical know-how and fiscal discipline that had made Matthews Foods a model borrower for the last 20 years.
John knew he had to have a heart-to-heart discussion with Susan about the future of Matthews Foods. Although Susan really wanted to see Abigail take over the reins, she wondered if Abigail was truly qualified for the job and willing to dig in. Moreover, Susan wondered if Matthews Foods would survive her.
When Susan admitted that her daughter really didn’t have much of a “head for business” or even an interest in learning the trade, she gifted stock to Abigail, which provided her with a passive income stream, as well as a seat on the company’s board of directors. Susan’s treasurer filled in as interim CEO and assembled a professional management team that would handle all the day-to-day operations going forward.
Susan did make her dreams come true and retired in Maui. Although she isn’t involved with the company anymore, her legacy still lives on through Matthews Foods. The new management team took the company to the next level, and is currently considering a public offering.
Get up Close and Personal
At some point all companies outgrow the “first-generation” entrepreneurs. Maybe the founder wants to retire, or has health issues. Or perhaps the business reaches a critical mass that exceeds the founder’s abilities. When current management is struggling just to stay afloat, the owner must deal with some tough choices. For example, should it bring in a family member, sell to a larger organization or hire more experienced outsiders? In order to recognize when it’s time to upgrade management, lenders should visit the borrower’s premises to get acquainted with all the staff.
When interviewing owners and managers, it’s important to consider their health, ages and retirement goals. Determine if the owners are so buried in administrative chores that they are spending less time in important management activities such as selling new accounts and brainstorming ideas.
Also, ask to see the business’s organizational chart and job descriptions. Every company should have a tiered structure and a viable succession plan. Such planning can help minimize the risk of relying too heavily on key people. Also evaluate the qualifications of any up-and-coming managers. Consider whether they truly have what it takes to run the show. If they don’t, mentoring and training are in order.
Time for Change?
If one of your borrowers is in a similar situation as Susan, it’s time for a management upgrade or change. With higher-than-average unemployment rates in the United States, it’s truly an employer’s market. There are hundreds of skilled but out-of-work managers that would likely be eager to jump aboard your borrower’s ship.
Lenders can help introduce borrowers to their networks of business contacts. Moreover, lenders often know of retired corporate executives who would be willing to fill a seat on the board of directors. Experienced people like these can be invaluable advisors to a business in need of advice.
As a lender, you value established customer relationships. And when you see a change in a relationship on the horizon, take advantage of the opportunity to render sound advice and prepare yourself for the future.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your customers’ collateral by performing pre-loan surveys and rotational collateral monitoring field examinations.
We also provide specialized succession planning services to assist your clients with ownership transitions.
For more information about our services for asset based lenders, contact us here, or call us at 716.847.2651.
Author: Paul Muldoon
Six questions – and answers – to help you better evaluate your borrowers’ performance
According to Generally Accepted Accounting Principles, “GAAP”, any revenue from projects that span more than a calendar year are typically recorded under the “percentage of completion method” for long-term contracts. Here’s what you need to know to help you better evaluate your borrowers’ performance.
Q: What do I need to know about the percentage of completion method?
A: If a borrower enters into a long-term contract, the percentage of completion method will affect its financial statements, and the subjective use of estimates might put you at risk for financial misstatement. It’s critical that you understand the basics of percentage of completion accounting so you can make more informed, prudent lending decisions.
Q: What types of lenders typically use the method?
A: Any company entering into a long term contract. For example, homebuilders, architects, commercial developers, creative agencies or engineering firms, use this method. There are several ways to report long-term contracts, according to the AICPA’s Accounting Research Bulletin (ARB) No. 45, Long-Term, Construction-Type Contracts, and Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.
The first method is known as the “completed contract.” With this method, revenues and expenses are recorded once the contractor fulfills the terms of the contract. The “percentage of completion method,” on the other hand, ties revenue recognition to the incurrence of any job costs (or estimates of an annual completion factor). SOP 81-1 establishes a strong choice for the percentage of completion method, so long as businesses can make estimates that are “sufficiently dependable.” Many contractors use the method for income tax purposes.
Q: How does the method differ from the revenue recognition principle?
A: GAAP requires that all borrowers report revenues as earned, regardless of when the cash is received. Typically, revenues are considered as “earned” when a business delivers the products or services to the customer. The percentage of completion method deviates from the revenue recognition principle by identifying income before a job’s completion.
This method matches any revenues to costs incurred, including materials, direct labor, and overhead. Normally, borrowers use the cost comparison method in order to estimate percentage complete. And sometimes, contractors will estimate the percentage complete with an annual completion factor. Keep in mind that the IRS requires detailed documentation or certification from an engineer or architect to support annual completion factors.
Q: How does percentage of completion work?
A: This is how percentage of completion affects financial statements: Let’s look at a $1 million job that’s expected to span two years and cost somewhere around $800,000. In the first year, the contractor incurs some $400,000 in costs and then sends an invoice of $450,000 to the client.
At the end of Year 1, the percentage complete is 50% — that is, $400,000 in actual costs divided by $800,000 in expected total costs. Thus, the contractor would record some $500,000 in revenues (calculated as $1 million times 50%) to match the $400,000 in costs. So, the contractor’s net gross profit is $100,000 in Year 1.
Next, the contractor reports billings in excess (a liability) or costs in excess (an asset) on the balance sheet. Here, the borrower has billed $450,000 but has recorded $500,000 in revenues. The $50,000 difference will show up as costs in excess, a current asset account that reflects the under billings in Year 1.
Many companies run several jobs simultaneously. GAAP doesn’t allow contractors to offset (or net) assets against liabilities. So it’s possible that a contractor will report both costs and billings in excess on its balance sheet.
As you can see, percentage of completion accounting requires subjective estimates about expected costs. Further complicated by job cost allocation policies, changes in estimates and orders, and differences between book and tax accounting methods.
Freed Maxick’ s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your customers’ collateral by performing pre-loan surveys and rotational collateral monitoring field examinations.
For more information about our services for asset based lenders, contact me here, or call us at 716.847.2651.
Authors: John Costello
Skimping on Repairs and Maintenance Can Put Your Asset Based Loan at Risk
As you know, fixed assets are often pledged as loan collateral. Because of this, lenders have a vested interest in making sure these assets are adequately maintained. To ensure this, ask clients about their fixed asset maintenance policies, and tour their facilities to get a first-hand look at how they keep house.
Keep everything running smoothlyBusinesses may be tempted to put off repairs and maintenance work when cash is tight. But this strategy can be costly. For instance, regular oil changes are a really small price to pay because they can prevent a machine’s engine from seizing up and needing to be rebuilt.Furthermore, adhering to a regular maintenance schedule is just as important for professional services firms as it is for manufacturers and retailers. All types of companies should update and replace software and computers regularly. If they don’t, productivity will be impaired.
Maintaining fixed assetsBe sure to create a printout of the fixed asset register. Clients should not only record the location and condition of each asset, but also tag each asset with an identification number. Companies may quickly discover that some items on the register are missing or broken and, therefore, should be repaired, replaced or written off.When tracking down fixed assets, you need to not only look at equipment and furniture, but also real property assets such as HVAC systems, elevators, drainage systems, foundations, interior and exterior painting, and windows. And borrowers who rent their facilities may have leasehold improvements that will require maintenance.
Developing a scheduleThe next step is for the business to create a formal repairs and maintenance schedule. The schedule should describe every asset in detail, such as:
- The name of the manufacturer,
- Standard operating procedures,
- Location of the operating manual, and
- Warranty details.
Do your due diligenceLenders need to monitor repairs and maintenance, as well. To start off, go to the client’s income statement and then compute repairs and maintenance expense as a percentage of revenues, gross fixed assets and net fixed assets. Such ratios should be stable over time and be comparable to other companies that are in the same industry. Ask your borrowers for industry benchmarking guidelines — many trade associations will include repairs and maintenance metrics in their studies.If a company has lower repairs and maintenance spending than its peers, it might signal that management is deferring upkeep to save money over the short run, which can jeopardize fixed assets over the long run. On the other hand, it might signal that management is keenly on top of its repairs and maintenance schedule, so major breakdowns are prevented, thus reducing long-term costs. Additional due diligence, including management inquiries and site visits, will uncover the true story.When you start benchmarking repairs and maintenance, keep in mind that some items will be capitalized on the balance sheet, instead of being expensed immediately. Under IRC Section 263(a), borrowers must record capitalized improvements if repairs lengthen an asset’s useful life or adapt it to a different use.
When it’s time to replace an assetOften it’s smarter to replace a worn or broken asset than to repair or maintain it. For instance, buying a new furnace that will lower utility bills, improve reliability and require less upkeep may save a lot of money.Moreover, new equipment might qualify for Section 179 and bonus depreciation tax deductions. For 2013, the $500,000 Sec. 179 expensing limit begins to phase out dollar-for-dollar when total asset acquisitions for the tax year exceed $2 million. But, these amounts will drop to $25,000 and $200,000 respectively in 2014, unless Congress enacts further legislation.Keep in mind that replacing large items, such as a roof or servers, may require borrowers to create a replacement reserve and apply for additional financing. Before financing a replacement, however, inquire whether management has compared the costs and benefits of purchasing a new asset to the costs and benefits of repairing and maintaining a trusted old workhorse.
The final wordBorrowers should pay close attention to repairs and maintenance. Unfortunately, because of our uncertain economy, some may choose to treat upkeep as a discretionary expense. As a lender, you need to monitor this spending, so you can get a clearer picture of the quality of your borrowers’ loan collateral. Bottom line: When a client’s repairs and maintenance spending seems to be out of whack, contact your CPA.……………………………………………………………………………………….....................................................Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your customers’ collateral by performing pre-loan surveys and rotational collateral monitoring field examinations.We also have extensive experience in tax planning and consulting relative to fixed asset tax issues.For more information about our services for asset based lenders, contact me here, or call us at 716.847.2651.
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SWOT Analysis Looks at Borrowers’ Strengths and Weaknesses
Author: Paul R. P. Valera, CPA, MBA, Senior Field Examiner
The best lenders understand the strengths, weaknesses, opportunities and threats (also known as “SWOT”) of their clients and prospects. The analysis can also play a critical role in due diligence, in addition to assisting borrowers identify opportunities to make improvements or better respond to external threats.
Here’s how a client’s SWOT analysis can asset based lenders make better lending decisions.
Unearthing the source of each strength
A SWOT analysis begins with identifying strengths and weaknesses from your customers’ perspective. Strengths typically represent potential areas for building value and boosting revenues. These may be competitive advantages or core competencies. Examples might include a loyal customer base, a strong brand image, or an established customer list.
It’s critical to unearth the source of each strength. Some are tied to the company’s owners or key employees, such as an older partner with influential standing in the business community and an impressive client list. This is especially common among professional practices, such as accounting, advertising or law firms. But retailers and manufacturers may rely on key people, too.
When strengths are tied to people, rather than the business itself, you need to consider what might happen if a key person were to suddenly leave the business. Ask whether the borrower has non-complete contracts, key person life insurance, a buy-sell agreement, or a formal succession plan to transition management to the next generation.
Weaknesses represent potential risks and should be eliminated or minimized. Often they are evaluated in relation to the company’s competitors. Weaknesses might include weak internal controls, high employee turnover, unreliable quality or a location with poor accessibility.
Of course, all businesses have an Achilles’ heel. But when a borrower reports the same weaknesses every year, it’s cause for concern. It’s not enough to simply recognize a weakness — the borrower needs to take corrective action.
For example, one borrower decided to boost its weak sales force with a headhunter to acquire new talent, Dale Carnegie sales training classes to inspire the staff, and a new-and-improved commission structure. Within just a few months, the business’s year-to-date sales were up 35%. And the borrower now lists its salesforce as a strength, not a weakness.
The second part of a SWOT analysis looks externally not only at what’s happening in the industry, but also with the economy and regulatory environment. An opportunity could be favorable external conditions that might increase revenues and value if the company acts on them quickly.
For example, a pharmaceutical company responded to emerging health care legislation and the aging baby boomer demographics by purchasing smaller medical device and generic drug manufacturers. Both the acquirer and its targets have acted on favorable external opportunities with a roll-up to improve their financial positions.
As you can imagine, threats are unfavorable conditions that can prevent an unwary borrower from achieving certain goals. Threats arise from the economy, competition, technological changes and increased regulation. It’s critical to watch for and minimize any existing and potential threats.
Hospitals and doctors, for example, are keeping a close eye on health care reform legislation, because it threatens to lower their billing and collection rates from private and public sources. Many physicians are banding together to improve bargaining power and achieve economies of scale.
How about your customers?
If your customers haven’t completed an in-house SWOT analysis, it’s time to do it. SWOT is a proven management tool that’s been taught at business schools around the world. Strong borrowers will say “yes!” immediately and discuss the results. But you may need to encourage your weaker, less experienced borrowers to tackle the analysis. The end result, however, will enlighten them.
A SWOT analysis is typically presented as a matrix (see the chart), and provides a logical framework for understanding how a business operates. It can not only tell what a borrower is doing right (and wrong), but it can predict how outside forces can impact cash flow in a positive (or negative) manner.
Business owners love their work and typically don’t want to hear that their businesses aren’t operating at peak performance. So, if you have concerns about a risky borrower, suggest they do a SWOT analysis. It can be an objective forum for discussing sensitive or negative issues.
Don’t put it off
As you know, due diligence can be a daunting task. And no single approach works for every customer. But a well-executed SWOT analysis can provide a method to the madness.
If you have any questions about SWOT analysis or any other asset based lending issue, give us a call at 716.847.2651, or you may contact us here.
What You See Might Not Be What it’s Cracked Up to Be
Guidance for Asset Based Lenders
As you know, borrowers often pledge accounts receivable as collateral. But what you see on the business’s balance sheet might not be what it collects — even if the company sets aside a certain allowance for doubtful accounts. Such allowances can be quite difficult to audit, particularly during economic turmoil.
As you know, trade receivables are classified under current assets if a seller anticipates collecting them within the operating cycle or a year, whichever is longer. Unless the business sells services and goods exclusively for cash, some of those receivables will inevitably be uncollectible. So which methods should your company use when assessing an allowance for doubtful accounts?
Some companies will record their write-offs only when a specific account is truly uncollectible. This is called the direct write-off method. Even though it’s an easy and convenient method, it doesn’t match bad debt expense to the period’s sales. In addition, it can actually overstate the value of accounts receivable on the balance sheet.
Many businesses turn to the allowance method to match revenues and expenses. With this method, the company estimates any uncollectible accounts as total outstanding receivables or a percentage of sales. The allowance shows up as a bad debt expense to offset sales on the income statement and as a contra-asset to offset receivables on the balance sheet.
Companies usually base the estimates on factors such as general economic conditions, receivables aging and the amount of bad debts in prior periods. Some businesses may also include allowances for unearned discounts, returns and finance charges.
Comparing apples to apples
An auditor will use several techniques to determine whether the allowance for doubtful accounts appears reasonable. Most begin with the company’s aging schedule. The older a receivable is, the harder it will be to collect. A U.S. Department of Commerce study provides these guidelines for accounts receivable aging and collectability:
Age of receivable
Likelihood of uncollectability
30 days or less
Once accounts receivable aging goes beyond the four-month mark, the debts are extremely difficult to collect. And, of course, the actual collectability will vary by the economy, the industry, the company’s credit policy and a myriad of other risk factors.
Statement on Auditing Standards (SAS) No. 57, Auditing Accounting Estimates (AICPA Accounting Unit Section 342), suggests that businesses compare their prior estimates for doubtful accounts with actual bad debt write-offs. For each accounting period, your ratio of bad debt expense to actual write-offs should be very close to 1. If one of your borrowers has several periods in which that ratio is lower than 1, beware: The company is overvaluing receivables and lowballing its estimate.
You’ll also want to look at the business’s exhaustion rate, which is how long the beginning-of-year allowance will cover actual write-offs. Suppose a company reported an allowance for doubtful accounts of $100,000 as of Jan. 1, 2011, and eventually writes off $70,000 in 2011 and $60,000 in 2012. The exhaustion rate would be as follows:
1.5 years ($100,000 - $70,000 = $30,000 left for 2012; $30,000/$60,000 = 0.5 years).
Opening the door to fraud
When you assess a company’s allowance for doubtful accounts, understand that accounting estimates are subjective and might be used to manipulate earnings. How? Well, suppose one of your borrowers postponed write-offs indefinitely and reduced the allowance to artificially inflate its profits and collateral base. That’s fraudulent behavior!
Dig deep and get help
If you find that a borrower’s bad debts are rising, it’s time to dig in and find out the root cause of the customer’s bad debt. Other warning signs are that the business can’t give you an estimate of an allowance for doubtful accounts, or the allowance just seems out of whack. In such cases, tap into your CPA’s expertise to help you better assess the situation.
For any questions about doubtful accounts or other issues facing asset based lenders, contact Freed Maxick’s asset based lending team here, or call us at 716.847.2651.