Back to basics 

Entity choice is a strategic decision that affects your customers’ legal liability, tax obligations and financial reporting. S corporations and C corporations are two popular choices for private business ownership. Here are some differences to keep in mind when lending to these corporations.

Pinpointing basic contrasts

Unlike partnerships or sole proprietorships, which may expose individuals to unlimited personal liability in certain instances, corporations are legal entities that are separate from their owners. So, the corporate structure limits an owner’s liability for business debts to the cost of his or her stock. A corporation faces generally unfavorable tax treatment, however, unless its shareholders opt to operate as an S corporation. S corporations blend the limited liability of C corporations with the tax benefits of flow-through entities, such as partnerships or proprietorships.

Identifying tax issues

Corporations can elect to be taxed as either a C or an S corporation. The primary difference is that C corporation earnings are taxed twice — first when the company earns income (at the corporate rate) and then when shareholders receive dividends or sales proceeds (at the shareholder’s individual rate).

S corporation earnings flow through to the shareholders’ personal tax returns, avoiding an additional level of taxation. S corporations aren’t taxed at the corporate level and shareholder distributions have no tax effect, since they’re coming from previously taxed income. Instead, S corporation shareholders allocate and claim business income, deductions, capital gains and losses, and tax credits annually on IRS Form 1120S Schedule K-1.

Spotting reporting nuances

Different tax treatments make C and S corporation borrowers look quite different on paper. Most notably, S corporation income statements won’t show federal income tax expense, and their balance sheets won’t include deferred tax assets or liabilities.

Private C corporations, for example, tend to maximize salaries paid to shareholder-employees in lieu of paying dividends. Reasonable salaries are deductible for tax purposes, but dividends are not. This strategy distributes cash to owners while it minimizes the amount of double taxation.

Most S corporations choose shareholder dividends over above-market salaries. That’s because dividends aren’t taxed again.

The tradeoff between owners’ compensation and dividends means that a C corporation borrower could appear less profitable than an otherwise identical S corporation borrower, simply by virtue of its tax-planning strategies.

Modifying due diligence

When comparing S and C corporations, lenders must know these differences and adjust their analyses accordingly to avoid apples-to-oranges comparisons. Always check what type of entity you’re dealing with before reviewing a borrower’s financial statements.

Do you read the statement of cash flows?

The statement of cash flows is sandwiched between income statement and footnote disclosures in borrowers’ annual financial reports. Much like a middle child, it rarely garners the attention it deserves. But savvy lenders know that it contains valuable information about the sources and uses of their borrowers’ cash.

Cash flows from operations

The statement of cash flows customarily consists of four sections. The first is cash flows from operations, which roughly converts net income from accrual to cash basis.

Net income is the first item listed here. Add backs include noncash deductions (such as depreciation and amortization expense), investment income (or losses) and gains (or losses) from asset sales. Next come changes in working capital accounts, such as accounts receivable, inventory, prepaid assets and accounts payable.

This section provides insight into operating efficiency and effectiveness. Companies that consistently generate negative cash flows from operations won’t survive long. Beware of balance sheet accounts that seem to increase much faster than revenues. Usually working capital moves in tandem with sales.

Cash flows from investing

Next are cash flows from investing activities, such as equipment purchases and divestures. This section tells a lender whether a borrower is reinvesting in the company.

Some distressed borrowers sell non-operating assets — such as idle equipment or marketable securities — as a quick fix to cash flow shortages. But there’s a limit to how long this strategy will work. Eventually fixed asset divestitures compromise a business’s ability to generate future earnings.

Cash flows from financing

The third part displays cash transactions with lenders or investors. Examples of cash inflows from financing activities include new loans and stock issuances. Financing cash outflows include loan payments, dividends and Treasury stock repurchases.

This section provides insight into a company’s blend of debt and equity financing. Mounting debt and forgone dividends may be warning signs of financial distress.

Schedule of noncash transactions

Some important investing and financing transactions — noncash transactions — are reported at the bottom of the statement and, therefore, easily overlooked. Examples include like-kind exchanges, long-term debt refinancing and assets purchased directly with loan proceeds.

Pay attention

The statement of cash flows is often upstaged by the income statement and balance sheet. And, because the statement isn’t always required, small businesses generally don’t prepare one on a regular basis.

Experienced lenders see the statement of cash flows as a critical part of their analytical drill, and request them from potential loan customers. The borrowers’ CPA can assist in their preparation.

“Internal controls” is commonly-used terminology in today’s skeptical business environment. Everyone wants them, but many are lacking. Borrowers with weak internal controls expose you to greater risk of fraud and misstatement than those with solid internal controls. So, understanding your borrowers’ control systems is an important part of loan due diligence.

Master the basics

Internal controls are processes set forth by an entity’s board of directors, management, and other personnel. According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), controls should be “designed to provide reasonable assurance [of] the achievement of objectives in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with laws and regulations.”

COSO lists five components of internal controls:

1.       Control environment. Environmental factors include the integrity, ethical values, management operating style and delegation of authority systems. The “tone at the top” is a fundamental building block for all other control components.
2.       Risk assessment. Companies should be aware of relevant risks and decide on the best ways to manage them.
3.       Information and communication. Enabling employees to fulfill their responsibilities, these systems and processes identify, capture and exchange information. Effective communication ensures information flows down, across, up and outside the organization.
4.       Control activities. These are the policies and procedures that ensure management’s directives are carried out. Examples of control activities are authorization of transactions, accounting reconciliations, supervisory reviews of operating performance, physical security of assets, and segregation of duties.
5.       Monitoring. Companies should continually review and improve internal control performance.

Managers and internal auditors should assess whether internal controls are adequate and explore ways to improve controls. AICPA auditing standards also require external auditors to evaluate their client’s internal controls as part of their audit risk assessment procedures. Auditors tailor audit programs for potential risks of material misstatement, but they aren’t required to specifically perform procedures to identify control deficiencies — unless the client hires them to perform a separate internal control study.

Obtain management letters

The simplest way for lenders to identify internal control problems is to have management letters for every loan file. They provide constructive criticism of a borrower’s control systems from the perspective of an independent third party.

Specifically, Statement on Auditing Standards (SAS) No. 115, Communicating Internal Control Related Matters Identified in an Audit, requires auditors to consider whether controls are sufficient to prevent and detect financial statement misstatements or theft of company assets, as well as whether they enable management to correct misstatements in a timely manner. SAS 115 requires auditors to report any material weaknesses and significant deficiencies (see the sidebar “Which deficiencies make it to the management letter?”), including those remedied during the audit.

Internal controls have been top of mind with auditors since the Sarbanes-Oxley Act passed in 2002. Today, management letters are more in-depth and helpful to financial statement readers.

Auditors disclose findings from prior periods that have yet to be remedied by management. If they continually report the same deficiencies from year to year, lenders should ask why management is reluctant to resolve deficiencies in their controls. Some gaps may seem minor — separating billing and cash receipts in a small family business, for example. But other gaps may put you at excessive risk.

Ideally, a management letter should accompany a borrower’s financial statements in an audit, but SAS 115 allows auditors 60 days from the audit report release date to compile their findings. If the management letter has been omitted from a borrower’s financial statements, ask for a copy as soon as it’s available.

Think like an auditor

Sometimes lenders have to think like auditors. This mindset can help you assess risk factors that could lead to delinquent payments and loan defaults. Internal controls are a big part of an auditor’s risk assessment. A solid system of internal controls can ensure that your borrowers prevent, detect and correct financial misstatements. Weak controls can result in costly theft or embezzlement, misstatements and errors.

Sidebar: Which deficiencies make it to the management letter?

Under SAS 115, management letters must identify “material weaknesses” and “significant deficiencies” in internal controls discovered during audit procedures.

The more egregious of the two shortcomings, “material weakness”, refers to “a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis.”

A significant deficiency is “less severe than a material weakness, yet important enough to merit attention by those charged with governance.” Note that a control deficiency is dependent on the potential for misstatement; misstatement need not actually have occurred.

SAS 115 permits significant leeway in how auditors classify internal control weaknesses, such as lack of segregation of duties, inadequately trained accounting personnel, restated prior period financial statements, and material audit adjustments.

When classifying deficiencies as material or significant, auditors evaluate the probability and magnitude of the potential misstatement. They also consider “compensating controls,” which are substitute procedures that limit the potential of a deficiency to result in an actual misstatement.

Abstract:   With priced-right sales opportunities ripe for the picking, some customers may be tempted to acquire another business as the economy mends. Others — those feeling the strain of the prolonged downturn — may be considering a merger with another, stronger business. In either scenario, a bank may be asked to provide financing. Here are some questions a lender should consider when sorting the potential winners from losers in a merger or acquisition deal.

8 questions to consider in M&A deals

 With priced-right sales opportunities ripe for the picking, some of your customers may be tempted to acquire another business as the economy mends. Others — those feeling the strain of the prolonged downturn — may be considering a merger with another stronger business.

 In either scenario, you may be asked to provide financing. Here are some questions to consider as you sort the potential winners from losers in a merger or acquisition deal.

 1. What are your borrower’s strategic motives? Before devoting substantial resources to due diligence procedures, identify the borrower’s strategic motives for acquiring another company. For instance, is it seeking economies of scale, production synergies or personnel from the deal? Acquisition targets that won’t accomplish the borrower’s overall strategic goals are a poor fit.

2. Does your borrower have a competent due diligence team? Problems may not be apparent to borrowers in an acquisition mode. In the midst of negotiations, due diligence can help your customer gauge success or failure. Business owners typically put together a due diligence team with managers from their company’s functional departments. These in-house experts can help assure lenders that all risk factors and contingencies have been addressed.

3. Are you satisfied with the due diligence findings? Before approving the loan request, determine what procedures were used in the due diligence process, and make sure you’re comfortable with the due diligence team’s performance. When due diligence is performed too hastily or its scope is too narrow, the borrower may overlook important risk factors, such as contingent liabilities, concentration risks and employee retention problems.

4. What’s the financial forecast? To get a sense of the acquisition target’s historic and future earnings, the due diligence team should make sure income and cash flow projections are complete and reasonable. Balance sheet items also should be investigated, and assets inspected to evaluate overall quality and obsolescence. Contingent or unrecorded liabilities, as well as whether the company is complying with federal, state, sales and employment tax obligations, also should be examined.

5. Have operations been properly analyzed? The due diligence team should tour the target’s facilities and, if possible, interview key personnel, customers and suppliers. The goal should be to identify company-specific risk factors, including obsolete assets, concentration risks and poor internal controls. The borrower’s production manager should flowchart the target’s production process on site to identify core competencies and operating maladies.

6. How does IT fare? The business’s IT should be up-to-date and compatible with the borrower’s systems. When the target company must integrate new IT systems, it will take time and money to get the seller’s employees up to speed. Postmerger IT integration requires a detailed action plan to avoid business interruptions, such as delayed deliveries and lost purchase orders.

7. What about human resources? Among a company’s most valuable — but transitory — assets are its employees. The compatibility of corporate cultures is key. The due diligence team must review the target’s HR policies and determine how salaries and benefits will change after the proposed merger or acquisition. To improve employee retention and guarantee the seller’s ongoing cooperation after the deal closes, employment contracts, noncompete agreements or consulting arrangements also must be reviewed.

8. What are your customer’s postmerger expectations? Beware of the unrealistic. Purchase prices are typically based on projections of future income streams, including future cost savings and revenue opportunities. Many transactions fail because purchasers overestimate acquisition synergies and economies of scale. Borrowers also may overlook the full costs of improving production or integrating two companies into one. Make sure your customers devise detailed action plans.

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