A Tour of the Balance Sheet – Part 2

January 19, 2017 Ryan Perrone No comments exist

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Last week, we toured the left-hand side of the balance sheet, a.k.a. the assets.  This week, we will review liabilities and discuss the pitfalls and minefields that need to be avoided.

 

The right side of the balance sheet starts out with current liabilities- those that are expected to be repaid within a year.  All other non-current liabilities are those expected to be repaid over one year.  Keep in mind that if you have a credit facility expiring within a year, and there is reason to expect that it will not be renewed (i.e. covenant violations), all the debt should be classified as current, even if there are term loans with amortization schedules in excess of one year.

 

It is worth noting that not all debts are created equal.  Don’t pay a vendor, they will stop shipment and eventually sue you.  Don’t pay an employee; a firestorm of rumors can engulf a company.  On top of that, it could invite the state labor department.  We’ll discuss what happens below when you don’t pay the government.

 

As mentioned with assets, there are many instances where a company may want to reserve against an asset in case there is some risk.  The same does not hold true with liabilities, there is no hiding or reducing liabilities, at least ethically (see Enron).  Below are some of the typical and less-typical accounts one may find in the liabilities section.

 

Outstanding Checks – Not all companies disclose this separately, as it can be an offset to cash.  This one is always nice as it highlights uncleared checks, it can also illustrate if the company is holding checks.

 

Accounts Payable – Otherwise referred to as AP, this is where all unpaid invoices are housed.  If updated properly, an AP Aging will help you understand what vendors are owed, and how delinquent you might be in paying your bills.

 

Payroll Liabilities – This can be the death knell for many small businesses.  If poorly managed, this can turn into an epic cluster.  I cannot be any clearer on this.

  • Employee Payroll – This is the first portion of payroll liabilities.  This represents the work done by employees that they have yet to receive compensation for.  In many organizations, there is a one week lag on issuing paychecks.  Therefore, when payday comes around, an employee is still owed for another week of pay if they quit or were terminated on that day. A state labor department may have the ability to shut down your business if an employee files a valid complaint regarding unpaid payroll.

  • Payroll Taxes – Since employers are required to be tax collectors, they end up holding taxes in trust and remitting them to the government.  Many businesses utilize third parties to calculate and assist in making these payments so that they are never in a position of holding these funds.  Payroll taxes are deemed to be trust fund taxes, which carries a special level of authority.  The end result is that anyone who could conceivably play a hand in overseeing these funds (even an account signer or minority owner) can be held personally liable for failure to remit funds.  This exposure cannot be avoided with personal bankruptcy.  Yes, it’s a big deal.

  • IRA Liabilities – Less of an issue than payroll taxes, this is still problematic.  This form of liability arises when a company deducts and transmits funds for a retirement plan.  If your business processes its own payroll and / or offers a retirement plan, good luck, you are subject to ERISA (virtually every company is), meaning there are many rules and regulations to follow.  For instance, failure to file form 5500 annually can lead to a fine of up to $2,063 per day.  Have insomnia? Check out the rest of the penalties here in the July 1, 2016 Federal Register.  If ERISA were to disappear overnight, Georgia Pacific’s stock price would most likely take a large tumble as many legal documents would shrink.

Sales Tax – Sales taxes must be remitted timely (usually within 3 weeks of month-end).  These are another form of trust fund taxes that a business owner cannot escape from with bankruptcy.  The penalty is steep for not complying.

 

Property Taxes – Many organizations like to deal with their property taxes in arrears, meaning they recognize the expense when they are paid, not when they are incurred.  If a business attempts to sell that property, they will quickly realize that there was a hidden liability that WILL get paid before they are able to monetize any real property.

 

Revolving Lines of Credit – This form of financing is essentially a credit card for a business.  There is a limit to how much can be borrowed and usually the business is only required to make interest payments.  Also keep in mind that there is an expiration date on lines of credit, similar to how credit cards can be cancelled by the issuer (the expiration date on the front).   Big companies can have big borrowing limits, I had a client that acquired another business for $70 million on their line of credit.

 

Term Loans – These are amortizing loans, usually secured by one or more assets.  Capital leases can be a form of a term loan, which usually only has a lien against a specific asset.

 

Insurance Liability – If your line of business requires providing indemnification to another party, this can be a massive exposure.  Years ago, I worked with a security staffing company that provided general liability coverage to shopping centers for routine safety items (slips and falls) and non-routine items (murders, abductions).  Previously, this liability exposure was only expensed as claims were paid.  Due to the nature of the business, lawsuits often took 5-7 years to reach conclusion, meaning that there was a huge unrecorded liability.  Once recognized, this turned the company’s balance sheet upside down and eventually lead to a bankruptcy filing.

 

Warranty Costs – A business’s products can be subject to claims for defects and damage that arise in the use of its items.  For instance, if your business manufacturers electrical products and a teacher dies due to a poorly conceived electrical experiment where your product could have been involved, you will likely be implicated in a lawsuit and may have legal exposure (true story).

 

It is important to remember that not having a liability listed on the financial statements does not make it magically disappear.  In fact, once it does surface, it will be a much bigger problem to deal with and potentially include fines, penalties, checks paid to accountants and lawyers, and most likely lots of stress and anguish.  The best way to avoid these problems is having competent staff and engaging outsiders to provide reassurance that the books are accurate.

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