Hidden Issues in Balance Sheets

Suspect Assets

Users who simply accept the information presented on a balance sheet at face value assume multiple risks. The real-life examples below should help illustrate how various categories of assets might have significant “back stories” that the balance sheet doesn't reveal. Bear in mind that assets are generally listed on balance sheets in the order of ease of liquidation, so the first few categories should ' in theory ' be more dependable as sources of value.

Cash

Ostensibly, cash is the most dependable value on a balance sheet. However, sometimes “cash” is inaccessible to the company. For example, employment taxes withheld from payroll checks between the date the checks are prepared and the date the funds are transferred to the respective taxing authorities are held in trust for those entities and no longer available to the company. But sometimes a cash-strapped company will withhold appropriate taxes and employee benefit contributions, pay to the employees their “net” payroll, and then delay sending the funds withheld from the payroll check to the appropriate agency. These funds are used instead to satisfy cash-flow shortfalls, thus in essence funding operations using withheld taxes that are legally being held in trust. One client used millions of dollars of trust-fund cash to fund operational losses ' as a sort of a short-term, interest-free loan ' and planned to keep doing so until business improved.

Such cash would be reflected on the balance sheet despite being held in trust for the taxing agencies and legally unavailable to the company. This can be misleading to someone reviewing the balance sheet and assuming that the entire cash amount is an available asset.

Another example is cash that is pledged as security on a loan (restricted cash). This type of cash frequently accompanies a loan secured by accounts receivable, so that the lender receives the cash proceeds when the accounts receivable are collected. In some instances, the receipts are directed to an account owned by the lender to make sure the funds are not diverted to cash.

This redirection of funds is not possible in all instances, however. One example is healthcare receivables from Medicare, where Medicare expressly prohibits placing a lien on the accounts receivable. Medicare receipts therefore appear as cash on the balance sheet even though they might be pledged to a lender. It is critical to verify that the cash on the balance sheet is truly unencumbered cash and not subject to the claims of third parties.

Accounts Receivable

Accounts receivable represent monies due for services performed or merchandise sold on credit. These should be collectible and reflected on the balance sheet net of appropriate discounts.

One example of a collectibility issue involves a healthcare company with a large amount of receivables due from various health insurance companies. Typically, healthcare providers both: 1) negotiate discounted reimbursement levels with insurance companies at a significant discount from the so-called rack rate; and 2) obtain a preauthorization of insurance coverage prior to providing services to patients. This company did neither and listed the accounts receivable balance at a rack rate (a rate virtually never paid). Advisers and constituents who fail to explore this issue may be disappointed with the effect that the inflated value and uncollectible amounts have on the value of the enterprise. This is particularly true for management at financially troubled or bankrupt entities where value is scarce.

Another item to examine is the validity of the receivables ' that is, whether the customers are willing and able to pay them. Perhaps a receivable is from a defunct or troubled entity, or from an insider or related entity unlikely to ever pay.

Validity can be tested as part of the diligence process, before significant negative effects can take hold. In one instance, an outside party told the customer that an entity was billing the customer fraudulent amounts. This delayed payment to the entity significantly because it provided a justifiable basis for the customer to withhold payment indefinitely. The entity disputed the fraud allegations and included the original amounts in the accounts receivable on the balance sheet. To the extent that a company relies on collection of accounts receivable to fund operations (which is quite common), this type of collection delay materially affects the company, perhaps putting its survival in peril.

Consignment sales are sometimes also listed as accounts receivable. But when the owner allows a third party to hold and sell its goods, a right to payment is created only when the goods are subsequently sold. There is no right to payment simply because the items were placed into consignment, for the consignee has the right to return the goods and not sell them.

Inventory

Generally, inventory is considered product for sale that is easily converted to cash in the near term. It includes raw materials, items available for sale, and items in the process of being prepared for sale.

The value of inventory on a balance sheet raises several potential concerns. For example, one company was involved in the repair of 10-year-old used laptop computers and had an inventory of parts. The parts were valuable because they were not readily available in the marketplace, but demand for them was limited. As a result, the inventory was valuable to the company, but perhaps less so in the general liquidation market. The inventory value on the company's balance sheet, therefore, merited further examination.

It is important to understand the nature of the inventory listed. Technological items, for instance, quickly lose value or become obsolete. Unless the customer is a museum looking for a Commodore 64, new product technology and game-changing innovation can render the inventory virtually worthless. Some industries are more susceptible to these rapid changes and require greater consideration before the value as stated is accepted.

Another example involves a company with an inventory of plants. Because plants are priced based on the size of the pots, it would be a relatively easy process to inflate the value of the inventory by simply putting the plants into larger pots. The limited demand for large plants, however, could limit the realization of the inflated value shown on the company's balance sheet.

Land and Buildings

The value of land and buildings would appear to be straightforward and easily ascertained via a simple real estate appraisal. Lenders, creditors, and potential buyers need to be aware, though, of whether the buildings are special-purpose structures (such as Hummer car dealerships) or structures that could harbor environmental cleanup issues (for example, gas stations or manufacturing/service bays). Often, the value of the building to the debtor is greater than it is to the general public.

Interested parties also should be wary of value-inhibiting conditions such as when the optimal means of access is across a parcel that is not included in the sale. In addition to having a valuation done, reviewing land-use restrictions, title reports, easements, and environmental reports is advisable to help spot major issues related to land and buildings. A narrow definition of “the highest and best use” is a red flag to creditors seeking to liquidate the company, because it signals fewer potential buyers and a greater potential discount on the value on the balance sheet.

Furniture, Fixtures and Equipment

Items in the furniture, fixtures and equipment category generally are worth significantly less than their depreciated purchase price as stated on the balance sheet prepared according to GAAP. Because fixtures are typically not removable from a leased space, their value as collateral to a tenant is minimal. (The exception would be a subtenant.) Some equipment, such as certain large or heavy items that are encased in concrete as part of their installation, is effectively impossible to move. The value of an expens-
ive piece of radiology equipment installed in a concrete footer, for example, is high where it is installed but very low to a third party that would need to remove it. Similarly, sometimes a building is constructed around a piece of equipment in such a way that removal of the equipment destroys the building.

Notes Receivable

Notes receivable are longer term than accounts receivable. Several issues related to the payee should be evaluated. First, is this entity creditworthy? A note receivable is a loan, and if the entity responsible for repayment is illiquid, the note might not be collectible and the value of the note is diminished. Be mindful, too, that it is preferable for the payee to be completely independent of the entity whose balance sheet is under consideration. If a note is a related-party transaction, diligence on the obligation is appropriate. Sometimes these transactions are ways of tracking funds moved between legal entities with no expectation that the obligation will be repaid. Understanding the payment terms, collateral, enforcement rights, and collectibility of the obligation is critical.

Beyond the Balance Sheet

In addition to scrutinizing the asset categories reviewed above, balance-sheet users must also remember that several material items are not included in full ' if at all ' on the balance sheet. For example, intellectual property developed by employees (and not purchased by the entity) is often not reflected at its full value.

Similarly, several liabilities exist but are not reflected. Operating leases, for example, are truly long-term payment obligations, and that future liability is not presented on the balance sheet. Guarantee liabilities and contingent liabilities may also not be fully reflected, though their obligation could have a tremendous effect on the value of the enterprise. Pledged assets, the value of which is reflected on the balance sheet yet not available to creditors, should be another area of inquiry.

Conclusion

A balance sheet is a valuable tool for understanding a business or other entity. Conducting due diligence of the potentially misleading items discussed here is vital ' not only for discovering issues but also for becoming comfortable with the way the business has been operating. Investing time and asking questions to discover the facts behind the figures will result in a fulsome understanding of what previously had been an incomplete picture. Lurking in the shadows is the information essential to truly grasping the nuances of the business.

[IMGCAP(1)]

David Gottlieb is a partner with Crowe Horwath LLP, Los Angeles. He can be reached at 818-325-8415 or [email protected]. Michael Schwarzmann is also with Crowe Horwath in the Los Angeles office. He can be reached at 818-325-8461 or at [email protected].

Just one report in a financial statement, the balance sheet provides a snapshot of the financial condition of an entity as of a specific date. Users rely on the balance sheet as a means of evaluating a company's stability, investment potential, and creditworthiness, but it should not be accepted at face value. Increasingly, nonfinancial professionals are making recommendations based on the results of their analyses ' often accepting a balance sheet without question. Attorneys for creditors and debtors and bankruptcy judges are making recommendations or decisions based on only cursory consideration of potentially misleading balance sheets. Neglecting to delve into the issues more deeply can result in serious pitfalls ' and, ultimately, business decisions being made based on an inaccurate picture of the entity.

Balance sheets alone are of limited use. The amounts stated on a balance sheet represent the book values according to U.S. generally accepted accounting principles (GAAP) and not necessarily the fair market value (FMV), which is often of greater relevance. For example, the price of a parcel of land plus the cost to build the structure on it (the GAAP value) is not necessarily equal to the market price to purchase the combined finished project (the FMV).

Moreover, a financial statement user could look at the balance sheet'below and mistakenly believe that the entity is worth $1 million, the value of the owner's equity. A balance sheet is not a valuation tool, however, and by itself it cannot provide an accurate measure of the value of an entity. Even if all the information is straightforward, understandable, and fairly presented, a balance sheet is not a good tool for determining the value of an entity.

Suspect Assets

Users who simply accept the information presented on a balance sheet at face value assume multiple risks. The real-life examples below should help illustrate how various categories of assets might have significant “back stories” that the balance sheet doesn't reveal. Bear in mind that assets are generally listed on balance sheets in the order of ease of liquidation, so the first few categories should ' in theory ' be more dependable as sources of value.

Cash

Ostensibly, cash is the most dependable value on a balance sheet. However, sometimes “cash” is inaccessible to the company. For example, employment taxes withheld from payroll checks between the date the checks are prepared and the date the funds are transferred to the respective taxing authorities are held in trust for those entities and no longer available to the company. But sometimes a cash-strapped company will withhold appropriate taxes and employee benefit contributions, pay to the employees their “net” payroll, and then delay sending the funds withheld from the payroll check to the appropriate agency. These funds are used instead to satisfy cash-flow shortfalls, thus in essence funding operations using withheld taxes that are legally being held in trust. One client used millions of dollars of trust-fund cash to fund operational losses ' as a sort of a short-term, interest-free loan ' and planned to keep doing so until business improved.

Such cash would be reflected on the balance sheet despite being held in trust for the taxing agencies and legally unavailable to the company. This can be misleading to someone reviewing the balance sheet and assuming that the entire cash amount is an available asset.

Another example is cash that is pledged as security on a loan (restricted cash). This type of cash frequently accompanies a loan secured by accounts receivable, so that the lender receives the cash proceeds when the accounts receivable are collected. In some instances, the receipts are directed to an account owned by the lender to make sure the funds are not diverted to cash.

This redirection of funds is not possible in all instances, however. One example is healthcare receivables from Medicare, where Medicare expressly prohibits placing a lien on the accounts receivable. Medicare receipts therefore appear as cash on the balance sheet even though they might be pledged to a lender. It is critical to verify that the cash on the balance sheet is truly unencumbered cash and not subject to the claims of third parties.

Accounts Receivable

Accounts receivable represent monies due for services performed or merchandise sold on credit. These should be collectible and reflected on the balance sheet net of appropriate discounts.

One example of a collectibility issue involves a healthcare company with a large amount of receivables due from various health insurance companies. Typically, healthcare providers both: 1) negotiate discounted reimbursement levels with insurance companies at a significant discount from the so-called rack rate; and 2) obtain a preauthorization of insurance coverage prior to providing services to patients. This company did neither and listed the accounts receivable balance at a rack rate (a rate virtually never paid). Advisers and constituents who fail to explore this issue may be disappointed with the effect that the inflated value and uncollectible amounts have on the value of the enterprise. This is particularly true for management at financially troubled or bankrupt entities where value is scarce.

Another item to examine is the validity of the receivables ' that is, whether the customers are willing and able to pay them. Perhaps a receivable is from a defunct or troubled entity, or from an insider or related entity unlikely to ever pay.

Validity can be tested as part of the diligence process, before significant negative effects can take hold. In one instance, an outside party told the customer that an entity was billing the customer fraudulent amounts. This delayed payment to the entity significantly because it provided a justifiable basis for the customer to withhold payment indefinitely. The entity disputed the fraud allegations and included the original amounts in the accounts receivable on the balance sheet. To the extent that a company relies on collection of accounts receivable to fund operations (which is quite common), this type of collection delay materially affects the company, perhaps putting its survival in peril.

Consignment sales are sometimes also listed as accounts receivable. But when the owner allows a third party to hold and sell its goods, a right to payment is created only when the goods are subsequently sold. There is no right to payment simply because the items were placed into consignment, for the consignee has the right to return the goods and not sell them.

Inventory

Generally, inventory is considered product for sale that is easily converted to cash in the near term. It includes raw materials, items available for sale, and items in the process of being prepared for sale.

The value of inventory on a balance sheet raises several potential concerns. For example, one company was involved in the repair of 10-year-old used laptop computers and had an inventory of parts. The parts were valuable because they were not readily available in the marketplace, but demand for them was limited. As a result, the inventory was valuable to the company, but perhaps less so in the general liquidation market. The inventory value on the company's balance sheet, therefore, merited further examination.

It is important to understand the nature of the inventory listed. Technological items, for instance, quickly lose value or become obsolete. Unless the customer is a museum looking for a Commodore 64, new product technology and game-changing innovation can render the inventory virtually worthless. Some industries are more susceptible to these rapid changes and require greater consideration before the value as stated is accepted.

Another example involves a company with an inventory of plants. Because plants are priced based on the size of the pots, it would be a relatively easy process to inflate the value of the inventory by simply putting the plants into larger pots. The limited demand for large plants, however, could limit the realization of the inflated value shown on the company's balance sheet.

Land and Buildings

The value of land and buildings would appear to be straightforward and easily ascertained via a simple real estate appraisal. Lenders, creditors, and potential buyers need to be aware, though, of whether the buildings are special-purpose structures (such as Hummer car dealerships) or structures that could harbor environmental cleanup issues (for example, gas stations or manufacturing/service bays). Often, the value of the building to the debtor is greater than it is to the general public.

Interested parties also should be wary of value-inhibiting conditions such as when the optimal means of access is across a parcel that is not included in the sale. In addition to having a valuation done, reviewing land-use restrictions, title reports, easements, and environmental reports is advisable to help spot major issues related to land and buildings. A narrow definition of “the highest and best use” is a red flag to creditors seeking to liquidate the company, because it signals fewer potential buyers and a greater potential discount on the value on the balance sheet.

Furniture, Fixtures and Equipment

Items in the furniture, fixtures and equipment category generally are worth significantly less than their depreciated purchase price as stated on the balance sheet prepared according to GAAP. Because fixtures are typically not removable from a leased space, their value as collateral to a tenant is minimal. (The exception would be a subtenant.) Some equipment, such as certain large or heavy items that are encased in concrete as part of their installation, is effectively impossible to move. The value of an expens-
ive piece of radiology equipment installed in a concrete footer, for example, is high where it is installed but very low to a third party that would need to remove it. Similarly, sometimes a building is constructed around a piece of equipment in such a way that removal of the equipment destroys the building.

Notes Receivable

Notes receivable are longer term than accounts receivable. Several issues related to the payee should be evaluated. First, is this entity creditworthy? A note receivable is a loan, and if the entity responsible for repayment is illiquid, the note might not be collectible and the value of the note is diminished. Be mindful, too, that it is preferable for the payee to be completely independent of the entity whose balance sheet is under consideration. If a note is a related-party transaction, diligence on the obligation is appropriate. Sometimes these transactions are ways of tracking funds moved between legal entities with no expectation that the obligation will be repaid. Understanding the payment terms, collateral, enforcement rights, and collectibility of the obligation is critical.

Beyond the Balance Sheet

In addition to scrutinizing the asset categories reviewed above, balance-sheet users must also remember that several material items are not included in full ' if at all ' on the balance sheet. For example, intellectual property developed by employees (and not purchased by the entity) is often not reflected at its full value.

Similarly, several liabilities exist but are not reflected. Operating leases, for example, are truly long-term payment obligations, and that future liability is not presented on the balance sheet. Guarantee liabilities and contingent liabilities may also not be fully reflected, though their obligation could have a tremendous effect on the value of the enterprise. Pledged assets, the value of which is reflected on the balance sheet yet not available to creditors, should be another area of inquiry.

Conclusion

A balance sheet is a valuable tool for understanding a business or other entity. Conducting due diligence of the potentially misleading items discussed here is vital ' not only for discovering issues but also for becoming comfortable with the way the business has been operating. Investing time and asking questions to discover the facts behind the figures will result in a fulsome understanding of what previously had been an incomplete picture. Lurking in the shadows is the information essential to truly grasping the nuances of the business.

[IMGCAP(1)]

David Gottlieb is a partner with Crowe Horwath LLP, Los Angeles. He can be reached at 818-325-8415 or [email protected]. Michael Schwarzmann is also with Crowe Horwath in the Los Angeles office. He can be reached at 818-325-8461 or at [email protected].