Warning Signs Clients Are Spending Too Much (and May Not be Able to Pay You)
You know a lot about your clients' finances, but not everything. In fact, it might not always be immediately obvious they're in financial trouble. In this article, audit expert Steven D. Hovland explains the red flags you can look for in their documentation and goes over how to help them save themselves.
The COVID-19 pandemic has been a trying time for many individuals, including the owners of small businesses. The sudden loss of revenue caused a cash crunch and changes in operations. Fortunately, many businesses have been able to manage their cash flow and have started to rebound from the mass lockdowns. However, some individuals and businesses were not successful in doing so, and their outflows remain unchanged. Unfortunately, they might not always be forthcoming with their accountant that this is the case, even though you need this information.
Here, we will cover ways an accountant can identify the red flags that their clients are possibly living beyond their means, and offer some recommendations you can make that will help your client improve their financial position.
Living Beyond Their Means
One of the hardest questions to answer on a tax organizer or an audit program was, “Is the client or are the employees living beyond their means?” This is a challenging query, as most of us only have limited contact with our clients throughout the year. We do not have intimate knowledge of all of their activities, just access to their tax returns. These provide us with a window into their cash flow situation.
Sources and Application of Funds Method
To utilize the tax returns to determine whether the client is living beyond their means, we first need to have a refresher on the IRS’s “Sources and Application of Funds Method.” This method is an indirect calculation of unreported income. Think of this as the 30,000-foot view of the client’s finances. The Sources and Application method takes the following information:
For the accounting firm purposes, we are only going to use the tax return portion of the above calculations. Personal living expenses are outside of the information the firm will have readily available.
Tax Returns: Cash
When the accountant prepares the client’s tax return, they are reporting the latter’s cash activity for the year. The cash inflows, or sources of funds, and the cash outflows, or applications of funds, are integral parts of the tax returns.
When preparing the client’s business return, it is easy to focus on making sure revenue and expenses are reported correctly. The accountant will make sure all balance sheet items (Sch L) are input and the book net income and equity sections tie out to the client’s trial balance. In the height of the busy season, these returns are reviewed for accuracy and then signed and filed.
But, how often does the preparer or reviewer look at the actual cash the client has taken out of the business? Significant amounts of net income are great, but the client must somehow get the cash out of the company and into their personal bank account. Guaranteed payments, distributions, rent and interest are some of the more common ways the owner will get cash out of the organization.
When preparing the personal tax return, the accountant will usually focus on making sure all income is reported and all allowable deductions have been utilized. Lost in this all of this is the cash coming out of the business and going to the client.
When the accountant has access to both the business and the personal returns, they have a bird’s-eye view of the cash flows of their clients. These returns give insight into how the individual is funding their lifestyle.
Let us assume Widget, LLC is 100 percent owned by the client (for simplicity, we will assume they file Form 1065 and a personal return). Widget had a net income of $200,000 in 2019, with no distributions taken, no guaranteed payments and no rent. On the client’s personal return, the only income they have in addition to ownership of Widget is interest income from investments of $10,000. For deductions, they have $5,000 in property taxes and $30,000 in mortgage interest.
With these facts, we can see that the client had a six-figure income year, but the cash flow for the year was negative $25,000. These expenses are only the ones that are allowable for the tax return and do not include personal expenses (home utilities, food, mortgage principal, etc.). How is the client able to fund their living expenses? With personal expenses taken as business deductions?
One year of losses should not cause most clients to live beyond their means. However, multiple years can point to a trend of poor cash management, unreported income or non-businesses expenses being deducted. Some of the red flags you, the accountant, need to be on the lookout for are:
1. Increasing company credit card debt
When a client is living beyond their means, the company credit card is an easy way to keep funding this lifestyle. A continued increase in debt, with little to no increase in sales or inventory, should be a red flag.
2. Increased line-of-credit usage
Like the credit card debt, the line of credit offers the client quick access to cash funds. A continued increase in these balances with no logical increase in sales or inventory can signal possible cash flow issues.
3. Low or negative bank balance
As the client continuously funds their lifestyle, they will pull money from their bank account. Poorly done bank reconciliations or overdrawn bank accounts (e.g. checks in excess) are another red flag.
4. New personal vehicles
In some states, a portion of the vehicle registration can be deduced on the Schedule A. With new vehicles, the registration cost tends to be significant. If the client has low or negative cash from sources and application of funds, the purchase of a vehicle can be a significant red flag.
5. Current ratio below 1
The current ratio for the client’s company is below 1:1. This signals that the company will have to pull from other non-current sources, such as capital or debt, to pay current liabilities. Couple this with low sources and application of funds, and the client could be showing another red flag.
Individually, these red flags do not specifically point to a client living beyond their means. However, when there start to be more and more red flags coming up, pay attention.
What Can the CPA Do for Their Client?
The client relies on you to help them with the accounting tasks associated with running their business, including tax returns. So when you notice them living beyond their means, it’s important to get involved. Here’s what you can do:
- Communicate: The first thing is to start the communication process. Some clients may not realize that they are in a negative position. A simple phone call can help them understand the situation.
- Educate: Utilize your accounting skills, and educate the client. Go over the concepts of free cash flow, current ratio and other liquidity measurements. Chances are, the client will utilize these measurements for their business and for their personal finances.
- Assist: Initially, you can run a rough projection on cash flow. If the client accepts the assistance, set up more formal projections. Even a higher-level budget can be of great benefit to the client.
Finally, if the firm believes that the client is living beyond their means, then the collectability of accounting fees comes into question. When working with a client with possible cash flow issues, it is best to start requesting a retainer. The amount is up to the individual firm; however, it should never be applied until the final billing is done.
When an accountant is focused on getting the tax returns done, they sometimes can’t see the forest for the trees. This busy season, take a careful look at those returns, and see if there are any red flags. In the end, you may end up assisting the client more than you might have in a normal year.
Hovland Forensic & Financial was founded by Steven D. Hovland (#TheForensicCFO), Certified Public Accountant (CPA) and Certified Forensic Accountant (CRFAC). Utilizing his 20 years in public accounting performing audits, Steve has created a Fractional CFO and Forensic...