Business owners are in trouble. Income property owners, too. The demands of running a business or managing investment properties has reached an all-time high and banks are demanding more detailed financial statements than ever before. And therein lies a side gig opportunity with high income potential.

Every tax season my office sees hundreds of financial statements prepared by the client or their staff. You can’t imagine the mess most are in.

The client always thinks they are doing an awesome job of keeping their books. . . until they need a loan and the bank is less willing to decipher their books than the accountant.

The ability to read a financial statement is a powerful wealth building skill. You can detect fraud, analyse an investment and manage business liquidity. 

Banks will not spend time trying to figure out a mess. It is easier to pass. If the funding required is significant pristine records are not an option.

In short, reading a financial statement is a requirement for wealth building and business management. The financial statements tells you how the business is doing and the direction it is heading. Often, the financials will indicate problems before they are apparent in the real world. These festering problems are easier to fix when they are still small.

Reading financial statements are a good opportunity for you to generate extra income. It can even be a high-paying full-time business. Understanding how money works requires you to understand how money is recorded and that means financial statements. The number of business owners looking for help in securing a loan is a business opportunity that starts with the ability to read financial statements.

Buyers of a business are investing serious money and definitely need help understanding the value of the investment. Real estate buyers the same.

Accountants and attorneys are an obvious choice. However, many do not handle this kind of work. As a specialist, you can solve a business owner’s financing problems while earning an excellent income.

We will now review the three most common financial statements: the balance sheet, income statement and cash flow statement. The examples used are filled with errors I see in my office frequently. You can find more errors than I discuss as I added plenty.

By understanding common mistakes business owners make you can become familiar with the issues and become a value added service. Good financial statements (good records) are not an expense! Clients seeking help improving their records will be more profitable and therefore, a long-term client.

 

The Difference Between an Income Statement and the Balance Sheet

This may come as a surprise to you, but very few people know the difference between an income statement and a balance sheet. And don’t get me started on the cash flow statement.

I see clients recording entire loan payments as an expense on the income statement. For some reason they know loan proceeds are not income because they don’t want to be taxed on that money. However, when it comes time to pay the loan they think the whole payment is an expense (and deductible). It isn’t!

Loan proceeds go on the balance sheet, of course, as a long- and/or short-term liability. If you require detailed records for a business sale, purchase or bank loan, you will need to separate a loan into long-term (amounts due in over one year) and short-term (principle due in one year or less). If the business is small the owner may not want to separate the loan into long- and short-term. In those instances the loan should be recorded as a long-term liability. (The correct way is to list long- and short-term. In no way do I feel the shortcut of listing all loans as long-term acceptable.)

Loan payments have three entries in a general journal: cash out of checking (balance sheet), principle portion of the payment (balance sheet) and interest payment (income statement). As all accountants know, only the interest is an expense. 

If you can clean up this one issue you will save more businesses than you can imagine. If your client is making this mistake you may need to junk the entire set of books and start over. The books are a mess and in no condition for a banker or the tax accountant. (Tax accountants deal with this all the time and if the books are bad enough and the client unclear in explaining what they are doing, taxes can be wrong as well. If you give your tax accountant clean records she will save you money in taxes versus wasting time trying to ferret out what your numbers really are.)

 

QuickBooks Does Not Make You an Accountant

The biggest mistake business owners make is thinking QuickBooks makes them a good bookkeeper or accountant. This is about as true as saying TurboTax makes you a tax professional. If you believe that I have some cheap ocean front property to sell you in Montana.

The only thing QuickBooks lets you do is dig the hole faster unless you understand basic accounting. 

As we review the following financial statements you will see some of the crazy things tax professionals see every tax season: balance sheets with equipment and no accumulated depreciation and negative numbers where they don’t belong. (Yes, I know contra accounts happen. But negative petty cash?)

I gathered financial statement issues from multiple sources and introduced as many issues as I could in one set of financials. I started with a sample account QuickBooks provided in an older version to construct this monstrosity. I have seen worse unfortunately, but this will do for our needs. 

Do not focus only on the errors. Keep a keen eye on issues the financials expose. Getting the books in order before presenting to a bank is vital. Once the bank (or investors) start expressing concerns over the financials they start to lose confidence. Deal with the weaknesses of the financial statements before presenting. You still need to provide honest information and it must be clear. Having answers prepared in advance can make or break a deal.

The same rules apply from the other side. As a buyer of an income property or business you will be looking with the same jaundiced eye at the financials. If the books have errors it becomes difficult to trust the investment is solid.

 

Balance Sheet

You can click all financial statements in this post to open in a second, larger window.

Novices always want to start with the income statement. The income statement is too easily doctored to give a false picture. Assets and liabilities are the place you want to start, especially if concerned with the value of the business..

The above balance sheet has the head-scratcher of a negative petty cash account. In effect, this means the petty cash account is overdrawn. Someone will need to explain that one to me. 

The other account issues that make no sense is a negative loan to John Doe, a negative bank loan for equipment, negative accounts payable and receivable, and negative payroll taxes due. You might be amused by this, but half or more of all business financial statements I see each tax season have these types of errors.

To be fair, QuickBooks (QBs) is a disaster when it comes to payroll. Payroll taxes payable need to be adjusted periodically for some reason on the balance sheet. QBs even has a neat tool to make the adjustments. The rest of the payroll module is accurate, just the balance sheet has this slowly roaming error that needs periodic correction.

I’m not sure how you get a negative accounts receivable and payable. 

This balance sheet has too many loans to friends. Don’t loan money to your girlfriend from the business. Take a distribution (if allowed) and give a personal loan to your girlfriend. Better yet, don’t be your girlfriend’s banker. It never works. I see that in the office, too.

Under fixed assets we have office equipment listed without any accumulated depreciation. Land isn’t depreciated, just about everything else is. Was depreciation expense missed, too? Yup.

All these errors are the result of incorrect accounting entries. The loan to John Doe shows up as a liability because I treated it as paid from a payroll deduction. John is an employee. It takes fancy footwork to get the books this bad in QBs.

Financial records this bad are unsalvageable. You will need to start over. Fixing this mess would take more time than building a whole new QBs file. You could have a full-time business just setting up QBs files for businesses. If you never turned a client away you would have an army of employees hired to keep up. There is that much to do. Almost all records kept internally by the client are in need of attention. And if you think this balance sheet example is bad, you are wrong. This is typical. The only matter is the degree of issues involved.

I intentionally excluded the equity accounts to save time. 

 

Income Statement

You can click all financial statements in this post to open in a second, larger window.

There are plenty of concerns on the income statement, sometimes referred to as the profit & loss statement. 

There is a large amount of non-taxable revenue listed. This should be clarified and listed below sales for aesthetic reasons. I’m concerned this could be “other income” or a refund of some sort that should be listed under Other Income at the bottom of the statement or treated as an adjustment to an expense. 

Auto expense requires explaining. Was the IRS mileage rate or actual expenses used. If the mileage rate was used there is an opportunity to add the depreciation portion of the mileage rate back into income for lending purposes. (What condition is the vehicle log for tax purposes? Were personal miles mixed in?)

Contributions were really donations to charity. Sometimes a business can deduct donations as a sponsorship. Personal donations to church are not a business expense and should not come from the business account. 

Miscellaneous expenses are high and need to be accurately classified. 

Payroll and payroll expenses should utilize sub accounts. The officer’s wage looks fine (if this is an S corporation) compared to net income, but the type of business may change that determination. Removing contributions and a few other items from the expense column could leave the reasonable owner’s wage requirement a bit light (for corporations only).

The SEP/IRA is a concern. Is this a retirement account run through payroll or an IRA contribution for an owner paid out of business funds? It needs to be cleaned up or clarified. Payroll with sub accounts would be ideal to address the lack of clarity.

The business portion of Social Security is listed, but is the wrong percentage. The Social Security portion of FICA is 12.4%; half paid by the employee, half by the employer. The Social Security expense of $5,562.26 is more than 10% of the officer’s wage of $53,800. The employer’s portion is only 6.2% and there are no other wages listed on the income statement!

Payroll expenses are listed as $18,909.25. Is this employee wages? It would explain the FICA issue. This would need to be cleaned up/clarified before presenting to a bank or buyers.

Finally, utilities are not an “other expense”. This needs to be moved up with the regular expenses. The sales tax adjustment also needs addressing.

 

Cash Flow Statement

You can click all financial statements in this post to open in a second, larger window.

The cash flow statement is my favorite. I want to see where the money is coming in and going out. This includes loan proceeds and retirement of debt. If the statement is accurate it can tell you a lot about the health of a company. As you can see, this is not an ordinary business.

If the balance sheet and income statement were clean I would have confidence in this cash flow statement. However. . . 

We discussed several issues on the income statement and balance sheet which reflect here. The item I want to point out is the shareholder distributions. Added to the officer’s wage, we get the total cash the owner received from the enterprise in 2018. 

Even with terrible books we are still able to get a vague idea how much the business is disbursing to the owner. The odds are pretty good the owner received a $53,800 wage and $35,950 in distributions. Cash was negative at the beginning of the period (unbelievable) and around $34,000 higher at year-end (believable if the rest of the books were not a mess). Messy books means the business probably throws off close to $90,000 in cash to the owner, more if contributions are not really a business expense. If the books were clean we could add the $34,000 increase in cash for the year since I don’t see any lending activity.

 

Analysis and Opportunity

Obviously this was an extraordinary mess used to illustrate multiple recordkeeping issues. Many businesses have books this bad, if they have any records at all. A thriving business can fail due to mismanagement of recordkeeping. Poor records can cause a business to over-pay taxes, lose bank funding and result in a lower sale price of the business at the end of the owner’s career.

Warren Buffett has said many times Accounting classes were the most important he attended in college. I agree. Without a fundamental knowledge of accounting it is difficult to build serious wealth and almost impossible to run a successful business. With a sound understanding of accounting and financial statements you are qualified to manage most businesses and investments, including finding the true value of the asset.

You don’t have to be a banker or financial analyst to use financial statements. Investing in a stock is investing in a company and should be treated the same way as buying an entire smaller local firm. Buying income property successfully requires understanding financial statements to make a sound decision. You want to know the rent history and expenses, plus required deferred maintenance, before making a decision to buy or pass.

Since most roofers are good at roofing and poor at keeping accurate records, you have a powerful side gig opportunity to make a difference in your community while earning above average income. 

All business eventually need funding. Your ability to read financial statements allows you to consult with clients at a higher level and to gain desired result. You can handle the raw data entry if you want or farm it out to a bookkeeper. Regardless, you lead and give directions. 

Done right, you and your clients will profit.

 

Coda

So how can you start reading financial statements as a side gig or person use if you don’t know how already? You could always take a college or technical school course. Or, you can self-study. Here is a good book to get you started. It will cover 99% of what most people will ever need. Note you will still look things up from time to time. It is the nature of the skill. The linked book is a good reference source. 

 

 

More Wealth Building Resources

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

How to give a powerful speech or presentation. Move the crowd. Create engagement and interest. Get more sales. Turn your speaking gig into profits. #speech #sales #motivation #engagement #presentation #speaking #publicspeaking #profitLast Monday I attended a one day seminar on Reading Financial Statements. While I am not a CPA, I am an enrolled agent (tax professional). Working in business my entire adult life in the tax field means I have a working knowledge of financial statements. I also took accounting, business and economics courses in college.

Having a strong background does not always mean you are good at it. Sometimes we fall into bad habits or forget some of the more esoteric details of the craft. My hope was to learn at least one new insight into reviewing financial statements that would give me a better or clearer view of the report.  

Financial statements are the lifeblood of business and investing. Running an efficient company requires solid recordkeeping and the ability to understand what basic financial reports tell us. Without a firm understanding of the financial reports you are guessing when making important decisions in your company. 

The same applies to investing. Warren Buffett said that accounting is the most important class he took in college. Buffett feels business classes are important, but accounting gives you the knowledge you need to run virtually any business. A firm understanding of financial reports means you understand details about the firm. You don’t need a world class business school to acquire a firm grasp of accounting. A local tech school or extension college is just as valuable.

Even in personal finance financial reports are important. If you don’t understand your own financial condition (the balance sheet) you are at risk or serious financial error and loss. The same can be said if you don’t understand where the money is all going (cash flow statement). Tracking your income and expenses (income statement) is a powerful tool for building wealth. Guessing is not a substitute for knowledge when money is involved.

 

Train Wreck

Last Monday promised to be a day of review with a few additional insights. The promise took a left turn quickly.

I was the first to arrive at the class. (I am like that; teacher’s pet, showing up early.) About 20 students filled the room. Kimberly, a fine young lady from Florida, was our instructor.

From the beginning she looked nervous. I was quiet, yet attentive as she struggled to deliver the message. 

A small class of 20 student should not shake a speaker. At first I thought she might have personal issues or feel ill. 

Then she interspersed light comedy pieces between sections. They didn’t match the curriculum and were very out of place.

 She decided not to follow the workbook, instead, using a PowerPoint of her own design as her teaching tool. 

There were several glaring errors. At one point she had the accounting equation on the screen and proceeded to  explain how the equation worked on the balance sheet. This is what her slide showed:

Asset=Liabilities-Owner’s Equity

Can you see the problem? The formula is really:

Assets=Liabilities+Owner’s Equity

Some people call Owner’s Equity Capital or just Equity. The point is that liabilities and equity are added, not subtracted, to equal assets.

Kimberly went on to explain why her equation was how accounting worked. Nothing added up. Something was very wrong!

I bit my tongue. It isn’t my place to embarrass her. However, it did bother me the other students were getting bad information. Some of the other students were drinking it in because they really didn’t know the right answer.

 

Some Education is Better than None

By mid-morning it was painfully obvious Kimberly was in over her head. Situations like the formula above and statements like, “accounts payable should never exceed accounts receivable” were blatantly false. 

The course provider (name withheld to protect the innocent) had a workbook we did not use. By going off on her own PowerPoint Kimberly was reinventing the wheel. I still has not put the pieces together as to what was really wrong with our speaker. She has 17 years experience in bookkeeping. You don’t survive that long (and get hired to teach a course) if you are that bad at it.

The few questions asked by the class I answered. To help the group move in a more appropriate (and hopefully more accurate) direction I asked a few questions and guided the responses. I decided to gently mention accounts payable (AP) can, and in many instances should, be higher than accounts receivable (AR).

It was time to drop a golden nugget to return interest to the class. I went back to an earlier discussion on cash versus accrual accounting and asked: When should a small business use accrual accounting instead of cash accounting?

The room looked like a herd of deer in the headlights. Small businesses can use cash accounting for taxes by default. You can elect to use accrual if you choose. (The upcoming Halloween post on  Financial Horror Stories II includes a story where a client made a big time mistake I fixed by understanding why accrual accounting can be a powerful tool. Be sure read it.) 

Most small businesses have an accounts receivable. Not all, but a large percentage do. If your receivables are larger than payables you want to remain on cash accounting, especially for taxes. However, if your AP tend to always be larger than your AR you will want to consider accrual accounting. 

The reason for this is clear. If AR are larger you don’t want to pay tax on money not yet received so cash accounting is better. If AP is larger you can deduct the expense before it is paid under accrual. 

With this it was time for lunch (fifteen minutes early). Thank God.

 

Time for a Break

Kimberly did not join us for lunch. As some of the students ate together we talked. One student was a retired CPA from a large CPA firm. He was not happy.

I admit I expressed concerns over lunch. It is my policy to never denigrate another person pouring out their soul to a group. I am by no means always innocent myself. In this instance I was reasonably true to my policy, and as will soon become clear, I am glad I was.

A third of the class never returned from lunch. Kimberly looked worse than in the morning. 

From what I gathered, she ran out of material in the morning.

The afternoon session was worse than the morning. We returned from lunch at 1:00 and by 1:30 it was getting ugly. The material was all over the map and did not make sense. Most was a glossing over of the morning material. 

Either I had to take action or the class would be over on the spot.  

I interjected, “I read the workbook over the weekend and would like to review some of the material there.” 

Everyone, including Kimberly, was happy for me to provide some direction. 

“On page 32 of the workbook there is an income statement. What is wrong with it?”

A good discussion on fraud prevention ensued. In a short period of time I was able to pry from the financial statements many details of the company presented.

What glaring problem do you see with this balance sheet?

What glaring problem do you see with this balance sheet? I’ll answer in the comments in a few days after publication. Hint: The company is in trouble.

I will not give a play-by-play of the remainder of the afternoon. What I will say is the discussion picked up and for the few that remained for the afternoon we had a good discussion with value.

Class ended early.

 

The End was the Beginning

When the curtain came down the remaining students left. Many grabbed my card (I didn’t bring my business card so I handed out my card for this blog).

The first to arrive I was to be the last to walk out with another student, a retired teacher.

Kimberly walked behind us and said, “Thank you for asking questions and moving the class forward.”

I replied it was no problem. I mentioned I could tell something was wrong.

“This is my first class,” Kimberly said. She was nearly in tears. It was a long, hard day for her.

The pieces all fell into place. 

“I can’t understand what went wrong,” Kimberly continued. “I spent two weeks planning this class and practiced.”

The school teacher and I stayed for about an hour helping Kimberly improve her game and good thing. Kimberly was headed back to Illinois for two more presentations of the same program before heading home. The reviews from today’s class were brutal. If she didn’t make a comeback she was at serious risk of losing her job.

I recommended she dump the PowerPoint. The school teacher said she might want to use a meme.

I gave an example of how I would conduct the class: Use the workbook, ask students questions, get the students thinking. Tell stories. Engage the class. Find the reason they came and work it. 

Kimberly recorded some of my remarks on her phone for review as she drove back to Illinois. She wanted to listen to it again and again. In less than an hour I outlined how I would conduct the class. It would be impossible to finish it all in a day. That makes for a good, fast-paced class.

Mostly, I told Kimberly, she needed to have confidence. She has almost 20 years experience as a bookkeeper. Yes, she is not a CPA, but she is very familiar with financial statements. There is plenty of material to engage and peak the interest of any group. Focus on what is relevant to the attendees. Each presentation, as a result, will be slightly different.

Kimberly looked very tired when we left. She also looked like she had hope. The company had a workbook with plenty of material to easily fill a day. Mixing in personal stories would keep the group awake and engaged. 

 

For the Sake of One

I made it clear to Kimberly she had nothing to lose. It is unlikely she will ever see any of these students again in her life. Just give the best darn presentation you possibly can, I suggested. Give a piece of you. Make it real. Go in with the goal of helping everyone present learn at least one new thing this day.

The knowledge doesn’t have to come from you, I continued. You would be surprised how often the best insights come from other students as they ask questions and debate answers. 

As I said to Kimberly, it is unlikely we will ever cross paths again. There is nothing to lose. Nothing to be embarrassed about. This was not about personal gain; it was about paying-it-forward. It is the only thing that gives life meaning; helping others find meaning in their’s.

Kimberly did not contact me afterwards. I have no idea how it turned out in the Illinois classes. 

Steve Jobs asked John Sculley if he wanted to change the world. Well, I haven’t changed the world at the level of Steve Jobs.

But I may have changed the world for one. And it was worth the effort.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?

Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

PROTECT YOUR CASH!!! Investments too good to be true are. Learn the language of business before investing. #accounting #investing #Buffett #WarrenBuffett # money #cash #realestate #stocks #alternativeinvestmentsMy office manager, Karen, sat with a new restaurant client. Ten minutes later Karen was in my office with the financials of the client.

“She doesn’t understand why she is losing money, boss,” Karen said. “She says business is good, but she loses money every month.”

I looked at the profit and loss statement for less than ten seconds when I asked Karen, “Is this correct?” 

Karen named the bookkeeping firm the client used. It was a reputable firm. Karen said the client reported all income daily and reported it to the bookkeeper. The bookkeeper paid all the bills and provided a statement each month.

If the P&L was correct there was only one explanation. “One or more of her employees is embezzling.”

“Can you talk with the client?” Karen didn’t know what to tell her.

I went to Karen’s office and explained to the client she had at least one employee embezzling. 

“How do you know?” she asked.

I held up the P&L. “The cost of goods sold compared to wages compared to revenue are off. Someone is either walking out the back door with steaks and seafood or someone is stealing cash receipts.”

The client assured me she had honest employees. With only a glance at her financials I was certain there was malfeasance. 

“It might be a waitress. Do people leave money at the table or take it to the checkout person?

“Checkout person.”

“Okay, it probably isn’t her because the amount is too large. And while steak and seafood might be walking out the back door, the cost of goods sold is somewhat in line with employee wages. It is revenue that is off. 

“So tell me, do you have a security camera on the cash register?”

She told me she had no security cameras. 

“The employee at the cash register might be the problem.

“No,” she said. “That employee has been a friend since we were in kindergarten.”

That was all I needed to hear. With rare exception, embezzlement comes from people you trust the most. Either a family member, close friend or the faithful employee who hasn’t taken a vacation in eight years. There is a reason accountants demand business clients require anyone in their business handling money to take a two week vacation every year. You would be surprised how much embezzlement is uncovered when someone is on vacation.

“Your friend is robbing you blind,” I confirmed.

She still insisted her friend would never steal from her.

“Okay. This is what I want you to do. Go back to your restaurant and call a meeting with your employees. Tell them your new accountant is a real a-hole and demands a security camera be placed over the cash register.”

She did as I asked. Her friend since kindergarten quit on the spot. And profits arrived for the first time at her restaurant.

Unfortunately the theft had gone on for too long and the financial damage too great. A year later she closed her restaurant, deep in debt.

 

Warning Shot

A few weeks ago I published on the Fleecing of the FIRE Community. Some readers were irritated while others were concerned. I wrote things like:

Since you managed to acquire a respectable nest egg you think you are an experienced investor. It is doubtful you are!

and

Buying into an unconventional investment, which these bike communities are, should never happen unless you are very experienced financially and have the ability the lose 100% of your money without changing your lifestyle one iota.

and

You have no idea of some of the people on my desk I’m helping. These are serious issues; small fortunes completely destroyed unless I can find a way to preserve their wealth. I don’t always win.

When I published:

To keep this short I will close with one last suggestion. If you can’t read and interpret financial statements like a seasoned accountant you have no business being in any kind of exotic investment, real estate included. Stick to index funds and money market accounts.

You might not shoot the moon, but you will not suffer a catastrophic loss sending you back to square one, as a neophyte in the FIRE community once again.

people wanted to hear some of the horror stories, hoping to learn from other’s mistakes. 

I stand by my original advice: Don’t invest in things you know nothing about. If you can’t read a financial statement how will you understand if a rental property is a good buy? Or a business?

The next time you are tempted by a slick sales pitch at a conference (this is being published while FinCon is running in D.C.) or camp, come back and read a few of these true stories. Names are changed to protect the guilty (yeah, I think I’m funny); the stories are all true.

 

Supper Club

I have a group of clients that own several businesses around town. Two from this group with several outside investors own a supper club near my office. They called me in to handle taxes and consulting. It was bad from the start.

Once they bought the supper club they hired a manager. This was a guy they knew from running some income properties they owned. 

The manager and his wife handled the books.

The club was open for a bit before I was called in. I would review the books monthly and consult before preparing the annual corporate tax return.

I was to meet with the manager. When I arrived it didn’t take long to know something smelled bad. From the front door to the bar was all it took for me to know embezzlement was rife.

The bartender game me a cold attitude. There is no reason an employee of a business client should ever give the accountant an attitude. This told me the employees knew or suspected the malfeasance. The environment was bad.

I was shown to the office where I waited as the manager was running late.

I noticed a gap in the security cameras between the back office where I was and the safe. 

When the manager arrived he was livid. He made it clear I was never to touch the books unless he or his wife were present.

After the meeting I called one of the owners. I told him he had serious misappropriation of funds issues. I told him it was the manager bleeding him dry.

I was assured the manager was a good guy. I pointed out:

  1. The bartender’s attitude was unusual to see. Employees should care less if the accountant shows up. They should have been more interested in serving me a drink, hoping for a tip.
  2. The security camera gap between the office and safe was a serious issue.
  3. Any manager who is that adamant the accountant not see the books without supervision is practically an admission of guilt. There is only one reason to control what the accountant sees.

I knew who was embezzling (manager), where they were doing it (security camera gap near the safe), when they were stealing the funds (at closing the manager or his wife handled the money with no oversight) and how much (I estimated between $100,000 and $150,000 based on revenue).

When I was not taken seriously I said I was not interested in the account and hoped it would not affect my work on their other accounts. 

A year later one of the owners was in my office. It seems I was wrong. The manager was embezzling just as I said he was, except he misappropriated at least $300,000.

I reminded my client he probably did the same when he was managing their rental properties which always seemed to lose money, too.

 

Fish Farming

The moral of the first story is: If you can’t read a financial statement you have no business being in business.

The moral of the second story is: When your accountant’s BS alarm goes off, listen.

Invest in what you understand. Know your circle of competence. It is better to pass on a good investment than to invest in a bad one you don't understand. #stockmarket #business #sidehustle #sidegig #investmentsIn the second story the business survived and even later thrived. (Though I never got the account, but never lost the accounts of their other businesses.)

Now we turn to an income property story.

This didn’t happen to my client. I was a member of the Fox Cities Apartment Association many years ago when I owned a massive amount of real estate when I heard the story.

It seems a neophyte watched late night TV when he discovered he could be a gazzillionaire buying income property no-money down and cash flow right out of the gate. 

This guy bought an up/down duplex, filled the unit and enjoyed his new-found cash flow machine. 

As winter approached the tenant called and said the furnace was not working. The landlord went over to see if he could fix the problem without calling an expensive technician. 

When he gets to his property he finds the problem right off. The basement is filled with water!

It seems the tenant wanted to raise fish. Thank God he didn’t fill the basement to the electrical panel.

The foundation of the building was shot. Insurance didn’t cover the damage because it was the tenant’s fault. The landlord sued the tenant and won, but the tenant had no money and later disappeared. 

The city condemned the property and the bank foreclosed and socked the landlord with the shortage when the bank sold at a fire sale price. The landlord later declared bankruptcy. The stress destroyed his marriage. He lost his easy money investment, wife and had to pay 29% of his gross income in child support. I have no idea how he ever recovered.

The morals of this story are:

  1. Income property is NOT easy money,
  2. Always screen your tenants (his tenant had prior litigation with landlords),
  3. Always check your property, even if you have a property manager. An annual (or more often) personal inspection is a requirement in my opinion,
  4. Alternative investments, including income property, require a reserve to handle maintenance and excess damages, and
  5. No-money down deals are rarely a great deal. They are desperate deals.

This guy did everything wrong. He bought a crap property which attracted crap tenants. He put no money down and had no reserve, He never screened his tenants or inspected his property. What did he expect would happen?

 

Bad Advice

Some readers might notice I have no hair. It’s because I pulled it all out.

What non-bloggers might not understand is that bloggers can see when other blogs link to their site. Usually I’m curious to see what is said; usually I’m sorely disappointed.

For example, a blogger once published she never has an LLC for her income properties and linked to this post of mine as her reasoning. It was a 100% misunderstanding of what I said!

I have no problem with, and even recommend, income properties be held inside an LLC. What I also say is that you should never place real estate inside an S corporation or LLC electing to be treated as such for tax purposes.

The post this blogger linked to is about small businesses and not real estate so she read it all wrong. Which leads us to our last example so I can take an aspirin to dull this throbbing headache resulting from pounding my head into the corner of my office.

 

When it rains, it pours. I’m not talking salt either.

Last summer I had two consulting appointments with the exact same issue: income properties inside an S corporation. 

Since I could kill two birds with one stone I tried my darnedest to find a solution. I even hired a law firm in California to help. Alas, nothing could be done. Once real estate is inside and S corp it stays there, regardless the negative consequences. 

No-money down real estate is rarely a good deal. Usually you are buying something with lots of problems that is hard to sell. These steps can point out the ones that are really a bargain. #realestate #investing #nomoneydown #investment #goodinvestments(If you transfer real estate from an S corp to an owner of the S corp it is still treated as a sale at fair market value, triggering a capital gain (or loss). )

There are several reasons why you should never, ever, ever put real estate inside an S corp or LLC electing to be treated as an S corp. 

First, if the S corp spent any time prior as a regular corporation (C Corp) it probably has accumulated earning. An S corp with any C corp accumulated earnings and 25% or more of the S corp’s earning are passive (rent, interest, dividends), the S corp is taxed at the highest C corp rate.

I know that is a mouthful and a lot of details are disregarded. (It’s actually more complicated than that tongue twister indicates.) Regular corporations now have a flat 21% tax rate so it might not be as bad as it once was. Still, it causes an S corp—a vehicle for managing a business with fewer taxes—to be taxed at the regular corporate rate.

It also adds complexity to the tax return. Good for the tax professional (if he can keep his sanity); bad for you.

This problem is easily avoided by going straight to an S corp which many do.

The real problem—and this is a big one—involves basis.

I know basis is hard to understand, but it is of vital importance here. 

Most people understand they have basis in their S corp if they invest money into their business. What is harder to understand is how loans affect basis.

S corps are unique in that loans by the corporation do not add to the shareholder’s basis unless the loan is from the shareholder. Even if you guarantee a loan taken out by the S corp it does not add to basis!

We will not bog ourselves down today on S corp basis nuances so don’t take my next statements as complete answers; they are not.

The two clients I consulted (and latter prepared their tax returns) have serious S corp basis issues because they had real estate in their S corp and the S corp took out loans. 

When this happens it is possible to show a loss (real estate depreciation can cause a loss while still cash flow positive) and use up basis. When that happens it is possible in some circumstances to pay a capital gains tax on distributions when the S corp shows a loss. 

Accelerating depreciation can really complicate this issue. Current tax law allows faster depreciation in some instances. Repairs and improvements are deducted easier now. And cost segregation studies can super charge depreciation deductions.

When real estate is in an S corp you always have to keep an eye on basis from the corner of your eye. 

Nothing is worse than paying taxes on losses! And it can happen in an S corp when the rules are not followed.

The clients’ intentions were never to break tax laws either. They did what they thought was correct or might have even read some tax articles and misunderstood the complex issues surrounding S corp taxation.

To fix this problem I’m working with the client to verify all loan are from the shareholder. Loans are structured so the shareholder takes out the bank loan and lends the funds to the S corp. That does add to basis! (This is the opposite of what banks do so they have to be told the consequences. If they don’t listen, get a different bank!)

The moral of this story is: Always seek the counsel of a competent legal and tax professional before buying real estate and/or starting an entity.

I know people around here love saving money, but you don’t save when you make a serious tax error. A small investment in an attorney and tax professional can yield massive returns and peace of mind. 

 

Coda

Warren Buffett once recommended you focus less on business school and more on taking a few accounting classes. I couldn’t agree more.

You can’t make an investment or run a business optimally without understanding the language of business: accounting. 

While business classes are great, a fundamental understanding of accounting will serve you in every facet of your life: personal finance, investing, work, side hustle, small business.

You would be surprised at how many people doing their own books record loan payments as an expense. (The interest portion of the payment is an expense; the rest is principle which is recorded against the liability on the balance sheet.) If something as simple as this is not understood, how can you possibly trust your judgement in running the business or in any investment decision?

My original comments are correct: People have no business making investments in things they don’t understand! My buddy Warren has said at least a googolplex times. 

All these crazy ideas brought to conferences and the various FI camps are accidents waiting to happen. You can make informed decisions when you understand the language. You, like me, might enjoy making small investments in strange products just to see how it works and plays out. Nothing wrong with that as long as you understand what you are doing.

Making large investments without understanding the investment is insane. Index funds and bank deposits are what you should limit yourself to if your accounting knowledge is limited. In fact, you shouldn’t even listen to any investments offers. All that could happen is you get sold and then God help your net worth because no one on the earth will. 

It is also never too late to learn. Colleges and tech schools around the country have superb accounting classes.The great news is accounting has been around a long time is and virtually unchanged in that time. You don’t need a prestigious college for a good accounting education. Even local night classes will make you a better investor.

 

It is temping to think you know more than you do when your stash grows. Success gives the illusion of intelligence. When the crisis arrives the illusion evaporates. 

Please, kind readers, use common sense. If you don’t fully understand the concept and the financials then take a pass. Better to miss a deal than to go all-in on a scam.

 

 

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