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Audited Financial Statements Open Doors

Article-Audited Financial Statements Open Doors

When Jimmy Tosh's lender suggested he spend thousands of dollars just to verify that his financial records are accurate or, perhaps, to discover that they are not, you can imagine he wasn't enthused.That's changed. Now he's so sold on an annual financial statement audit that he budgets for it every year.Tosh Farms includes a 5,000-sow, farrow-to-finish operation plus 6,000 acres of row crops near

When Jimmy Tosh's lender suggested he spend thousands of dollars just to verify that his financial records are accurate or, perhaps, to discover that they are not, you can imagine he wasn't enthused.

That's changed. Now he's so sold on an annual financial statement audit that he budgets for it every year.

Tosh Farms includes a 5,000-sow, farrow-to-finish operation plus 6,000 acres of row crops near Henry, TN.

"What it really amounts to is having an outside observer come in and review your financial records to make sure everything is reported and that it's accurate," Tosh says. "The auditors also follow Generally Accepted Accounting Practices (GAAP). That makes it possible to compare your operation to other operations and know you're making a true comparison."

Usually, it's a lender who triggers the first audited financial statement. They want an outside accountant to put their seal of approval on the borrower's records to be sure the producer isn't accidentally, or deliberately, embellishing the numbers.

But farmers usually find plenty of benefit for themselves, too. Tosh says he has found enough management benefit from audited financial statements to make it worth more than the cost.

"The biggest change we are making is to use book value on all assets," Tosh says. "Book value rather than market value takes the inflation out of your balance sheet. Then you have a true picture of what you have accomplished from your management ability."

Remember what happened in the pre-farm crisis years, the 1970s. Land values were rising fast. Many farmers put every dollar of that inflation on their balance sheets so they could borrow more money to buy more land.

If a farmer had 1,000 acres of $1,500 land and the value increased by 12"percent", he could add $180,000 to his balance sheet.

The trouble was, profit was disappearing. And, it was inflation, not profit from good management, that was building the bottom line on many balance sheets.

When the bottom fell out of land values, it was the farmers who took the big hit. They couldn't pay back the money those inflated balance sheets and equity-minded lenders allowed them to borrow.

Tosh likes the idea of knowing that his growth is coming from profit. In fact, as a result of the audited financial statements, he plans to produce a monthly profit/loss statement. That will give him a monthly, management check-up rather than waiting for year-end statements. He figures that will help him spot problems quicker.

There's a phrase: "garbage in, garbage out." It applies to research, computerized recordkeeping and farm records. You want numbers that will allow you to do financial analysis and to make good decisions with a high degree of accuracy.

There's nothing wrong with a market value balance sheet, too. It can tell you what your business is worth as you do effective estate planning or if you decide to sell out.

But you can easily have both. It's just a matter of putting market value on the inventory shown on your book value statements.

Does It Really Cost? Dan Peregrin says he's disappointed if he can't show clients how to save enough on their income tax returns to at least pay the cost of an audited financial statement. It doesn't happen every time. But information gleaned from the process often provides income tax savings equal to his fees, and sometimes a lot more.

In a recent case, he found enough tax savings for the client to pay the cost of the audits for 10 years. "Initially, an audit of their financial statements is a nuisance and a seemingly unnecessary cost to the farmer," says Peregrin, a Certified Public Accountant (CPA) and attorney with the Moore Stephens Frost CPA firm in Little Rock, AR. "It's the banker who wants the audit."

Peregrin suggests talking to farmers who have been through the experience, CPAs who have done audits and lenders who want audits to show to the bank examiners. As you hear their stories, the pain of dollars and time spent diminishes.

"The audit, in itself, doesn't create good information," he explains. "It basically tells you if your records are good or not. Then, we tell you what to change to create the good information."

"Hog production is a growing business with individual operations getting a lot bigger," adds Alan Duncan. "What has happened in many cases is that, as these guys grow, the recordkeeping hasn't grown with them. The audit process may help them keep better records for their present needs."

Duncan, also a CPA, and Peregrin work together. Duncan is the auditing specialist and Peregrin is the income tax expert. Their firm specializes in animal agriculture and works with farmers coast-to-coast.

"The big boys in the hog business have used audited financial statements for years," says Duncan. So have other businesses where credit is important.

Three Credit Benefits While it's lenders who often trigger the first audited financial statements, they may also be triggering some competition for themselves.

"We have one client, for example, who has had several banks calling on him, wanting his business," says Duncan. "Once lenders know a producer has audited financial statements, the banker has confidence in his records and that makes him a much safer risk."

Realize that other vendors such as your feed suppliers who extend credit are also going to feel more comfortable when you show them a validated set of financial reports.

There are at least three borrowing benefits producers can harvest with audited financial statements.

* Instant credibility with lenders - "If you meet a producer for the first time and he has audited statements with him, his credibility is clearly in the upper tier automatically," says Lee Fuchs, senior lending officer with AgriBank FCB in St. Paul, MN. "You can take an identical producer with the only difference being that he doesn't have audited statements and there is always that lingering doubt as to whether he is representing his financial position accurately."

Fuchs doesn't expect all his clients to be experts in finance. But he does expect them to know that the financial matters in their business is being handled and reported properly.

* Attract a better lender - Lenders prefer the safe route. Borrowers who run into trouble making payments create extra cost in money and time for the loan officer, not even counting stress, headaches and lost sleep. Therefore, that loan officer is going to look for borrowers who are more likely to be trouble free.

"Borrowers with proven records will be able to attract better, more qualified lenders," says Fuchs. "Those are the lenders with bigger lending limits, more services to offer and who are more knowledgeable about the industry."

* Negotiate better terms - "Audited statements should put you in a better position to negotiate more favorable loan terms," says Fuchs. "That, alone, can offset the cost of the audited financial statements.

"If a producer is borrowing $5 million, for example, a quarter of a percent lower interest can pay most or all the cost of having the financial records audited," he adds.

Getting the best interest rate you can get is good. But being able to get as much money as you need to grow is probably even more important to you.

"We see the results of audited financial statements," Peregrin says. "One of the biggest is that the producer with proven records can get more money with the same amount of collateral. He is allowed to be higher leveraged."

Think about why you borrow money to expand. "Being able to get the money you need to expand is probably worth more than a lower interest rate because it gives you the opportunity to make more money with that additional money," Peregrin adds. "When you know your records are accurate, you know that you can get a bigger return on additional borrowed money than you are paying in interest. That's when you expand."

Just realize that the lender can pull the string that lets you grow. Or, he can tie the knot that keeps you where you are. It may not be your management ability that makes the difference. It may be his comfort level. A set of financial records he knows are accurate is what gives him that comfort level.

To Catch A Thief Nobody really wants to talk about the idea that somebody handling the money could be "skimming a little off the top." We prefer to trust people. But it happens and makes good coffee shop gossip in small towns.

An in-house accountant, for example, was admired by the company owners for all the long hours and weekends he spent on the job without ever taking any vacation. They were so impressed that they bought a cruise vacation for the accountant and his wife.

Finally, he was forced to take time off. That's when his assistant discovered why he came in early, stayed late and never took a vacation. He was afraid somebody might see the books and discover the quarter of a million he had skimmed off for himself over the past four years.

"If somebody other than you is handling the money, you need some safety checks," says Fuchs. "In a 5,000-sow operation marketing about 100,000 hogs a year, there's usually $10 million or more revenue. It wouldn't be too hard to 'lose' a few thousand of that."

Honest money handlers aren't going to be offended by an audit. In fact, they should appreciate the chance to prove they are trustworthy and do quality work.

"We often suggest closer control over who can write and deposit checks and who can approve purchases," Peregrin says. "The main reason you want tight control is to make sure everything gets reported right. If an item is supposed to end up on the balance sheet, you want to be sure it gets there."

Fuchs sees those controls especially important in joint ventures, networks and cooperative projects owned by a variety of people.

"They hire a management team to run the business," he explains. "But the owners are often a fragmented group. Therefore, they need to have a way to assure that the management team is working for the owners and that they aren't taking a little off the top."

Duncan and Peregrin say working with many hog producers can be an advantage for their clients. "We can say, 'This is the way the industry is accounting for inventory,'" Peregrin says. "Or, maybe it's, 'Your insurance is high compared to most producers. Let's look for something cheaper.'"

That's another way Duncan and Peregrin help their clients save some, all or more than the cost of the audit. As Peregrin says, "I like to say we are free. Numbers that are out of whack with the averages jump out at us because we see the numbers from so many operations."

The Cost Not just anybody can validate your records. Your lender, for example, wants to know the CPA is well trained and respected for quality work. You pay for quality. For large hog operations, expect to pay $8,000 and up, says Duncan.

Pressed to put it on a per sow basis, a rough estimate might be $2/sow. But there's no flat fee because every business is different.

"The biggest advantage is that it lets independent observers come in and examine your operation and make sure everything has been handled properly so you know you aren't fooling yourself," adds pork producer Jimmy Tosh.

The annual payment for a $5 million loan over seven years is about $960,350 if the interest rate is 8"percent". But if you can borrow that money for 7.75"percent", the annual payment drops to about $952,150.

While $8,200 may not seem like a lot in a multi-million dollar operation, it may pay for the tool that could get you that lower interest rate. The tool is the audited financial statement. Then, the rest of the benefits will add to your bottom line.

When you borrow big, it doesn't take much of a break on interest rate to add up to a savings of $10,000 or more on your annual loan payment.

Notice that the example above is the annual savings on a seven-year loan. Therefore, over the seven years, the total savings would be about $57,400.

Table 1 shows the annual payment per $1,000 borrowed for different interest rates and lengths of repayment.

If you borrow $5 million, that's 5,000 - $1,000s. Therefore, to get the annual payment for a $5 million loan, multiply the table figure for the interest rate and years of loan repayment by 5,000.

If you can make yourself look good enough to your lender to consistently get a half percent lower rate than you would otherwise, that's worth $3.30 for every $1,000 you borrow if you get 7.75"percent" rather than 8.25"percent" on a 5-year loan (from the table: $252.11 - $248.81 = $3.30).

On a $5 million loan, that difference in interest payment will be worth $16,500 a year ($3.30 x 5,000) - every time you make a payment.

When Lee Fuchs looks at an audit of a client's financial statements, he's watching for clues that might jeopardize the borrower's ability to repay his loans. He doesn't expect to find anything "shady." It's more likely the business might be doing some things inadvertently that could be putting the owners at some risk.

Correcting any problems found in these should also be beneficial to your business.

Fuchs lists 12 things he looks for in an audit of a client's financial statements.

1. Who the owners are, their percentage of ownership and voting power and how much of the profit is being paid out to them in dividends. In a sole proprietorship, that might be how much is being taken out for family living. If too much is going out to the owners, there might not be enough left to make loan payments or to build liquidity.

2. Revenues are being recognized when they should be. If inventory is valued at market value, increases in price can show up as revenue before the inventory is sold. You have a 100 lb. pig that is worth $40. But, then, the market goes up and he's worth $50. A market value balance sheet can result in that $10 increase showing up as revenue even though the pig hasn't been sold.

3. Inventory numbers are accurate. An audit provides for an independent party to validate that the number of animals shown in the records are actually out there. This one is a major point with lenders, says Fuchs.

4 . Costs of operation are being allocated correctly. If costs are allocated to animals when it should be going to overhead or machinery, for example, that's going to make the animals look like they are worth more than they really are on the balance sheet.

5. Depreciation matches the true life of the assets. If the useful life of an asset is 10 years, but the business is showing a 15-year depreciation schedule, the depreciating assets will look like they are worth more than they really are.

6. Control over cash. If there's not a policy that one or two trusted people have control over cash receipts and disbursements, it can be too easy for somebody to "take a little off the top." Sometimes an auditor can make good suggestions for improvements on this one. This is another major one with lenders, says Fuchs.

7. The right amount of insurance is in place at the right cost.

8. The hedging position doesn't become a speculative position.

9. What the income tax consequence would be if the business were sold. As Fuchs puts it, "Accelerated depreciation can be good for tax purposes. But if you sell out, it can catch up with you."

10. The amount of employee benefit obligations. How much money is going to be required to fund pensions, 401(k) retirement plan and employee insurance?

11.The amounts and terms of all loans. It will verify the amounts owed, the length of the loan, interest rates and if the interest is at a fixed or variable rate. When a lender sees those, he will look at it with an eye on beating the terms of existing lenders - a potential savings for your business.

12. Are there contingencies and legal issues? Has the business guaranteed loans for somebody else? Are there any judgments or lawsuits pending? What are the commitments under contracts such as with other businesses who are finishing animals for you?