Misleading balance sheets

Your financial statements can lull you into a false sense of security unless they take note of future estate-tax obligations and succession events. Accounting methods for family businesses need to get real.

By Peter Baudoin

Joe Maravich, founder of a wood products manufacturing company, died two years ago at the age of 89. At the time of his death, total stockholder equity in the business, as indicated on the balance sheet, was $5 million. But the IRS had been auditing Joe’s estate tax return and had figured the value of the business at $12 million. As a result of the higher valuation, his family would not be able to pay the tax without disposing of some of the business assets.

How did Joe get his family into this fix? The problem was that the primary asset of the business was 10,000 acres of hardwood forests which had a market value at the time of his death of $10 million. But Joe’s accountant figured the value of the asset according to book value, or “historical cost”—$1,000—which was what the founder had originally paid for it. This was the customary, approved method used in the profession.

To make matters worse, the company’s financial statements did not take into account the potential impact of Joe’s death on the next generation. Joe’s daughter Ann, his only heir, had become CEO of the business, but at 61 years of age, she was relatively senior even by today’s standards. If she, too, happened to die in the near future, the family would be socked with a second sizable estate tax bill which would also have to be paid from business assets.

In figuring the taxable estate of a decedent, the IRS uses the market value of the business. The financial statements had in no way prepared the family for the reality of the taxes they would have to pay.

The facts described are based on an actual case, although the names have been changed. The lesson is that when business assets will be needed to fund estate taxes, accountants should disclose the market value of assets and the expected estate tax liability in the company’s financial statements. This is valuable information not just for the heirs but for all the people with whom the company does business, including bankers, suppliers, and venture partners. Yet it is rarely noted by the accountants who prepare the statements.

The fact that standard accounting practices, and even accounting theory, are not responsive to the needs of family owned businesses will not come as news to business owners. But as the Maravich case shows, owners and their accountants who don’t understand how devastating it can be to overlook some of the unique family business accounting practices are setting their companies, and their families, up for disaster.


Outdated formulas

The financial statements of most family companies are based on standard measures—and thus ignore a great many issues that bear on the value of a business, particularly estate tax and succession issues. In the accounting profession this topic is debated as Big GAAP versus Little GAAP. Big GAAP consists of “generally accepted accounting principles” for large enterprises and Little GAAP obviously is “generally accepted accounting principles” for small enterprises.

In preparing financial statements, members of the American Institute of Certified Public Accountants are required to follow all the standards, interpretations, opinions, research bulletins, technical bulletins, industry guides, and statements of position that have been “cleared” by the rule-setting bodies of the profession. And guess what? None of these deal specifically with the needs of family businesses. Two fundamental principles of accounting theory, in particular, create conundrums for the accountant interested in presenting financial statements in the context of the family business. They are the “entity” principle and the “going-concern” principle.

The entity principle requires, among other things, that the economic interests of owners be kept separate from the accounting for their businesses. In the ordinary course of accounting for business transactions, the separation requirement seems like a good idea. One can imagine the difficulty of interpreting financial statements in which the personal financial assets of individuals and business firms are commingled. However, in some instances this results in distorted representations of reality. For instance, when an owner provides a personal guarantee for a business loan, the accountant will treat the loan as a liability of the business even though, if the business defaults on the loan, the lending institution will pursue collection from the owner. It’s all the same wealth as far as the family is concerned.

By the same token, shouldn’t the potential future impact of Joe Maravich’s personal estate tax liability be noted on the company’s financial statements? Given the consequences to the business of the family owners’ personal liabilities, it seems that strict adherence to the entity concept will be quite misleading.

The going-concern concept is based on the assumption that a business will have a long life. A succession event, such as the pending death of a majority owner or a developing impasse in the transfer of ownership or leadership to the next generation, can threaten a family business as a going concern. An accountant to a family business can follow all of the rules of the profession and still end up with financial statements that are substantially wrong and lull the family owners into a false sense of security.

Another issue is the use of “historical cost” as the foundation for numbers in a company’s financial statements, which has long been a cornerstone of accounting theory. It is also the profession’s Achilles Heel, and is constantly debated. Until about 20 or 30 years ago, numbers based on historical cost remained fairly stable. But in more recent times values in many industries have begun to change drastically, so that book values are way out of line with market values. In the case of Joe Maravich, it was totally unrealistic to value the company’s trees, which probably started as seedlings, at $1,000 when they had grown and appreciated in market value to $10 million.

Although the assets of every company—public or private—are valued according to the historical cost formula, it is a bigger problem for the family company in the transfer of assets to the next generation. When there is a question about the ultimate survival of a business, a liquidation approach, which uses the fair market values of the assets and liabilities, may promise a more accurate representation of the company’s actual financial status.

It is true, of course, that a more accurate picture can be a double-edged sword. If it raises questions about the company’s future viability, it can hurt its status with lenders, suppliers, and business partners. In the long run, however, a realistic picture benefits everyone. If the future of the company hangs on a heartbeat, the family is better off facing up to the issue and doing something about it. Unfortunately, accountants, rather than helping to convince their clients of this, have been content to ignore the issues.


Impact on credit lines

The estate tax burden isn’t the only issue that can have a huge impact on a family company’s financial status. Ownership arrangements in the family also have an important effect. Take the case of Ted Marwell (not his real name), who died five years ago at the age of 90. Forty years ago Ted founded an industrial services company that today employs 1,200 people and generates $120 million in annual revenue, and has an estimated market value of $85 million. What is critical in this case is that the company carries $25 million of debt with loan covenants that require the company to maintain certain debt-to-equity ratios.

Audrey, Ted’s 90-year-old surviving spouse, owns 60 percent of the business. A buy-sell agreement between her and the company provides that when she dies, the company will be obliged to buy her stock for cash. Currently, the formula in the agreement would call for a purchase price of $40 million. The company, however, would be unable to increase the $20 million insurance policy it owns on Audrey’s life because of her age and medical condition. This means the business would have to borrow $20 million in order to execute the agreement.

Accounting for the transaction would thus result in a $20 million increase in debt, and a $20 million net decrease in stockholders’ equity after flow-through of the life insurance proceeds. These changed financial circumstances might very well trigger provisions of the loan covenants and other credit-line requirements such as personal guarantees. If this happened, would the business be capable of securing the additional $20 million needed to fund the buy-sell agreement? Shouldn’t the company’s financial statements indicate the risk of this cascade of events?


Successor deadlock

Questions about leadership succession cast doubt on the future of Bill Applewaite’s wholesale distribution business as a going concern. Over a lifetime, Bill, 68, built a company with 385 employees and $84 million in annual revenues. In recent years, his son and daughter had become increasingly active in the management, though in ways that turned somewhat destructive. It seems that the son and daughter were competing vigorously to replace the founder, who planned to retire soon but could not make up his mind about the succession.

Bill had a serious problem. If the business was to remain successful beyond his tenure, he had to move expeditiously to select the next CEO or at least establish a process or framework for selecting the successor. Failure to do so threatened the management, leadership, and control systems of the business. Gridlock in decision-making at the top after Bill retired, moreover, could frustrate employees and undermine the company’s ability to serve customers.

Is this business going to have a long life? The realities of the situation should be addressed in the financial statements—at least in a footnote describing the current lack of a process to control succession and resolve conflict in management. The company’s financial statements should be based on market values, so that the family and other stakeholders of the business are fully aware of its post-succession liquidation value.


Questions about governance

Dan Phillips is the current chief executive officer of a third-generation retail business with 90 employees and $36 million in annual revenue. He is 67 years old and a member of the second generation. Currently, 40 heirs of the founder own stock in the business. Upon Dan’s death, the number of shareholders will grow by 15, to a total of 55, with no one individual or branch of the family owning a controlling interest.

Dan’s position of authority as CEO depends in part on the trust of his sister, Jane; together, Dan and Jane control more than 50 percent of the outstanding shares of the business. Jane has deferred to Dan in all matters of business but has insisted that her children and their spouses have a right to employment there. Accordingly, several of Jane’s children and in-laws are employed in the business, as are several of Dan’s children.

In his will, Dan has identified 16 people who will inherit his shares in the business, but he has not yet established any system of shareholder governance that will survive his death. The company does not have a board of directors with outsiders on it or any other formal body and procedures for resolving shareholder issues or selecting leaders. After he is gone, the shareholders will have no system in place to elect officers and directors or make decisions on officer compensation, dividends, and other shareholder issues.

Planning control and governance succession is a critical aspect of ensuring that the business remains a going concern. In this case, ownership is becoming so diffused that governance may become unwieldy, particularly if this family, like so many others, is vulnerable to emotional and historical “coalitions.” Again this is a reality that should be duly noted in the financial statements.


Your accountant’s responsibility

Business owners should prepare for the possible consequences of succession just as they would for a potential disaster such as a fire in the main factory or a computer breakdown. The likely consequences of the plan—or the lack of a plan—should be reflected in the company’s financial statements. One way to test those consequences is to assume various succession events or scenarios have taken place. Ask your legal staff to report on what financial claims or transactions would be initiated by the various changes in leadership or ownership. Who would be in charge during the initial crisis period? Would a transition team be in place until the succession-related transactions were consummated?

Ask your banker and other financial stakeholders (including major suppliers and customers) what actions they might take, if any, as a result of a change in ownership and leadership. Analyze the facts and ask your advisers to suggest ways to minimize the consequences of the “succession event” on the business and the stakeholders.

Your accountant has a responsibility to adequately report the status of your succession planning on your financial statements. This is an obligation that accountants have not only to owners and stakeholders but to their profession and society. The pertinent facts can be disclosed in simple footnotes that make straight statements without causing undue alarm. For example, a footnote might read, “The majority owners have begun work on a succession plan, but no decision has yet been reached on who will succeed the current CEO.” Another may be worded: “The shareholders have implemented arrangements to ensure continuity of management and control within a framework that will not unduly burden the company with any currently contemplated estate tax obligation.”

Many accountants are simply unaware of the economic impact of succession on a company and its stakeholders. Creditors and investors need detailed information about the company’s plans. Accountants can perform a much needed public service—and a service to the owning family—by developing methods that more accurately reflect the needs of the business and by helping to persuade the family owners to plan for continuity.


Peter Baudoin is an accountant and adviser to family businesses, and runs his own firm, Peter Baudoin Consulting, in Lafayette, LA.

Samples of disclosures

The following are examples of disclosures that might be noted in simple footnotes on the financial statements of family businesses:

• “Management has a plan for an orderly transition in leadership prior to the departure of the current CEO.” Or: “There is a plan that is in place for a transition in leadership in the event of the CEO’s death.” Or: “No succession plan has yet been adopted.”

• “There is a plan for the transfer of ownership control.” Or: “No plan for the transfer of ownership control has yet been formally adopted.”

• Indicate the extent to which business assets will be needed to pay estate taxes in the event of the death of the principal owner. If liquidation of business assets will be necessary, include a sample balance sheet showing the effects of selling such assets on the financial position of the company.

• Note whether loans will be called or personal guarantees triggered as a result of the succession plan or the lack of a plan. If such consequences will follow the death of the majority owner, include a sample balance sheet showing their effects on the company.

-- P.B.