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Creative accounting short-circuits business sale

Creative Accounting Short-Circuits Business Sale

Recently I received a phone call from a man who wanted to sell his business.  We began to talk, and early in the conversation, I detected holes in his story. 

 In a nutshell, here is what he shared:

 His company’s current inventory had a retail sales value of $4 million. The markup on product cost averaged 100% (if it cost $1 it would sell for $2).   As the conversation continued he stated that the cost of his inventory on hand was $800,000.  The recent calendar year reflected sales of $1,000,000. 

 When I received his corporate income tax returns, I saw that in fact, the company reported approximately $1,000,000 in sales with a cost of sales amounting $500,000.  Seems good so far, right?

I asked about the $4 million in “retail” sales value and the owner began to tread water.  He said that in reality, the company had purposely understated inventory costs at year end to save income taxes.  This comment muddied the water even further. Why?

 If in fact, the company sells merchandise costing $1 for $2 then the $1 million in sales with half a million in cost would seem correct.  But, the tax return balance sheet reflected a cost of remaining inventory at year end of only $800,000.  At a 100% markup, the approximate retail value of inventory would be $1,600,000 and not $4,000,000.  Was the owner exaggerating the retail sales value ($4 million) of inventory?

The owner then stated that the “real” cost of inventory on hand was really closer to $2 million.  That statement drew even more doubt.  Was a substantial portion of the inventory obsolete?  The response was “no.”  Why did I ask?  If the markup is truly 100% of cost, then why were sales during the prior year only $1 million?  And, moreover, why would the company need $2 million of inventory on hand to support only $1 million in sales?

Had the company been under reporting sales?  Or, was the profit margin on sales much lower?  Clearly, there were many questions the business owner was not willing (or couldn’t) answer. 

  1. If there are obvious problems that will keep your business from selling, why would any business intermediary want to represent you?   

In the above instance I did not accept the engagement to sell the company.  I think the owner had played so many games with the books to “save taxes” that he had lost all sense of what he really had.  

My suggestion to business owners is to be honest with themselves (and the government).  Learn to look at your own business as a stranger would look at it.  If you were a stranger looking to buy your business, what questions would you ask?  Would the answers make sense to you?  Would the answers make sense to your CPA and your banker?  If not, there should be some serious housekeeping in your future.

For more information, go to www.gruttercpas.com

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