Financial statements tell only part of the story. Investors, lenders and other stakeholders who know how to identify red flags of impending problems can protect their own financial interests. Additional due diligence may be needed to uncover these issues. For instance, stakeholders might need to talk to management, visit the company’s website and compute financial benchmarks using the company’s most recent financial statement. Here’s what to look for.

Employees who jump ship

Employee turnover — at all levels — often precedes weak financial results. One obvious reason is that company insiders are often the first to know when trouble is brewing. For example, if the plant manager’s innovative ideas are frequently denied due to lack of funds or if employees hear shareholders bickering over the company’s strategic direction, they may decide to seek greener pastures.

The reverse happens, too. If certain key people leave the company, it may cause revenue or productivity to nosedive. Given time and sufficient effort, most established companies can recover from the loss of a key person.

Another reason for high employee turnover may be layoffs. Companies that can’t meet payroll may need to shed costs and dole out pink slips.

Employee turnover can also be a vicious cycle. Top performers in an organization may respond to perceived financial problems by moving to healthier competitors. That leaves behind the weaker performers, who must train new hires on the company’s operations. Finding and training new workers can be time-consuming and costly, compounding the borrower’s financial distress.

Working capital concerns

Working capital is the difference between a company’s current assets and liabilities. Monitoring key turnover ratios can help gauge whether the company is managing its short-term assets and liabilities efficiently.

When accounts receivable turnover slows dramatically, it could signal weakened collection efforts, stale accounts or even fraud. For example, a company that’s desperate to boost revenue might solicit business with customers that have poor credit. Or one of a company’s major customers might be underperforming and it’s trickling down the supply chain.

Likewise, beware of deteriorating inventory turnover. Similar to receivables, a buildup of inventory on a borrower’s balance sheet could signal inefficient asset management. Certain product lines may be obsolete and require inventory write-offs. Or a new plant manager might overestimate the amount of buffer stock that’s needed in the warehouse. It might even forewarn of fraud or financial misstatement.

Changing market conditions 

External factors may affect a company’s financial performance, but the effects vary from company to company. For instance, some companies permanently closed when the economy shut down during the COVID-19 pandemic, while others pivoted and prospered.

Today, business performance may be adversely impacted by geopolitical pressures, rising interest rates, supply chain shortages and inflation. Stakeholders should continue to monitor financial results closely in these volatile conditions.

Extra assurance

When a company shows signs of financial distress, stakeholders should encourage management to supplement its year-end financial statements with interim reports or engage a CPA to perform targeted agreed-upon procedures. Doing so can help the company assess risk, identify problems and brainstorm corrective measures, if needed. Contact us for more information.

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What are the tax consequences of selling property used in your trade or business?

There are many rules that can potentially apply to the sale of business property. Thus, to simplify discussion, let’s assume that the property you want to sell is land or depreciable property used in your business, and has been held by you for more than a year. (There are different rules for property held primarily for sale to customers in the ordinary course of business; intellectual property; low-income housing; property that involves farming or livestock; and other types of property.)

General rules

Under the Internal Revenue Code, your gains and losses from sales of business property are netted against each other. The net gain or loss qualifies for tax treatment as follows:

1) If the netting of gains and losses results in a net gain, then long-term capital gain treatment results, subject to “recapture” rules discussed below. Long-term capital gain treatment is generally more favorable than ordinary income treatment.

2) If the netting of gains and losses results in a net loss, that loss is fully deductible against ordinary income (in other words, none of the rules that limit the deductibility of capital losses apply).

Recapture rules 

The availability of long-term capital gain treatment for business property net gain is limited by “recapture” rules — that is, rules under which amounts are treated as ordinary income rather than capital gain because of previous ordinary loss or deduction treatment for these amounts.

There’s a special recapture rule that applies only to business property. Under this rule, to the extent you’ve had a business property net loss within the previous five years, any business property net gain is treated as ordinary income instead of as long-term capital gain.

Section 1245 Property 

“Section 1245 Property” consists of all depreciable personal property, whether tangible or intangible, and certain depreciable real property (usually, real property that performs specific functions). If you sell Section 1245 Property, you must recapture your gain as ordinary income to the extent of your earlier depreciation deductions on the asset.

Section 1250 Property

“Section 1250 Property” consists, generally, of buildings and their structural components. If you sell Section 1250 Property that was placed in service after 1986, none of the long-term capital gain attributable to depreciation deductions will be subject to depreciation recapture. However, for most noncorporate taxpayers, the gain attributable to depreciation deductions, to the extent it doesn’t exceed business property net gain, will (as reduced by the business property recapture rule above) be taxed at a rate of no more than 28.8% (25% as adjusted for the 3.8% net investment income tax) rather than the maximum 23.8% rate (20% as adjusted for the 3.8% net investment income tax) that generally applies to long-term capital gains of noncorporate taxpayers.

Other rules may apply to Section 1250 Property, depending on when it was placed in service.

As you can see, even with the simplifying assumptions in this article, the tax treatment of the sale of business assets can be complex. Contact us if you’d like to determine the tax consequences of specific transactions or if you have any additional questions.

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Many companies have an internal audit department that tests whether the organization is accurately reporting financial results and complying with U.S. Generally Accepted Accounting Principles (GAAP). But it’s important for internal auditors to think beyond compliance.

Internal auditors who understand the big picture can expand their department’s influence by helping their organizations mitigate risk, improve financial and operational processes, and evaluate business strategies. Here’s how to get more from your internal audit team.

Expand the scope

The skill sets of internal auditors make the department ideally suited to participate in managing a broad range of risks, including:

• Operational,
• Strategic,
• Investment,
• Information technology (IT),
• Merger and acquisition (M&A),
• Foreign corruption, and
• Business continuity risks.

To maximize its value, the internal audit team should take a forward-looking approach. Individual auditors are well equipped to help identify and assess risks — and even help businesses anticipate and avoid obstacles before an adverse event occurs.

Use internal auditors like consultants

Your company should tap auditors’ expertise to evaluate and improve controls and ensure compliance before problems arise, instead of waiting for internal auditors to report possible control or compliance deficiencies. The department can also highlight ways for other functional areas — such as production, sales, HR, finance and procurement — to improve processes and eliminate waste and inefficiency.

Optimize technology

Advances in technology make it possible to greatly enhance the value of the internal audit function. For instance, continuous auditing is an automated approach that allows auditors to gather critical information and identify problems in real time. This is a dramatic improvement over the traditional approach, in which internal auditors test a limited number of samples and then report their findings after the fact. Likewise, data analytics and predictive modeling enable internal auditors to quickly spot anomalies and focus the team’s resources on high-risk areas.

Conduct quality assurance reviews

Businesses should conduct regular quality assessment reviews (QARs) of their internal audit departments. The Institute of Internal Auditors’ Code of Ethics requires Certified Internal Auditors to undergo a QAR at least once every five years. This oversight helps assess the department’s performance, competence and objectivity, allowing the company to quickly identify and remedy any issues.

Functional diversity is critical

Do your internal auditors have the skills and training necessary to meet the demands of today’s volatile, complex business world? Effective internal audit teams include people from a broad range of backgrounds, including those with IT, management consulting and engineering expertise.

If these skills are lacking in your internal audit team, your organization might need to hire some new auditors to infuse fresh ideas into the department — or you might consider “co-sourcing” with an external firm to help fill any internal skill gaps. Contact us for more information.

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